Back in (the) Black
30 March 2023
In my last column I started with the song ‘What a Difference a Day Makes’, and in keeping with the musical theme, the soundtrack to this column is ‘Back in Black’ by AC/DC. I have chosen this song as we are in the midst of a market shift. Borrowing rates have skyrocketed and are outpacing property returns, and in turn, it’s now much harder to purchase commercial real estate when you need to borrow money to support the purchase. So, the question is when will property be Back In (the) Black?!
The Rising Price of Debt
As we have all heard on the news and felt at the shop tills, prices have been rising in almost all areas, but especially the price of food and fuel. The Bank of England has reacted to above-trend inflation by raising interest rates and this has affected all areas of the economy however as with all policy decisions there’s a delayed effect here and the impacts will get more deleterious even after the interest rate cycle has peaked, given how borrowers often take fixed interest rate products. The MPC has to operate with a view typically two years ahead.
Normally we expect markets to be correlated. In saying this I mean that as the cost of borrowing goes up, the value of real estate (and most other assets) fall. Property investors focus on a property’s yield. This is the level of return (typically rent divided by the value of the property). The low cost of debt post-Brexit and during COVID triggered a material increase in real estate values. When you were getting 0.1%pa interest on your savings a property yielding 3.5%pa seemed very good value. Fast forward to today though and you can get over 4%pa on your savings which are easy to access and well protected by the Government (through the FSCS scheme), so why would you accept a lower return for property which is large, bulky and far less liquid?
This graph shows the total cost of borrowing over time, comprised of the reference rate (SONIA), the average margin and a lender’s typical arrangement fee. As you can see, over the last 36 months the cost of borrowing has doubled. So, as noted above, we should normally expect the value of real estate to correspondingly fall, however, the overall drop in property values has not been as large as the increased cost of borrowing would imply.
For comparison purposes, Quarter 4 2022 was a record for commercial property in terms of outward yield shift and negative yield impact (falling prices) – greater than the Global Financial Crisis even. However, the negative impact was relatively short-lived and for some prime assets, yields are in fact starting to fall again (increased pricing). Overall then, pricing hasn’t dropped as much as it “should”, given the increase in borrowing costs.
In part this is because the increase in the cost of borrowing took an unprecedentedly sharp step up (notably after the mini budget in late September) and has thus presented the market with a range of investors with different borrowing costs – not everyone is borrowing at the new rate and other buyers aren’t borrowing at all. Such a big market shock needs a certain amount of time to adjust from one equilibrium to another.
Property Values
Whilst lots of people talk about ‘The Property Market’, it is not a single market, but rather one comprised of several different segments, each with its own structural headwinds or tailwinds. Each of these segments reacts differently to external market forces, be it industrial/distribution, offices, residential, retail, hotels, and many others.
Post the Kwasi Kwarteng disastrous mini budget in the autumn of 2022, we saw a rapid correction in property values. Industrial property, which had been the hottest asset class over the past few years, fell by 13%, offices by 9% and retail assets by 8% in the final quarter of 2022. But even this is hugely generalised, given these average figures cover all types of properties in each segment, and mask wide variation in quality, availability, and occupier demand.
This graph shows a broad range of asset classes and locations with the black line showing the total return (income return plus capital growth) from January 2022 to January 2023. You will note all the asset classes and locations show a negative total return.
So, What’s the Story?
We have spoken about two key elements:
- The rising cost of debt; and
- The falling value of property.
We spoke about correlated events earlier and the rising cost of debt has indeed caused a fall in property values, which is as it should be. However, the fall in value and the increased cost of debt have not fallen (or risen) at the same rate as they have in the past and this would suggest that, technically, property could have further to fall.
The increase in debt costs caused a narrowing of the spread of different property segment yields at the back end of 2022. Lower-yielding assets that tend to be more transparent and liquid (i.e.prime industrial) repriced more quickly. However, pricing on more secondary and thinly traded assets was less obvious and was stickier. Now in early 2023 the SONIA forward curve suggests a much lower peak in Base rates than previously expected. It’s now around 4.5%, compared with an expectation of around 6.5% after the mini-budget. Thus prime assets probably overcorrected and are now ‘bouncing back’ a little, while secondary assets probably still have a bit further go to re-establish their appropriate segment relativities.
Debt should have two positive factors.
- It reduces the level of equity you require; and
- It enhances your overall return.
But these factors only work when debt costs are lower than the yield on your property. If the cost of your debt is say, 5%, but your property yield is 10% it’s clear that debt is helpful. We now however find ourselves in a world where debt costs are closer to, say, 7% and property yields are, say, 6%, so debt is actually working against you as it costs more to service your loan than you can expect to earn. Now this does hugely simplify the issue obviously, as you may have rent increases due (increased income) or you may be able to develop or create additional space (increased rental ability). But for an asset without those options, debt no longer works, and property prices aren’t currently falling sufficiently to make debt a viable option. So, why is this?
The Cash Buyer Market
Large real estate investors tend to be specialist, sector-driven funds, such as insurance companies or pension funds, that generally require long-term income and asset backing. In short, these cash-rich investors aren’t focused on borrowing as they have large cash balances available to deploy. For these specialist funds, even a 5 - 6% return is still more attractive than sitting on cash, especially given the possibility of distressed and over-leveraged buyers being forced to sell. In general, these investors are content to sit on the sidelines and pick up prime assets at what they see as ‘knockdown’ prices. However, this will produce a two-tier market.
Prime assets will be snapped up by these cash-rich investors, but secondary assets (including older stock in need of refurbishment, buildings in non-prime locations or those with poor EPC ratings) will be less desirable and could see prices continue to fall to the point where leverage makes sense again. So, for instance, offices in out-of-town locations or with weak redevelopment/refurbishment potential, or retail assets outside ‘prime pitches’, are still likely to face downward pricing pressure.
This trend is likely to be compounded by the impending MEES regulations covering the EPC ratings of buildings. For some assets this will require significant capital expenditure, which in turn will need to be reflected in property valuations. As per the current legislation, any properties with a rating of F or G will not be MEES compliant after April 2023. Five years later by April 2027 this will include D or E rated properties, and this extends to EPC grade C by 2030 when only the top-rated EPC grade A or B properties will be acceptable. Consequently, buyers of older buildings will need to factor in what may be significant costs to bring a building within the guidelines, and this may mean old properties become and remain empty – but this is a whole other subject which we will cover at a later date!
