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Will ESG take a 'pounding'?
What does the tumbling pound mean for development?
I had a conversation today about what recent monetary and fiscal policy might mean for development, specifically ESG.
Rewind nine months and things were great (relatively). Rents high and lots of development activity. Right now we face high costs, continued high inflation, stuttering values, and the question is what lies around the corner. Of course no-one has a crystal ball, and there’s plenty of macro issues that could confuse things further, however it does look like the next year at the very least is going to be painful for most. Even the most bullish have to accept that this is happening and they must hope it’s a short term dip, but the more likely outcome appears to suggest that we’ve got a year or more of pain ahead.
With the turmoil of the pound falling this week and a round of ‘emergency’ quantitative easing (QE) announced this morning, it seems hard enough to predict what will happen next week, let alone in November or next year. The intervention by the Bank of England’s expert leaders this week is a complete U-turn against their Monetary Policy Committee’s plan to start selling government debt (quantitative tightening) from next week, which is now on hold.
What is QE? It’s a monetary policy where the Bank of England purchases government bonds or other financial assets in order to inject money into the economy to expand economic activity… essentially this is money creation (increasing the supply of money in the system), which generally leads to inflation…yes, inflation.
One thing that most are aligned on is that in the short to mid-term, interest rates are going up. There really aren’t many tools to pick from when it comes to battling inflation and it seems this part of the plan is now set. Since the 2020/21 lows, when rates were dropped to near-zero to stimulate the economy and we saw major hits of QE, we now see rapid moves to try and slow it down.
Reaction to Chancellor of the Exchequer, Kwasi Kwarteng’s, announcement on 23rd September is two-fold, and appears to compound the need to raise rates:
Increased borrowing to fund the tax cuts: Borrow to fund tax cuts > inflation > raise interest rates
Pound in free-fall as markets react: Emergency QE (print money) > inflation > raise interest rates
And what does this boil down to… people have less money.
The only thing working against rising interest rates will be the nation’s pain, as leveraged people and businesses struggle to make payments or get wiped out when it comes time to re-finance. We will have to wait and see how much pain is tolerated before something has to give, but as with economic cycles I’d expect many businesses to go under before that happens. Unfortunately, downturns and volatility like this will just be another chapter in history - painful as it is, these are needed to clear out the dead wood which could only survive the ‘good times’.
So back to ESG…
Rising costs and reducing values - this is not a good combination. Development appraisals are going to feel the pinch, even more so if using finance or external funding, as the cost of capital increases. Savings will need to be found. Get ready for some VE meetings!
But will a little sprinkling of VE be enough?
I’ve said before that highly sustainable/ESG developments could end up at the top of a two-tier marketplace, where they attract premium rents and the best tenants. However step away from that top tier and it’s not hard to imagine ESG under threat from hurting appraisals and a renewed focus on pure financial performance. Just look at what Liz Truss and Jacob Rees-Mogg have done in the last couple of weeks in the energy sector.
In theory (and I hope) strong developers should be able to look through this downturn and play the long game, with their sights on opportunity, good rents and demand for quality (ESG) space in the mid to long-term. But the short-term pain may prove too much for some, and the argument put to me was that if tenants can control only one thing, it is what rent they pay. If demand falls, rents fall. If rents fall, costs need to be cut. If costs need to be cut, you remove the non-essentials… perhaps ESG stuff? Let’s hope not in a major way, as this aspect of development has made great progress in recent years.
I’ll finish by pointing out I’m not an economist or a financial advisor. Sometimes when everyone (perhaps including me here) is saying the same thing, it’s actually time to do the opposite. Good luck, and remember the market will find a new level - this is all happening because things (in the UK and globally) are out of balance.
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