- The MSCI UK Quarterly Property Index dropped at a record pace during the second half of 2022, falling from its high in the second quarter of 2022 to its lowest level since the third quarter of 2009.
- Although factor returns behaved somewhat differently leading up to the most recent market peak in June 2022 vs. the lead-up to the 2006 peak before the global financial crisis, the return profile has been similar thus far through this correction.
- The performance of leasing and yield factors changed dramatically as the financial crisis unfolded. It remains to be seen whether those factors will follow a similar path through the remainder of this most recent correction.
U.K. real estate is experiencing a pricing correction at record pace. As the market environment changes so rapidly, it’s natural to make comparisons to the global financial crisis (GFC) in terms of the speed of the correction, relative performance of markets and property types and broader economic conditions, to find similarities and differences that might help us navigate the current market conditions. By drawing on earlier work on factors in private real estate, we can dig further into the dispersion of individual assets’ returns to understand other systematic drivers of real estate returns, which may aid our understanding of the current market conditions and, by looking to earlier corrections, give us some clues to what may happen next.
The evolution of factor returns over time
Source: MSCI UK Quarterly Property Index
The exhibit above illustrates the performance of six factors from the fourth quarter of 2002 to the fourth quarter of 2022. The most cyclical factors, yield and leasing profile, are highlighted. Both represent risk-on/risk-off behavior but have tended to move in different directions.
Conventional wisdom would suggest that as a crisis hits, there is a flight to safety — to assets with stronger leasing profiles, and away from higher-yield assets, which can be perceived as riskier. This was certainly the case during the GFC, where we saw the yield factor start to underperform and the leasing factor outperform, but this performance dynamic appeared after five quarters from the point where asset values had peaked.1 In the early stages of slowing returns, and even as returns started to turn negative, the yield factor was still associated with outperformance, while the leasing factor remained muted.
Performance before crisis arrives
But in considering the performance of factors during a crisis, it is interesting to consider their performance in the lead-up to those periods too. In the pre-GFC period from 2002 to 2006, the yield factor was consistently associated with outperformance of around two percentage points. U.K. real estate had attracted strong inflows of capital to higher-yielding asset types and locations in search of returns, as yields for more established and secure assets had been bid down.
In this current phase of the market, the starting point for the yield factor was somewhat different. The initial recovery from the GFC was followed by more muted performance around 2012 associated with the European sovereign-bond crisis. After this, there was a period of strong returns where the yield factor once again was associated with outperformance, but this gradually ebbed away to the point where its returns were negligible and then turned negative through COVID, before becoming positive again during the bounce-back of 2021.
Flight to safety started in earnest five quarters after asset values peaked pre-GFC
Source: MSCI UK Quarterly Property Index
The exhibit above compares the profile of capital growth and selected factor returns from their pre-GFC peak and more recently in the summer of 2022. The left-hand panel illustrates the speed at which strong returns in the latter part of 2022 fell away and turned negative much more quickly than they did in the GFC. The right-hand panel shows the evolution of factor returns through both periods. The yield factor’s outperformance has grown more quickly than it did during the GFC, perhaps because interest rates have risen so quickly and from a much lower base. Property yields were also much lower in the first half of 2022 than they were in 2006. The same basis-point shift in yields has a larger impact on capital values for lower-yielding properties than for higher-yielding properties.
Thus far during the current cycle, the leasing factor is following a similar path to that seen during the GFC. It remains to be seen whether it begins to trend upward in a flight to safety as it did further into the GFC, when financial turmoil began to hit the real economy.
A focus on industrial’s price movements
At the peak of the current cycle, returns were driven mainly by industrial assets. The larger, more prime, lower-yielding distribution warehouses with moderate vacancy (to potentially give investors exposure to a strong leasing market) strongly outperformed.
Once sentiment started to shift, inflationary pressure led to interest-rate rises, and expectations for economic growth — and therefore for rental growth — came down. The elastic band of pricing snapped back, and these assets started to underperform, experiencing the weakest capital growth, as relatively uniform basis-point shifts in yields had a more significant impact on pricing.
Industrial had largest negative yield impact, driven by lower-yielding assets
Higher-yielding industrial is defined as assets with an equivalent yield in the upper quartile, and vice versa for lower-yielding industrial. The gray isobars illustrate the relationship between yield shift and yield impact. For a given level of outward yield shift (e.g., 100 basis points), lower-yielding properties will suffer a greater fall in capital value. The colored lines show the path of yields for different groups of properties from the end Q4 2019 to end of Q4 2022. Yield paths to the left of the chart show property groups with lower starting yields that experienced a greater fall in capital values for the same outward shift in yields. The further to the left of the chart, the steeper the lines are in both upward and downward directions, indicating a strong move in capital value for the same yield shift. Source: MSCI UK Quarterly Property Index
The exhibit above illustrates how the path of yields translated to quarter-on-quarter yield impact on capital growth from Q4 2019 to Q4 2022. Industrial yields rose from 4.0% in Q2 2022 to 5.6% in Q4 2022, translating to -28.8% in yield impact over the second half of the year.
Industrial assets varied widely in their pricing in Q2 2022. For properties in the upper quartile of yields, they rose from 6.5% in Q2 2022 to 8.0% in Q4 2022, translating to -19.5% in yield impact. For tighter-priced industrial assets in Q2 2022, (the lower quartile), yields rose from 3.3% in Q2 2022 to 4.8% in Q4 2022, translating to -32.7% in yield impact.
Another lens to examine market movements
The U.K. real estate market shifted very quickly during the second half of 2022. While many aspects of today’s market environment may be different from those during the GFC, factor analysis provides another lens through which to examine market trends and conditions and could help investors think about the factors they wish to be exposed to depending on their views of how the market will evolve from here.
1Asset values peaked in June 2007 and June 2022.