Considering sustainability factors as a component of proper investing appears to me both necessary and unobjectionable. This applies to both ESG integration into investment decisions as well as active ownership.
09/01/2022
Considering sustainability factors as a component of proper investing appears to me both necessary and unobjectionable. This applies to both ESG integration into investment decisions as well as active ownership.
UK commercial real estate is facing 1970s-level inflation, but does it face the same boom and bust it did over 50 years ago?
08/31/2022
UK commercial real estate is facing 1970s-level inflation, but does it face the same boom and bust it did over 50 years ago?
08/31/2022
Nick Montgomery
Head of UK Real Estate Investment
Mark Callender
Head of Real Estate Research
In the last few months, the UK has echoed the 1970s in a surprising number of ways. Some fun, many less so.
On the cultural front, ABBA has reformed (at least virtually). Flared jeans are back in fashion.
Unfortunately, inflation has also surged, driven in part by war in Ukraine and a jump in oil and gas prices. Workers are striking for higher wages. The Bank of England is raising interest rates and there are fears that the economy could tip into recession.
Real estate investors may recall the 1970s as a dramatic period of boom and bust, and some are asking if we about to see a repeat performance. We don’t think so.
Overall, UK real estate carries less debt, is more transparent and its investor base broader than the 1970s, while construction activity in recent years has been less intense. As such, while we do expect real estate to face some headwinds, we do not expect the storm faced 50 years ago.
Taken as a whole, the 1970s was not a bad decade for UK real estate.
Inflation as measured by the retail prices index (RPI)1 averaged 13.8% per annum (p.a.) between 1970 and1980. UK real estate total returns averaged 16.3% p.a.2. While commodities proved to be a better hedge against inflation, real estate returns were above inflation and stronger than both UK equities and bonds with total returns of 14.2% p.a. and 10.2% p.a., respectively3
However, strong performance at the start and end of the decade sandwiched a major downturn in the middle.
Real estate returns averaged 24.4% p.a. over the three years to end-1973. This amounted to 14.1% p.a. in real terms (adjusted for inflation). The real estate market returned 23.0% p.a. over the four years to end-1980 (8.7% p.a. in real terms).
By contrast, real estate total returns dropped to 0.8% p.a. over the three year to end-1976. This is equivalent to -15.7% p.a. in real terms.
The strong performance at the start of the 1970s was driven primarily by rapid economic growth, the so-called “Barber boom”. The Barber boom refers to a series of policies introduced by then chancellor of the exchequer Anthony Barber that sought a “dash for growth”. The policies centred on aggressive fiscal policy, primarily various tax cuts, aiming to deliver a rapid period of economic growth.
At first it worked. Initially, the Barber boom lifted occupier demand and rents. However, the economy went into recession in 1974-1975. Oil prices rose fourfold. A miners strike interrupted coal and electricity supplies. The Bank of England (BoE) doubled the minimum lending rate (a forerunner of base rate) from 7.5% in June 1973 to 15% in October 1976. 10-year government bond yields jumped from 11% in 1973 to 17% in 1974, before settling at 15% in 1975-76.
The hike in interest rates impacted real estate capital values and returns in two ways.
The second period of strong returns was initially fuelled by a fall in real estate yields through 1977-78, as interest rates fell and the economic outlook improved. Rental growth then took over the running in 1979, although it began to slow in 1980 when the economy went back into recession.
Facing very high inflation, rising interest rates and a high risk of recession, should investors expect a repeat of the 1974 crash?
Capital values fell in 1974 fell in real terms by 33%. If we assume inflation over the next 12 months will average 8-10%, that would equate to a fall in capital values of 25-30%.
Is that about to happen?
Clearly, there are many more factors at play. A lot will depend upon the state of the economy and by how much the BoE believes it needs to raise interest rates to bring inflation under control.
We expect that the BoE will raise base rate to 3% by early 2023 and then keep it on hold. We expect 10-year bond yields will also rise to 3%. This in turn assumes that the UK avoids a repeat of the wage-price spiral seen in the 1970s when average earnings grew by 16% p.a., so that high inflation became self perpetuating.
There are also number of key differences between today’s real estate market and that of the 1970s. Here’s a quick breakdown.
Source: Schroders Capital
The factors above were broadly supportive for the stability of 1970s property.
The technology factor is relevant because in the analogue 1970s, demand for space moved in line with the economy. Online sales were not around to reduce retail space needs. Remote working did not exist to undermine office requirements. Both of these features were positive for real estate values and returns in the 1970s. But other differences added to volatility and made the real estate market more prone to large swings in capital values.
Real estate investors in the first half of 1970s were more reliant upon debt, so there was a greater risk of a downward spiral of falling prices and forced sales. In 1975 commercial real estate accounted for 13% of total bank lending, compared with 9% today5. The jump in interest rates and rise in vacancy between 1973-76 bankrupted many property companies. The BoE put pressure on UK insurance and pension funds to buy real estate in order to protect the big retail banks from the collapse of secondary banks. The more disciplined approach of banks and other lenders over the last decade reflects the tightening of financial regulations since the Global Financial Crisis (GFC).
In part because of this more disciplined approach from lenders, the last decade has seen much lower levels of speculative development than 50 years ago. In the 1970s total office floorspace in central London grew by around 10% and the amount of shopping centre space doubled. Over the last 10 years the total amount of central London office and shopping centre space has increased by just 1% and 8%, respectively. There is therefore much less risk now that the impact on rents of a recession from falling occupier demand will be compounded by a swathe of new space arriving on the market at the wrong time.
In the 1970s exchange controls meant that the UK market was dominated by domestic investors. International investors now own approximately 30% of UK commercial real estate6. The wide range of investors, with different time horizons and costs of capital, means that the investment market is inherently more liquid. Capital can respond more quickly if prices look detached from underlying value.
In light of these differences in market structure and assuming that UK 10-year government bond yields peak at 3%, we believe that a repeat of the 1974 crash is unlikely. That said, we believe all property capital values could fall by around 10-20% between end-2021 and end-2023.
Most of the decline will be due to an increase in the all property equivalent yield, in response to more muted interest rate increases. While it is possible in some segments (see below) that rental growth will accelerate in response to higher inflation, we expect that rental values on average will be flat.
That would leave total returns between zero and -5% in 2022 and 2023 or between -8% and -13% in real terms. Looking further ahead, we expect that total returns would then settle at 6-8% p.a. through 2024-2026, assuming real estate yields find a new equilibrium level and rental growth resumes as the economy gains momentum.
It is unlikely that any part of the market will completely escape the downturn.
We would expect to see a more limited rise in yields and smaller fall in capital values where there are good demand and supply dynamics and/or the landlord’s income is aligned with the success of the businesses. Where a landlord’s income is “operationally aligned”, higher inflation is more likely to feed through to rental income.
Generally the real estate market has broadened significantly since the 1970s, which means investors have more choice across sectors and exposures, each with its own dynamic.
Certain niche sectors are also gaining from long-term structural changes to make them more defensive. These include laboratories, self storage, social supported housing and student halls. The jump in construction costs and tightening in bank loan terms is likely to depress prices for land and re-development projects, limiting additional supply to these sectors and further supporting rental growth.
Rents in segments with weak demand and supply fundamentals are unlikely to enjoy a slipstream effect from higher inflation.
We do not favour any building with poor energy efficiency and general lack of higher-rated tenant amenities. We are also cautious on distribution warehouses. It is the one part of the market which has seen significant new building over the last three years and non-food retailers account for around a third of space. In the short term consumers are likely to cut back online, as well as in-store.
It is sometimes argued that prime assets are more vulnerable to an increase in yields, because prime yields start from a lower level. However, that assumes that prime and secondary yields rise in parallel. In previous downturns the gap between prime and secondary yields has widened as investors have become more risk averse. Furthermore, prime assets are less likely to suffer an increase in vacancy and fall in operating income. That was the main reason why prime out-performed secondary assets in both the early 1990s downturn and again during the GFC.
One area which investors should consider is UK real estate debt. There has been a gap in the finance market since the GFC as banks have cut back on loans with higher LTVs (i.e. > 60%). While the slowdown in the economy could lead to more defaults, the risk can been mitigated by careful underwriting and focusing on assets with good bricks & mortar fundamentals managed by experienced operators. The forecast rise in interest rates will add further to returns.
The current downturn is unlikely to be on the same scale as 1974.
Although inflation and interest rates are rising, they are still low by 1970s standards. Overall there is a lower level of debt and new building now compared with the 1970s, so real estate is better placed to withstand a recession. The UK investment market is also much more international, transparent and diversified.
We think the decline in capital values over the two years to end-2023 will be limited to 10-20%. Prime assets, segments with good demand and supply dynamics and assets where the landlord’s income is aligned with the success of the tenant will be more defensive. History may rhyme, but it shouldn’t exactly repeat.
1. Schroders estimate. MSCI UK equivalent yield data begin in 1976.↩
2. The more accurate consumer price index (CPI) measure of inflation does not start until 1988.↩
3. MSCI UK Annual Real Estate Index↩
4. Barclays Equity & Gilt Study↩
5. It is not possible to calculate an aggregate LTV ratio, because there are no data on the total value of commercial real estate in the 1970’s. Similarly, there are no data on ICRs in the 1970s. However, changes in the percentage of total outstanding bank debt owed by real estate investors provide a reasonable proxy for lending policies. The data quoted in the article and shown in Figure 2 include CMBS and non-bank lenders.↩
6. The Size and Structure of the UK Commercial Real Estate Market: End-2020” Investment Property Forum. January 2022↩
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.
02/25/2022
Snapshot
08/12/2022
Snapshot
05/05/2022
Schroders is a world-class asset manager operating from 38 locations across Europe, the Americas, Asia and the Middle East.
For any further questions, please contact us.
For Press inquiries or any media relations questions, please contact us.
Please consider a fund’s investment objectives, risks, charges and expenses carefully before investing. The Schroder mutual funds (the “Funds”) are distributed by The Hartford Funds, a member of FINRA. To obtain product risk and other information on any Schroders Fund, please click the following link. Read the prospectus carefully before investing. To obtain any further information call your financial advisor or call The Hartford Funds at 1-800-456-7526 for Individual Investors. The Hartford Funds is not an affiliate of Schroders plc.
Schroder Investment Management North America Inc. (“SIMNA”) is an SEC registered investment adviser providing asset management products and services to clients in the US and Canada. Schroder Fund Advisors LLC (“SFA”) is a wholly-owned subsidiary of SIMNA Inc. and is registered as a limited purpose broker-dealer with FINRA and markets certain investment vehicles for which for which another Schroders entity is an investment adviser. SIMNA and SFA are wholly owned subsidiaries of Schroders plc.
Schroder Adveq, Schroder Secquaero and other Schroders private equity advisors have been rebranded as Schroders Capital. Schroders Capital will be the private markets investment division of Schroders plc. Schroders Capital US Inc. (“Schroders Capital US” or “Schroders Capital” herein) is registered as an investment adviser with the SEC. It provides asset management products and services to clients in the United States and Canada.
Schroder Secquaero (formerly Secquaero Advisors AG) is Zurich-based and provides non-discretionary advice to certain strategies, including Insurance-linked securities, marketed in North America.
Schroder Adveq and Schroder Secquaero, currently known as Schroders Capital, are wholly-owned subsidiary of Schroders plc. For more information, visit www.schroderscapital.com
© Copyright 2022 Schroder Investment Management North America Inc.
© Copyright 2022 Schroders plc
Restricted to Financial professionals, Institutional investors and consultants only.
By clicking continue you are representing that you 1) agree and meet the definition of a “financial professional” (including, but not limited to, registered representatives and those governed in accordance with the Investment Advisers Act of 1940) and that you 2) acknowledge your agreement with, and understanding of, the following Terms of Use and any legal information concerning this website. If you do not agree to the terms and conditions below, do not access this website or any pages thereof. Please read these terms and conditions carefully.
Schroders uses cookies to personalise and improve your site experience. You can accept all cookies by selecting ‘I agree’ and continuing to browse the site or you can “Manage cookies” to apply only the categories of your choosing. Find out more details on how we use your information in our “Cookie Policy”
Disclaimer
The content herein is intended for a more sophisticated investor audience, and may not be suitable for retail investors or general public. Retail investors should visit www.schroderfunds.com or speak with their financial representative. The material on this website is issued by Schroder Investment Management North America Inc. (“SIMNA Inc.”) and contains the views and opinions of the particular individuals and is for general information only and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. Reliance should not be placed on the views and information herein when taking individual investment and/or strategic decisions. Investment strategies discussed in this website may not be available in every jurisdiction or may only be available only in institutional vehicles.
All queries about specific investment products should be directed to the Schroders office in the jurisdiction where you reside.
SIMNA Inc. is an investment advisor registered with the US SEC, and is registered in Canada in the capacity of Portfolio Manager with the Securities Commission in Alberta, British Columbia, Manitoba, Nova Scotia, Ontario, Quebec, and Saskatchewan providing asset management products and services to clients in Canada. This document does not purport to provide investment advice and the information contained in this newsletter is for informational purposes and not to engage in a trading activities. It does not purport to describe the business or affairs of any issuer and is not being provided for delivery to or review by any prospective purchaser so as to assist the prospective purchaser to make an investment decision in respect of securities being sold in a distribution. SIMNA Inc. is an indirect wholly owned subsidiary of Schroders plc, a UK-based company.
About Author
