Trying to understand the state of the UK listed commercial real estate investment market seems to get more complicated by the day.

The most recent boom in UK commercial property markets can be directly traced back to the QE programmes following the GFC of 2007/08.  Ultra-low interest rates made property an obvious target for investors looking to arbitrage the yield spread over UK Gilts. This benign investment environment continued until 2021 when inflationary pressures forced central banks to raise interest rates.

The resulting spike in UK interest rates from late 2021 onwards caused a subsequent collapse in market activity and a sharp yield correction in some sectors. In short, when the yield spread over “risk free” government bonds disappeared, so did the investors.

By summer 2023, we saw the first green shoots of a recovery. As often happens, it began in the listed sector as several vehicles were taken private and rumours circulated of pending mergers in the UK REIT market. Looking back, Blackstone’s acquisition of Industrials REIT proved something of a bellwether deal and in 2024 we’ve seen M&A deals come to fruition with the Tritax/UKCM merger, the acquisition of LXi by LondonMetric and New River’s recent purchase of Capital & Regional.

Post summer 2024 the sector received more good news in the form of the Bank of England cutting interest rates and promising further reductions in 2025. We also saw all the UK MSCI UK monthly indices, which are valuation based indices that track commercial real estate property level performance, turn positive for the first time in two years.

Underlying financial results for the listed sector in H2 2024 seem to have reflected this change in market sentiment and have been broadly positive across the major UK REITS. Values appear to have stabilised in most sectors and dividend yields remain attractive for the larger listed property stocks at 5.0% to 7.0%.

By way of a case study, a quick look at the recent results for LondonMetric were very positive with earnings per share up 26.5% on the back of careful cost controls and a 17.5% uplift in rental values for H1. By focusing on active asset management and careful underwriting they have created a well-diversified recurring revenue stream which has an INCANS® Equivalent Bond Default Risk rating of BBB-. At that level of default risk and with a stable outlook for property values, the recent dividend yield of 6.1% looked attractive. Looking forward, the 12p dividend in their latest results should drive the anticipated dividend yield to c6.7%. This would represent a yield premium of almost 210 bps over UK 10-year Gilts and c120bps over US BBB Corporate bond yields.

In short, we’d expect to see significant investor activity in the UK REIT sector, but it has been curiously subdued.

Since the start of the year the FTSE 350 Real Estate Investment Trust index is down almost 10% and much of that downturn has happened since mid-September just as the macro indicators for the sector all turned green. So, what’s going on?

Having spoken to several senior figures in the UK REIT industry in recent weeks there appears to be a mixture of structural and macro-economic themes holding back investors.

• Liquidity Constraints – investors have more faith in the strength of US financial markets and their capacity to keep outperforming all other economies. Global investors are committing more capital to a single country than ever before.  The US stock market dominates over everywhere else. Relative prices are at their highest since data began over a century ago and relative valuations are at a50 year peak. This has resulted in the US accounting for nearly 70 per cent of the leading global stock index, up from 30 per cent in the 1980s (Source FT Dec 2024).  It appears that investors believe that this gap between the US and rest of the world is justified by the earnings power of top US companies and their leading role in tech innovation. Investors seem happier buying the future and following the herd.
• Market Scale – the market cap of most UK REITS is simply too small for many institutional investors. They will normally have a minimum lot size in terms of investment and with smaller companies this can lead to investors owning a disproportionately large % of the stock. This is turn creates concentration risk for the investors and can ultimately create liquidity issues on exit. Consensus seems to be that to get attention from institutional investors UK REITS need to reach a market cap of c£4.0bn. This may help explain the recent spate of mergers as companies look to scale up while asset values remain relatively cheap.  As it stands only a handful of UK REITS fall into this bracket – namely SEGRO (£9.7bn), Land Securities (£4.3bn), Unite Group (£4.1bn), LondonMetric (£3.7bn) and British Land (£3.7bn).
• Interest Rate cuts – on the face of it the recent cuts in interest rates should have helped the UK property sector.   In August we saw the BoE cut rates by 25bps and in November we saw a further reduction of another 25bps. Again, consensus appears to be that markets has originally priced a sharper reduction in rates and the BoE’s recent talk of a slower taper has cooled expectations. Having said that, we have now been told by the BoE to expect 2 or 3 cuts in 2025 so while it may be slower than first anticipated the direction of travel is firmly downwards.
• Inflation: Higher for longer? – international political instability, increased trade friction and the rise of protectionist governments in the US and some European countries has raised the possibility of another spike in inflation. This in turn would put pressure on central banks to raise rates and heighten the risk of a rise in 10 yr government bond yields. Such a scenario would have a negative impact on UK property values but as yet it’s unclear how serious the threat of a US / China / EU tariff war actually is.

Taking a step back there appears to be quite a big disconnect here. Underlying market fundamentals remain positive across much of the UK commercial property sector and most UK REITS only carry moderate leverage. Perhaps investors remain cautious of further correction in capital values? However, the evidence on the ground would seem to contradict this with all MSCI UK commercial real estate capital growth indices now in positive territory.

Liquidity and scale issues are structural problems that are a little more difficult to address but perhaps the bigger issue here is that “old stocks” like property are simply out of fashion despite offering steady and replaceable income streams. Buying the future in US tech stocks has captured the imagination of the herd for now.

Either way, it cannot be coincidental that the major private equity groups (viz Blackstone, Brookfield, KKR and ARES amongst others) are all very active in the UK commercial real estate space. Their strong track record in previous cycles would indicate that a countercyclical play in UK property market may look smart right now. Especially if you are looking for relatively secure and replaceable cashflows. Analysis by Income Analytics suggests the average portfolio of institutional grade income producing real estate has an Equivalent Bond Default Risk rating of BBB- or better.

Perhaps one lesson from all of this is that weight of capital is the primary driver for UK commercial real estate rather than old fashioned demand/supply fundamentals. This is understandable as real estate becomes more integrated into the broader financial markets and competes for attention with opportunities in equity and debt markets.

Either way this points to a demand for greater transparency and a more careful analysis of the real underlying value in property – i.e. the cashflow. Real estate investors need to get better at promoting the long-term durability of property income streams in order to attract liability-driven investor allocations back to the market.