It is clear that we have entered 2022 in a period of uncertainty, as geopolitical concerns weigh on the global economy. Whilst it appears we have now passed the worst of the COVID-19 pandemic, the outbreak of conflict in Ukraine in February 2022 has sent shockwaves throughout the world. Whilst the conflict has not materially altered our outlook for UK real estate in 2022, new considerations have emerged as a result. The initial impacts on UK commercial real estate of the Russian invasion of Ukraine, and the subsequent sanctions placed on the Russian economy, are expected to be negligible, primarily as a result of Russian capital having little exposure to UK commercial real estate. This should mean there is a limited impact on market liquidity and a low risk of depressed asset values as a result. In fact, due to increased volatility in other financial markets, UK real estate may benefit due to being viewed as a ‘safe haven’ investment destination. However, the Ukraine conflict is likely to have wider consequences and the position of UK real estate must be set in the context of the macroeconomic environment. Prior to the outbreak of conflict, the year was already likely to be dominated by concerns over inflation and subsequent changes to monetary policy, and the conflict has skewed risks to the upside. The rate of inflation reached 6.2% in February and is likely to continue to grow throughout the first half of 2022, before peaking at around 8% as rising energy prices and supply chain issues take hold.
We forecast that the UK CPI rate for 2022 will be roughly 6.2%, illustrating that inflationary pressures are likely to moderate in the latter half of the year, but remain significantly above the Bank of England’s target rate. There are also significant risks that inflation could remain higher for a more prolonged period of time, particularly as the war in Ukraine, and sanction measures on the Russian economy, impact on pricing in the energy sector and on key raw materials. The high inflation environment is likely to have an effect on households across the UK and we expect consumer sentiment and real wage growth to suffer as a result; however, a build-up in household savings over the course of the previous two years will help to cushion this impact. That said, the distribution of these savings tends to be very heavily skewed towards high income households, with increased pressure on low income households possibly translating to weakening overall consumer consumption. In response to these inflationary factors, the Bank of England increased the base rate to 0.75% in March 2022 and is expected to continue tightening monetary policy over the course of the year, with the base rate expected to reach 1.25% by the end of 2022. The base rate is then expected to peak at 1.75% in 2023, but there is an elevated risk that this could surprise the upside and peak above 2.00%. Although low in a historical context, base rates and the feed through to the bond market has the potential to act as a natural cap on any further yield compression, particularly for the lower yielding areas of the real estate market. Despite this, a healthy margin between bonds and real estate will be maintained, and we believe investors will continue to view UK real estate as an attractive investment destination, but will become more selective when approaching investment decisions at both the sector and asset level. There are sectors which are more negatively exposed to the cost-push inflation we are experiencing in the UK at present, in particular the retail sector, given the increasing squeeze on household disposable incomes. There is also evidence to suggest that material cost inflation in the UK is resulting in the delay of some development projects. This could be viewed as negative, but for some sectors this may be beneficial. In the industrial and logistics sector, for example, national vacancy is approximately 3% and project delays are likely to stifle any supply response, supporting continued rental growth.
In general, UK commercial real estate has a much looser link with inflation and a much stronger correlation with economic growth. Although we are experiencing elevated levels of inflation at present as a result of cost-push factors, we do expect inflation to subside from April 2022 onwards, but remain significantly above the target rate. Prior to the Russian invasion of Ukraine, GDP growth was forecast to be closer to 4.4% in 2022 but we now expect the rate of economic growth to slow to 3.8% for the year. This leads to the possibility that we face an environment of weakening economic growth at a time when inflation is running considerably above target. Such an environment is likely to impact more heavily on, particularly, the office and retail sectors as a result of depressed job growth and falling disposable incomes. As such, the bifurcation of the office sector is likely to become more pronounced. Demand for prime assets should remain robust but weaken for secondary accommodation. Those office assets not deemed to be “future fit” are likely to see limited occupational and investor demand as ESG considerations become ever more prominent in investor decision making. The industrial and logistics market is anticipated to remain robust in 2022 but unlikely to match the extremely strong performance achieved over the course of 2021. The prospect of further yield compression, particularly on prime assets, is limited and rental growth is expected to be the main driver of performance in this sector. Demand continues to outstrip supply and, although there has been a pickup in supply in the sector, increasing land values, a shortage of suitable development sites, and increasing build costs mean there are no signs of a correction in the short term. We still expect the recovery in the retail sector to continue, primarily driven by market factors rather than sector specific confidence. Demand will remain focused on discount and food-led retail warehouse schemes whilst the occupational market will continue to be heavily impacted by the pandemic-induced change in consumer habits and the continued growth of e-commerce. As discussed, the impact of inflation on household disposable incomes is also likely to weigh heavily on the retail sector, and particularly on discretionary-based retailers, throughout the course of 2022 and the prospect of rental value growth remains remote. The alternatives sector will build on strong transactional volumes achieved in 2021 and will grow more prominent in investor focus. We expect the hotel sector to recover over the course of 2022 as restrictions ease. The PBSA and Build-to-Rent residential sectors should also continue their positive momentum.
Overall, we expect a positive year for UK real estate but the spread in performance seen in 2021 is unlikely to be repeated and sector performance will begin to converge in 2022, predominantly as a result of where we are in the UK real estate cycle. Geopolitical events, inflationary and base rate pressures are likely to weigh and, as a result, more care will be required when assessing any investment decisions in the year ahead.
Risk factors you should consider prior to investing:
- The value of investments and the income from them can go down as well as up and investors may get back less than the amount invested.
- Past performance is not a guide to future returns.
- The value of property and property-related assets is inherently subjective due to the individual nature of each property. As a result, valuations are subject to substantial uncertainty. There is no assurance that the valuations of Properties will correspond exactly with the actual sale price even where such sales occur shortly after the relevant valuation date.
- Prospective investors should be aware that, whilst the use of borrowings should enhance the net asset value of the Ordinary Shares where the value of the Company's underlying assets is rising, it will have the opposite effect where the underlying asset value is falling. In addition, in the event that the rental income of the falls for whatever reason, including tenant defaults, the use of borrowings will increase the impact of such fall on the net revenue of the Company and, accordingly, will have an adverse effect on the Company's ability to pay dividends to Shareholders.
- The performance of the Company would be adversely affected by a downturn in the property market in terms of market value or a weakening of rental yields. In the event of default by a tenant, or during any other void period, the Company will suffer a rental shortfall and incur additional expenses until the property is re-let. These expenses could include legal and surveying costs in re-letting, maintenance costs, insurance costs, rates and marketing costs.
- Returns from an investment in property depend largely upon the amount of rental income generated from the property and the expenses incurred in the development or redevelopment and management of the property, as well as upon changes in its market value.
- Any change to the laws and regulations relating to the UK commercial property market may have an adverse effect on the market value of the Property Portfolio and/or the rental income of the Property Portfolio.
- Where there are lease expiries within the Property Portfolio, there is a risk that a significant proportion of leases may be re-let at rental values lower than those prevailing under the current leases, or that void periods may be experienced on a significant proportion of the Property Portfolio.
- The Company may undertake development (including redevelopment) of property or invest in property that requires refurbishment prior to renting the property. The risks of development or refurbishment include, but are not limited to, delays in timely completion of the project, cost overruns, poor quality workmanship, and inability to rent or inability to rent at a rental level sufficient to generate profits.
- The Company may face significant competition from UK or other foreign property companies or funds. Competition in the property market may lead to prices for existing properties or land for development being driven up through competing bids by potential purchasers.
- Accordingly, the existence of such competition may have a material adverse impact on the Company's ability to acquire properties or development land at satisfactory prices.
- As the owner of UK commercial property, the Company is subject to environmental regulations that can impose liability for cleaning up contaminated land, watercourses or groundwater on the person causing or knowingly permitting the contamination. If the Company owns or acquires contaminated land, it could also be liable to third parties for harm caused to them or their property as a result of the contamination. If the Company is found to be in violation of environmental regulations, it could face reputational damage, regulatory compliance penalties, reduced letting income and reduced asset valuation, which could have a material adverse effect on the Company's business, financial condition, results of operations, future prospects and/or the price of the Shares.
Other important information:
Issued by Aberdeen Asset Managers Limited which is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Registered Office: 10 Queen’s Terrace, Aberdeen AB10 1XL. Registered in Scotland No. 108419. An investment trust should be considered only as part of a balanced portfolio. Under no circumstances should this information be considered as an offer or solicitation to deal in investments.