Will interest rate cuts help tide turn for property investing?

Property investments have performed disappointingly since May 2022, but with the popular assumption that interest rates will be cut further, many investors are once again considering the asset class.

There is a chance, however, that investors expecting rate cuts to rekindle the property market may be ignoring the strength of the economy. Moreover, the anticipated series of interest rate cuts may not materialise, at least not in a progressive and linear way. Rates could instead be subject to a series of minor adjustments, both down and up.

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Inflation is certainly looking stickier than expected in the UK, with recent metrics such as GDP growth, services inflation and wage growth exceeding the Bank of England’s forecasts. What’s more, while the headline inflation rate met the Bank of England’s 2% target in May and June, energy prices could bite in the second half, lifting inflation as high as 3% by the year end.

Investor appetite for commercial property also depends on the alternatives on offer in the savings marketplace. Most obviously, high inflation and rising rates in recent years made property yields look uncompetitive relative to gilts.

Investors also need to feel they have the ability to assess future returns. However, just as interest rates are not predictable, the direction of stock markets is also hard to predict. In particular, the US big technology stock roller coaster is difficult to read.

Some encouraging signs

What you can say is that each property cycle is very different, with its own structural drivers, and this time there are some very encouraging signs. Unusually, for example, there is no issue around rental income growth. Not only is the strong economic situation directly reflected in rental income, but low levels of development starts in 2023 and 2024 is putting pressure on vacancy rates in all sectors, even retail, which in turn will push up rentals.

This supply imbalance has created a real shortage of appropriate accommodation, particularly in areas such as assisted living. “When interest rates are high, construction is difficult to procure, and in Covid, projects slowed or stopped, so we are seeing a shortage of new supply, particularly in senior living in the US, Europe and the UK,” says Svitlana Gubriy, head of the Indirect Real Assets business at Abrdn, and fund manager of abrdn Global Real Estate fund.

“Baby boomers are the fastest growing cohort, and the oldest baby boomers are now around 80. People go into senior and assisted living at around age 82, so for the next five to 10 years, there will be a lot of demand and not a lot of supply.”

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Demand for student accommodation also shows no sign of letting up, despite concern over the visa changes preventing most international students from bringing family members to the UK. A trend among the young to rent rather than buy, which is supporting the built-to-rent sector, and in student accommodation this translates into “evidence that people like to continue living in professional managed accommodation even after they graduate”, Gubriy says. “They like the flexibility, with no need to deal with a Mom-and-Pop landlord (those that own a small number of rental properties).”

REITs such as UNITE Group (LSE:UTG) and Empiric Student Property (LSE:ESP) enjoy economies of scale and excellent relationships with clusters of universities. Keith Breslauer, managing director and senior partner at Patron Capital, which is very active in this market, likes student cities with good infrastructure and scale, favouring Birmingham over Brighton, for example, and says the next big market for university accommodation is for the 430,000 Sub-Saharan African students studying abroad, for whom the cost of further education is relatively cheap. “The UK provides an educational product that other countries can’t deliver”, he says.

The property hotspots

Most property sectors have repriced since the era of cheap debt ended, but continued valuation shocks are expected in the office space, which is suffering from high tenant churn and capital expenditure investment due to more flexible working policies.

In contrast, there is particular demand for data centres, which are specially designed facilities to house servers and networking equipment to store and access data, with un-interruptable power supplies, air-cooled chillers and physical security. The two main US companies operating in this space are Equinix Inc (NASDAQ:EQIX) and Digital Realty Trust Inc (NYSE:DLR).

Another niche, which investors were excited about a few years ago, is the life science sector, and the eponymously named UK offering, Life Science REIT Ord (LSE:LABS), which invests in properties leased to tenants operating in this sector, with a portfolio of properties located across the Golden Triangle of research and development hubs in Oxford, Cambridge and London’s Knowledge Quarter. Proximity to centres of academic excellence and innovation is critical for life sciences businesses and the companies says they are capitalising on the UK’s skilled talent pool. 

Life Science has had a torrid time, however, halving its dividend for 2023 after the value of its portfolio fell by -7.1% last year. Given that its property values are very close to their bottom, a bounce-back is possible.

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Overall, the perception is that value in REITs is at last emerging, bar the office segment. The UK is especially attractive as yields have adjusted faster than in most other global markets and could now be higher than they should be. Large established UK REITs holding London property include British Land Co (LSE:BLND), Land Securities Group (LSE:LAND) and Segro (LSE:SGRO), formerly Slough Estates, and each offers broad exposure to the market.

Recovery on the cards

“For specific segments –  such as industrial, logistics, and retail – we have already shifted into a phase of recovery, while offices continue to see values fall,” says Kevin McCauley, head of strategy and property research at Royal London Asset Management Property. He believes the interest rate cut be particularly beneficial in “the industrial and logistics sector where strong fundamentals are driving robust rental growth, particularly in London and the South East”. 

Matt Jarvis, who oversees at L&G UK Property Fund, argues the case for the asset class is as strong as since at least 2020. He adds: “The industrial and residential sectors in particular are supported by convictional structural trends such as demographic change, de-globalisation, digitalisation and decarbonisation. Specific strategies around urban logistics, assets enabling global digitalisation, affordable housing and build-to-rent residential offer attractive risk-adjusted performance.”

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When sizing up property funds bear in mind that in the past open-ended property funds have put suspensions in place during times of market stress. REITs arguably offer more liquidity, but the trade-off is that when sentiment is sour and investors rush for the exit the REIT’s share price takes the strain.

Key things to consider are to look for the depth of the manager’s experience, performance history and reporting transparency, in particular how aligned the managers are to that REIT in terms of reputation. For example, Schroder’s reputation is closely aligned with the performance of its Schroder Real Estate Investment Trust Ord (LSE:SREI), which focuses on sustainable buildings.

Uncertainty also impacts property, like any other asset class. Rental growth is normally halted by oversupply, which as we’ve seen, is unlikely in this cycle. However, the related question is whether the government will step in to cap that growth, as has happened in the US, Germany and Spain. “Rental increases are not top of Labour’s agenda, but they are undoubtedly there,” says Breslauer.

Ceri Jones owns shares in Empiric Student Property.