A change in the weather?

It’s been feeling quite gloomy in the UK – and in the property and development sector in particular – for some time. ?The economy has been flat, and productivity has been a concern, both of which have fed into the demand for buildings and property. But the inflation and the interest rate hikes of the past two years particularly hit investment and development, with debt and build costs rising massively.

Property and land pricing is notoriously sticky, as owners are slow to adapt to the new world (owing to a lack of transactional evidence, creating a vicious circle), may well believe things will get better in the future and owing to the unique characteristics of each piece of real estate, often believe their portfolio or property Is special and not subject to the fluctuations of the rest of the market. Given the lumpy and often quite public nature of property transactions – and the small size and somewhat incestuous nature of the industry – individual owners are also often, in my experience, very wary of appearing to have sold at the wrong time or for a low price. How could they show their face in their favourite Mayfair wine bar again? Larger owners, meanwhile, are fearful of crystallising prices given valuations so often lag (again, a result of the lack of transactional evidence).

But it does feel that the mood music has changed over the Summer. Firstly, of course, there has been good news on the economy since the start of the year; with 0.7% and 0.6% growth in Q1 and Q2 respectively. Recent monthly readings have been flat, but it’s misleading to read too much into individual months, and most forecasters expect the remainder of the year to see reasonable growth, if at a slower pace. This is feeding into improving retail sales figure – not yet stellar, but it does look like the consumer is well placed to help continue the pattern of growth over the medium term. (The risk here is accelerating rents; given that so many young people now rent, this is negatively impacting their ability to spend).

Falling inflation and, more recently, falling mortgage rates have also helped improve individual financial circumstances. But more important for large-scale real estate has been the impact of the changed tone from the Bank of England. A 25bp cut in the base rate does not mean a huge amount in the scheme of things, but what is clear is that there is more to come. We are now in a ‘cutting cycle’. The yield on 10-year UK government bonds (‘gilts’) has already fallen by 50bps (from c. 4.25% to c. 3.75%) since mid-July. The fall in this ‘risk free rate’ should make property look more attractive and begin to put some downward pressure on yields.

This isn’t just about financial and economic measures, though. It does feel as if what Keynes calls ‘animal spirits’ are returning to the market. He argued that psychological and emotional factors are more important in investment decisions than conventional economic thinking assumed. It feels to me as if more market actors are more confident – and there is hope (or should I say avarice) in the air. This will help both investment and development as the year continues.

Indeed, based on anecdotal evidence, there is already more stock under offer than has been seen for a while, and on the development side, the residential sector – in the doldrums for a while, with some of the lowest housing start figures ever seen at the start of the year – is also rumoured to be showing some life. Calling it a boom might be an exaggeration, but it certainly looks as if the market is hotting up; the start of a new cycle, perhaps.

There are a couple of issues, though. There is still a huge scepticism around the office market. Retail has rebased but the number of viable assets (and pricing) is lower now than two decades ago – although retail warehousing appears to be continuing its strong run. Industrial remains hugely popular but transactions are limited by the fact that few parties want to sell. In-demand areas like data centres and life sciences are hugely promising but comparatively small. Indeed, the recent increase in volumes – seen in Q2 – has been the result of activity in two sectors, residential and hotels (and mainly residential at that). Given wider tailwinds and government policy, this sector must surely be the one that continues to drive the recovery. On the other hand, there is the question of where the money will come from. With many domestic pension fund players looking to exit, and international capital expecting high returns, there does appear to be a gap.

The financial – and political – situation is also likely to remain volatile. There are many events that could upset the downward trend in yields, from the selling off of the gilt pile built up during QE, or another energy shock pushing up inflation; after all, it’s not as if the Middle East is entirely stable right now. The US election (and the potential for more protectionist policies) and concerns over an American economic slowdown, are also things to watch. Keynes’ animal spirits included fear, pessimism and uncertainty.

Nevertheless, it does feel like there has been a change of weather; Spring has arrived, if a slightly unsettled one.

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