"As it stands, the change in interest rate expectations will have a meaningful impact on the already high cost of debt, adding further risk of CRE distress as interest coverage ratios move into dangerously low territory"
UK CPI inflation surprised to the upside in April despite dropping to 8.7% from 10.1% the previous month. A substantial fall in the headline rate was expected due to the 48% rise in energy prices from April 2022 falling out of the annual calculation, but this was partially offset by other price rises.
Perhaps most concerning was the increase in core goods and services inflation, which provided clear evidence of persistent underlying inflationary pressure.
This has prompted the Oxford Economics macro team to increase its forecast for UK CPI. We still expect inflation will fall back through the year, driven by lower energy prices and base effects, but sticky core inflation now means a year-end CPI forecast of 3.8%, well above the 2% target.
The stickiness of inflation also means that the BoE is likely to hike policy rates a further two times this year to a peak of 5%, then hold them at that higher level through 2024. This is in sharp contrast to our expected policy rate paths for the US and the eurozone.
Financial markets also reacted to the inflation surprise with the 10y gilt yield and 5y swap rate moving up by around 50bps to 4.2% and 4.7%, respectively, since the CPI release.
Although bonds and swaps initially spiked on news of the inflation outturn, they then moderated before the surging wage growth data was released in mid-June, pushing bonds and swaps back up to the highest level since the mini-budget of October 2022.
As it stands, the change in interest rate expectations will have a meaningful impact on the already high cost of debt. It adds a further risk of CRE distress as interest coverage ratios move into dangerously low territory, which is particularly concerning for those with higher loan-to-value ratios with fixed-rate loans maturing this year and in 2024.
Stickier-than-expected core inflation has also pushed up the discount rate used to discount future cash flows back to their present value. A decent proxy for this is the 10y nominal forward rate. This was up by 40bps to 4.5% in May, higher than the October 2022 spike and on par with the average from 2010 to 2014 and the decade preceding the GFC.
The increase in the discount rate has not been priced in by valuers to date, so if it persists over the coming months, we think a further reduction in capital values may be warranted.
In contrast, CRE valuations have shown a modest recovery of late with month-on-month capital growth returning in March and April for all sectors except offices, according to MSCI. We think this is a temporary reprieve with further falls to come as tighter credit conditions, rock-bottom sentiment, inadequate risk premia, and high debt costs all continue to weigh on the outlook.
In fact, we already heavily downgraded our outlook in March on the expectation that the banking turmoil would tighten global credit conditions. As such, we have maintained our below consensus forecast of a further 8% fall in UK all-property capital values this year, followed by growth of just 0.4% in 2024.
By sector, we expect the largest corrections to capital values will be in the office and industrial sectors. Much of this fall in values has already occurred for industrial assets, but we think there is still a substantial adjustment to come, particularly for offices.
Although some high-profile companies have issued return-to-office directives this year, the majority continue to follow a hybrid policy, which we expect will gradually lead to a reduction in required floor space.
This, in combination with a declining working-age population later this decade, presents a challenging outlook for the office sector at an aggregate level. By contrast, residential has had the smallest overall correction in values, but we expect the bulk of the adjustment to occur this year as the broader housing market re-prices.