This year was definitely not a vintage year – but the future should taste better

As seasonal festivities get underway and activity in the real estate sector winds down, it’s time to reflect on 2023 and look ahead to 2024. While this year was one most investors in UK REITs would rather forget, there is growing optimism that 2024 will be better. Interest rates look to have finally peaked, there is a resilient outlook for rents, many REITs seem to have reasonable balance sheets. And the continued disconnect between real asset valuations and equities provides attractive opportunities for both consolidation and new investors to buy into the sector.

Inflation and interest rates

Bringing inflation under control has been far from straightforward and, while we are closing the year with CPI heading towards 4%, there have been several false dawns. The bond market saw gilt yields rising again from February back to the highs seen during the Truss/Kwarteng mini-budget crisis.

It is only now as we approach the end of the year that a new-found confidence has emerged that inflation finally is under control and will possibly be closer to the 2% Bank of England target by the end of 2024. Consequently, market expectations of interest rates peaking at 6% only a few months ago now look to have moderated, with some commentators expecting the first cuts to come as early as next year, which is good news for both real estate yields and financing costs.

Winners and losers

There have been two distinct groups of winners in 2023 among UK REITs in our view. Those with portfolios focused on industrial & logistics (I&L) and residential/student accommodation – the so-called ‘beds & sheds’ operators – and those with strong balance sheets and diversified debt stacks. Yields and valuations in I&L and residential have stabilised in 2023 giving rise to a material capital outperformance relative to offices, the year’s biggest loser.

The unprecedented increase in finance costs during 2023 left many REITs with weaker financing structures exposed, particularly to floating-rate debt. The requirement in many cases to purchase expensive out-of-the-money swaps to underpin finance costs not only soaked up free cash for these companies but also left dividends uncovered by earnings.

The winners, on the other hand, avoided these pitfalls and are well resourced to tap the expected increase in distressed assets coming from refinancing situations and open-ended fund redemptions in 2024.

A buying opportunity

Despite having enjoyed a modest recent rally, valuations of UK REITs generally remain highly depressed. However, we are closing 2023 in a much better place than where it began. Occupier markets remain resilient, balance sheets are improving and a lid finally appears to have been placed on rising finance costs.

This remains to be factored in to listed equity valuations and there continues to be a material disconnect between the valuations of real assets and equities. However, we expect this discount to narrow, and it will also provide an opportunity for further consolidation among listed REITs as frustrated shareholders in drifting entities look for alternative value.

We would anticipate an improving picture for UK REITs in 2024, with a sector of fewer but stronger companies.