UK economic outlook

Activity

The UK economy expanded faster than expected over the first quarter, rebounding from a short-lived recession at the end of 2023 to grow 0.7%. Real gross domestic product (GDP) per capita also outperformed expectations at 0.5%. A rise in consumer spending was a large driver behind this growth and, paired with increasing household savings, suggests the economy is improving. We expect real wage growth to remain strong as nominal wage growth slowly returns to a more sustainable rate. 

The UK manufacturing Purchasing Managers’ Index (PMI) is edging higher, as lower energy prices feed through to the sector. Meanwhile, the services PMI has been moderating following a strong start to the year. Some level of uncertainty around the General Election is expected to have noticeable effects on business activity, despite the expectation that any  new government’s enacted policies will remain close to the status quo.  

Inflation

The annual Consumer Price Index (CPI) made its hotly anticipated return to the Bank of England’s (BoE) target rate of 2% in May, as base effects and lower energy prices fed through. Services inflation is the outlier and remains sticky at 5.7%, propelled by rising real wages. Although this poses the risk of extending inflationary pressure, robust productivity growth will help to lessen these effects. The UK seems to be in a stable position, moving towards less restrictive monetary policy. Exact timings are still openly malleable, though. 

Policy

The Bank of England (BoE) has remained steadfast in maintaining a restrictive policy rate. It has cast aside any temptation from early movers, such as the European Central Bank and Bank of Canada. Borrowing costs remained at 5.25% for their seventh consecutive meeting, as the monetary policy committee voted in June to postpone any reduction into the second half of the year. By allowing any market uncertainty from the General Election to pass by, a small delay in policy action also gives stickier services inflation a chance to show signs of cooling. We expect the first reduction to arrive in August, with an additional two cuts by the end of the year. This would bring the policy rate to 4.5%. It is important to note the data must cooperate for this scenario to unfold. An upside surprise in services inflation could further delay a rate cut, despite policymakers’ relatively relaxed stance towards the measurement thus far. 

Source: abrdn, June 2024
Forecasts are a guide only and actual outcomes could be significantly different.

 

UK real estate market overview

We are seeing initial signs of stabilisation across UK real estate. Declines in capital values across the more favoured segments have slowed substantially over recent quarters. We expect pressure on these segments to subside further following reductions in the policy rate. Out-of-favour segments are expected to see additional declines in capital values, especially as transactions pick-up throughout the year.

According to the MSCI Quarterly Index, all property saw capital growth of -0.6% over the first quarter of 2024, its smallest quarterly decline in two years. Boosted by a resilient industrial sector and supported by retailers and their strong consumer base, overall property values are expected to recover as economic conditions also stabilise. Offices remain the laggard of the index, posting a decline of 1.7% over the same period. Much of this loss in value originates from secondary space, and properties without appropriate environmental, social, and governance credentials and amenities.

Total returns largely flipped back to positive territory over the first quarter of the year. Most segments were positive or close to flat on an annual basis. Offices were the exception at -9.3%, after seeing substantial repricing last year. Strong rental value growth is acting as a bastion for the industrial and residential sectors, registering 6.5% and 6.9% on an annual basis, respectively.

As investors await a more supportive macroeconomic environment, the investment market remains lukewarm. Total transactions over the first half of 2024 were down around 7% year-on-year to £24 billion, according to Real Capital Analytics. Around 23% of deals were in the residential sector. It remains a favourite among investors looking for strong rental value growth potential and favourable supply dynamics. Around 18% of deals were in the hotel sector, as North American investors were active on several large portfolios, namely around London. Unsurprisingly, secondary offices remain less popular with investors, given high capital-expenditure requirements for assets struggling with low occupancy. Outside of prime assets, lenders are still hesitant towards the sector, as valuations are correcting.

UK real estate market trends

Offices

The outlook for prime/best-in-class offices is looking more positive, although there is greater downside potential for secondary office stock. While vacancy rates are soaring for the latter, well-located prime assets are seeing strong occupational demand as the return-to-office trend cements itself. Although total returns over the first quarter were negative at -0.5% according to the MSCI Quarterly Index, this is a marked improvement over the prior six quarters. 

New supply is quickly being absorbed, as occupiers feverishly seek out best-in-class space. In Central London, around 60% of space under construction is currently pre-let, with hopeful occupiers staring down a significant drop-off in deliveries from 2026. Construction costs have seen large increases over recent years in tandem with rising inflation. Although cost rises have slowed, rental growth hasn’t expanded enough to warrant new construction. As favoured supply dwindles even further, we expect prime rental growth to pick up in the most constrained markets, such as London’s West End. 

Capital values posted a 1.7% loss over the first quarter. This was the steepest decline across UK real estate segments, but far better than the sector’s average of -3.7% over the previous four quarters. We expect to see values fall further, with prime assets faring better. Following this, we should see investors renew their interest in core assets, as pricing becomes more attractive compared with other asset classes. For now, financing and construction costs remain prohibitive for value-add strategies, further adding to supply struggles. As a result, any stranded assets will experience significant vacancies. Conversion activity remains expensive and alternative uses are limited for investors left holding the bag.  

Industrials and logistics

Following sharp repricing over the second half of 2022, the industrials and logistics sector appears to have returned to more sustainable levels of growth. The sector saw capital values grow by 6.5% over the past 12 months, as per the MSCI Quarterly Index, leading UK real estate by a healthy margin. While other sectors have lagged because of structural struggles and macroeconomic uncertainties, industrials and logistics have benefited from structural and thematic tailwinds.

A large component of the steep correction over the second half of 2022 was the lack of appropriate supply available to the market. Availability has since been increasing, although unequally across regions, and is expected to tame rental growth in the short term. Indeed, standard industrial and distribution warehouse rental value growth has softened over the year to March 2024. According to the MSCI Quarterly Index, rental growth for these sectors is 6.5% and 6.4% (down from the previous year of 8.8% and 8.5%) respectively. Occupational drivers for growth are still present in the sector though, as tenants remain steadfast in their preferences for sustainable and future-proofed assets.

Investors maintain high conviction towards the sector, owing to the resilience and penetration of structural drivers. Despite this optimism, transactions have been light over the first half of 2024, showing a 35% fall over the same period last year, according to Real Capital Analytics. Transactions are expected to pick up in the second half of the year, as bid-ask spreads narrow further and as economic certainty cements itself.  

Retail

The UK’s consumer base seems to have weathered a challenging couple of years, as retail sales have remained more resilient than expected. With inflation coming down from historic highs, real wages and consumer sentiment are both on the rise. Although capital value growth has underperformed all property over the past year, there are stronger performers within the sector when looking at total returns. According to the MSCI Quarterly Index, retail warehouses (1.7%) and shopping centres (1.3%) are garnering investor interest, given their strong income returns. 

Within the supermarket sector, fierce competition for market share has emerged between Tesco, Sainsbury’s, and Lidl, who are all gaining on Asda, Morrison’s, and Aldi. Sainsbury’s has reported strong grocery sales over the first quarter, while general merchandisers are blaming weaker-than-expected discretionary spending on poor weather. A strong consumer base and a growing appetite for discounter grocery stores are translating directly into expansion plans, with Lidl and Aldi planning hundreds of new stores across the UK.

Looking ahead, we see the dynamics of retail performance shifting as inflation becomes less of a driver for value growth. Although pricing now looks relatively attractive, changes in consumer trends and macroeconomic conditions are keeping large-scale investment at bay. Outliers here are prime London high street retail, which is typically picked-up by large cross-border entities. Retail parks have also seen increased interest over recent months.

Living

Rental value growth in the UK’s private rented sector (PRS) remains robust, albeit having backed off somewhat from recent peaks. In the 12 months to the end of June 2024, rents grew by 6.9%, down from 10% one year prior, according to HomeLet data. Favourable supply dynamics are front and centre here, meaning upward rental pressure across regions.  

Affordability concerns for PRS are still rearing their head, though, particularly in Greater London and in the South East. As a result, tenant demand is still trending downwards. This may result in a lower-than-expected ceiling on rental growth in more constrained markets, but it’s unlikely the demand/supply gap will completely erode. It’s a similar story for sub-sectors of the living segment. Purpose-built student accommodation (PBSA) is seeing favourable demand/supply dynamics, but rental growth is being tamed at the extreme ends of this spectrum. 

Investor interest in the living sector remains strong. Although net migration numbers are projected to fall from elevated levels, positive drivers for growth – such as constrained pipelines, the return of real wage growth, and mortgage unaffordability – all contribute to conviction in the sector. Relatively nascent products in the UK, such as single-family housing (SFH) are gaining interest from investors. Shifting consumer preferences and affordability constraints are presenting further opportunities for growth. 

Outlook for risk and performance

UK real estate seems to be pointing in a much more positive direction than this time last year. More economic and political certainty has filtered into the market, resulting in slowing declines in capital values. We have seen investors hold back over the first half of 2024. This is expected to shift into a more positive light as the rate-cutting cycle takes hold and as real estate returns look more attractive on a risk-adjusted basis.

From a risk perspective, a change in the UK’s government doesn’t seem to have much of an impact on investor intentions. The living sector may be under more scrutiny, given potential policy changes, but the probability of any radical shifts from Labour is low. A greater level of uncertainty comes from the BoE’s actions on rates. A cumulative reduction of 75 basis points is expected over the second half of 2024, though worries surrounding services inflation and wage growth persist. 

Still, given our current assumptions, we expect UK real estate to perform well over the forecast period, although bifurcation within sectors will remain a factor. We expect the industrial and living sectors to outperform all property, particularly over the next year. In a notable shift over recent months, offices are now projected to stay in positive territory, owing to strong rental growth. In fact, rental growth will remain a central growth story across real estate sectors, especially given the low levels of construction projected over the forecast period. Although construction prices have moderated from their peaks, restrictive financing costs will make development difficult in the near term.

Certain lenders are acknowledging the upside potential here, as we are seeing increased activity by UK clearing banks for all asset classes outside of offices. As the rate-cutting cycle bites, margins are expected to become more competitive among non-bank lenders. This should provide a much-needed boost to liquidity.