Written by Tim Munn, chief investment officer, Mayfair Capital
The investment market has thinned out in recent weeks, with investors opting to sit on their hands amid an increasingly uncertain economic outlook. Higher borrowing costs have narrowed prospective returns for leveraged buyers, and ultimately, investors do not want to overpay for assets that could suffer a drop in value by year end. However, in uncertain times, it is easy to become overly fearful and ignore the fundamentals.
Property pricing is determined by two components – rents and yields. In theory, the yield should provide an indication of the expected rental performance prospects of an investment. In my experience, this is not always the case. Rent, and the prospects for growth, is determined by the strength of occupational markets, including physical supply and tenant demand, while yields are predominantly determined by the weight of money in the market, the volume of investors bidding and competitive tension – rather than the perceived prospects of occupational markets.
There have been many past instances where rents and yields have been out of kilter, often for good reason. Real estate investors do not operate in a vacuum – they must be mindful of macroeconomic and financial conditions, as well as how property pricing sits relative to other asset classes.
Since the Global Financial Crisis (GFC), new development has been constrained. This, combined with a surge in post-Covid leasing activity, has left good quality commercial accommodation in short supply. Specifically, supply has shrunk significantly in the industrial sector and is at record lows in most regions of the UK, with overall supply equivalent to only one year of average annual take-up.
Office supply is more mixed, but there is a distinct shortage of Grade A space in London and large regional cities. The market dynamics in Manchester, Leeds and Bristol look particularly attractive. The tight supply of stock that is attractive to modern occupiers is being exacerbated by a narrowing definition of prime property, due to increasingly strict ESG requirements.
With construction activity anticipated to remain muted due to high build costs, the rental growth prospects for the best assets look assured. Available space and forecast completions are currently far lower in the office market than were seen prior to previous recessions. It is also worth noting total office stock has been shrinking since the GFC, but office employment has increased significantly, creating a degree of resilience against the fallout expected from post-Covid working patterns.
Reassuringly, despite mounting economic uncertainty, tenants are taking new space, buoyed by a strong employment market and consequent war for talent. However, they are almost exclusively focussed on best-in-class specification and amenity. Our rent collection levels are back to pre-pandemic levels, and despite the challenges of higher inflation, we have not seen signs of distress among tenants.
While it is easy to understand a cautious and patient approach to stock selection amid increased economic and market uncertainty, the sector’s strong occupational fundamentals should comfort long term investors. Given this, we feel any price correction will be short lived and the expected scale of reduction in pricing troubling many investors will not materialise – particularly for high quality assets. After all, the property market is far less leveraged than prior to the GFC, and there are far fewer daily traded retail funds susceptible to investor redemptions. We will not see the forced sellers we have in the past.
Investors should take a long-term approach to real estate, focussing on assets with robust fundamentals and a strong structural story. Assets aligned to structural trends will be most attractive to the occupiers of today and tomorrow, providing resilient income that will grow over time.