There are first- and second-order impacts associated with the crisis in Ukraine. In terms of its likely impact on UK real estate, we have not materially adjusted our outlook for the market in 2022 but new considerations have emerged. First-order impacts would be most visible through any liquidity constraints for UK commercial real estate, largely because of forced sellers or capital flows abating. We expect the initial impacts of the Russian invasion, and the subsequent sanctions placed on Russia by Western economies, to have a negligible effect on UK direct real estate. Anecdotally, Russian capital is understood to be heavily deployed in the prime London residential sector but, in reality, it has little exposure to UK commercial real estate. Ukrainian capital is also understood to have very limited exposure to the UK market. Therefore, the impact of freezing capital flows in and out of Russia should have limited impact on market liquidity and there is a low risk of forced sellers of UK commercial real estate. In fact, given the increased volatility in other financial markets, UK real estate may benefit from being viewed as a ‘safe haven’ investment destination.
However, the Ukraine conflict is likely to have wider consequences through second-order impacts and UK real estate must be set in the context of the wider macroeconomic environment. Prior to the outbreak of the conflict, 2022 was already dominated by concerns over inflation and subsequent changes to monetary policy. The conflict has skewed these risks upwards. The inflation rate is likely to continue to grow throughout the first half of 2022, as rising energy prices and supply chain issues take hold. The conflict has increased the risk of inflation remaining stubbornly high over a more prolonged period as sanctions on the Russian economy bite, and energy and commodity prices rise as a result.
Given the fluid nature of the sanctions regime, there is a significant risk that inflation could surprise on the upside, particularly if more penal sanctions are placed on the Russian energy sector. In response, the Bank of England is expected to continue tightening monetary policy over the course of the year, with the base rate anticipated to reach 1.25% by the end of 2022. It is then expected to peak at 1.75% in 2023 but could peak above this. We believe the impact of higher inflation and its subsequent economic effects will have a greater bearing on UK commercial real estate performance.
Historically, UK commercial real estate has had a weaker link with inflation and a much stronger correlation with economic growth. Prior to the Russian invasion of Ukraine, UK GDP growth was forecast to be around 4.4% in 2022, but we now expect it to be closer to 3.8%. This may lead to a situation where we are faced with a possible ‘negative cocktail’, including lower economic growth, tightening monetary policy and high inflation. This is likely to reduce the reasonable returns we were anticipating from real estate this year, although the sector impacts are expected to be asymmetric.
Prior to the outbreak of the conflict, the office sector was already facing structural headwinds. We expect that the economic impact of the conflict will only put further pressure on the sector. Weaker economic growth is likely to depress job growth and, subsequently, occupier demand for office accommodation. While we expect demand to remain robust in the prime end of the market, poorer-quality accommodation is likely to face even greater pressure. The retail sector is also expected to be negatively affected by the squeeze on consumers’ disposable incomes. This is likely to hit those areas that cater to discretionary spending, as consumers reduce non-essential spending in response to rising living costs. Conversely, budget retailers and discount-led retail schemes are in line to benefit and the conflict may, therefore, polarise the retail sector further.
We expect the alternatives sector of the market to remain robust, particularly in the Build to Rent sector, given its proven income resilience. This sector was anticipated to gain greater investor interest as inflation concerns grew, and the conflict’s impact on energy prices will add further tailwinds to this trend. The industrial and logistics sector also remains strong. Investor and occupier demand continues to be robust and we expect returns to be driven by significant rental value growth over the course of this year. Constrained supply and rising build costs will further drive rental value growth. That said, the situation will need to be monitored closely, particularly if the sector is exposed to further disruption in supply chains.
Overall, there are first- and second-order impacts of the Ukraine conflict on the UK real estate market. We expect the conflict to have a negligible direct impact on the UK real estate market through first-order factors, but the impact on the macroeconomic environment will likely have a greater bearing on UK commercial real estate performance. An expected slowdown in economic growth is likely to lead to greater polarisation in performance between prime and secondary areas of the market, and the uneven macroeconomic consequences of the conflict are also likely to exacerbate trends that were already in motion prior to the Russian invasion. The outlook for sectors that are under structural pressure has become more negative, as a result. However, we expect the same trends to add greater impetus to our favoured areas of the market, and we continue to support those sectors that benefit from thematic drivers.
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