As the UK interest rate cycle shows signs of reversing and fears of a US recession subside, sectors hit hardest by rising interest rates, such as UK commercial property, are beginning to attract renewed attention from investors.
Over the past year, UK commercial property has faced significant challenges. The sector saw a decline of 14.8% in 2022, failed to recover in 2023, and continued its downward trend with a 3.9% drop in 2024. The sector has struggled not only with rising interest rates but also with economic uncertainty and structural changes, including the rise of home-working and e-commerce.
Despite these setbacks, there appears to be untapped value within the sector. Many properties are trading at considerable discounts to their net asset value, with figures like a 19% discount for Custodian Property Income and a 23% discount for the Schroder Real Estate Investment Trust. Even the TR Property Trust, which typically trades near its net asset value, is currently at a 6% discount.
Ben Mackie, senior fund manager at Hawksmoor, suggests that UK commercial property could be a significant beneficiary of falling interest rates. He notes that property companies often carry higher levels of debt, typically on floating terms. As rates decrease, the cost of this debt drops, improving valuations for these companies.
There are also positive signals from within the industry. Hammerson, one of the UK’s largest retail landlords, reported its first increase in rent expectations since 2017. Similarly, Mark Allan, CEO of Land Securities, expressed optimism about the market for high-quality UK commercial property, noting that the macroeconomic environment has become more favourable and that the value of prime assets has likely bottomed out, with potential growth on the horizon as rents rise.
The RICS Commercial Property Monitor for Q2 2024 indicated that the sector might be at the bottom of its cycle or beginning an upturn. With 34% of respondents believing the market has bottomed out and 41% sensing the early stages of recovery, there is particular strength in areas like the London office market and the prime industrial sector.
July brought some positive momentum, with the FTSE EPRA NAREIT UK Index returning 3.5%, outperforming the FTSE All Share and UK Gilts. Capital values saw a modest rise, with the CBRE Monthly Index recording a 0.2% increase in June, marking the second consecutive month of positive movement.
However, the sector remains cautious. Despite some re-rating, all property investment companies ended the month trading at a discount to NAV, with an average discount of 27%. The correlation between property trust discounts and UK gilt yields remains strong, with the sector’s re-rating corresponding to a decline in gilt yields.
There is potential for further reductions in gilt yields, especially if interest rates continue to fall. This could lead to higher valuations for UK commercial property. Moreover, the current significant discounts suggest that investors remain wary of potential revaluations in the sector. As interest rates decline, valuations may stabilise, potentially boosting investor confidence.
The road to recovery for UK commercial property may not be smooth, with some areas, like regional offices, still facing challenges. Additionally, the recent failure to launch a ‘Special Opportunities’ REIT, aimed at capitalising on distressed property sales, underscores the cautious sentiment among investors.
Furthermore, the sector faces long-term challenges, such as the need for costly upgrades to meet environmental standards, which could dampen progress.
Nevertheless, there are reasons for optimism. After a period of significant consolidation, the sector may offer better value for investors, and falling interest rates could be the catalyst for a change in sentiment. Investors who have been patient may finally start to see the rewards of their perseverance.
While challenges remain, the outlook for UK commercial property is beginning to brighten, with falling interest rates providing a potential boost to the sector’s recovery.
Real Estate Credit Investments Limited (LON:RECI) is a closed-end investment company that specialises in European real estate credit markets. Their primary objective is to provide attractive and stable returns to their shareholders, mainly in the form of quarterly dividends, by exposing them to a diversified portfolio of real estate credit investments.
