While I have been more wrong on the forward trajectory for interest rates over the last decade than anything else, it finally appears that the long-expected normalisation of base rates is underway. The economic rationale for this at a time of high imported inflation and a slowing economy might be challenging, but the time has definitely come to question whether record low yields in some UK real estate sectors can continue to be paid when debt and other costs are rising.

The first point to be made is that not every investor borrows to finance their acquisitions, and the next few months or even years will be a great time for these buyers.

For those who rely on debt to some degree, the challenge will be what do you tweak in your appraisal to win the deal. The obvious answer is to take a lower return, but with value-add investors now taking core plus returns, the flex here might not be enough to compensate for the rising cost of debt, or the higher costs of refurbishment.

The next, and very typical option, is to push up forward rental growth expectations. This is definitely possible when you are looking at offices that are prime and green, or logistics more generally. However, there are occupational and other challenges in both sectors that suggest that being over-optimistic on rental growth could be a problem for the future.

Past cycles have shown us that there comes a point when taking lower returns or assuming higher rental growth prospects only supports pricing for so long; a period when the definition of prime gets thinner and thinner. Then comes the moment when secondary yields start to rise, and eventually the same happens to prime.

While we aren’t quite at that stage yet, indeed our latest Market in Minutes shows that the majority of prime sectors are experiencing downward pressure on yields, I do expect that price slippage will become a more common theme over this summer.

This will by no means be a turning point for the market, but more a correction where assets were perhaps already over-priced. There will be some segments such as retail where capital values move in the opposite direction, or others such as green offices where the undersupply continues to deliver strong rental growth. However, overall I expect the next six months to see lower than expected transactional volumes while vendors and purchasers take stock of the new environment. After that we should see a surge in activity where assets are newly right-priced and purchasers are once again comfortable with the outlook.

Further information

Contact Mat Oakley

Spotlight: Savills Global Capital Markets Quarterly – Q1 2022