The UK commercial property market is in a downturn right now. As with the wider economy, commercial property is subject to economic cycles, a pattern of growth and decline and hopefully, growth again.
According to one expert report the commercial market has, over a forty-year period, experienced seven distinct declines, which includes the one we’re in right now. The questions people ask are: (1) are we approaching the bottom of this market and reaching a point where opportunities for investments at bargain prices exist, or (2) is the market for commercial property shot; is it in a structural change phase where the previous values are unlikely to return?
The former governor of the Bank of England, Mark Carney, thinks that things are going to be tough in commercial property for the foreseeable future, primarily because of the number of what he terms "stranded assets". These are buildings that don’t meet the standards required by the government’s seemingly headlong march towards achieving net zero carbon emissions.
Thousands of older buildings in cities and towns around Britain are way behind the standards required and many may be uneconomic to revive. As such these buildings pose serious risks to property owners and lenders alike.
Largely since the pandemic, investors have been struggling with a perfect storm of events that have depressed commercial property values, made worse by the current economic environment: there are higher interest rates than have been the norm since the credit crunch in 2007-8, the working from home (WfH) phenomenon accelerated by the pandemic, and the relentless march of the government’s demands on improving energy efficiency.
For those investors with leverage, substantial mortgages that are tied to commercial real estate values, their plight is particularly acute. Mark Carney has said that regarding these assets, some of which may not survive the impact of the environmental regulations demanded by government:
"There will be a tail of stranded assets. . . which are going to have to turn over and be refurbished if possible or knocked down and repurposed.”
The fact is that new capital will be needed to meet energy efficiency targets for commercial real estate as we move to a greener economy. Many of the buildings across the country, especially the older ones, are affected. Some will be more difficult than others, or even impossible to convert to reach the required standard.
In some cases, as with older, less desirable office spaces, the costs of refurbishing may be too much given the fall off in demand and low rental income the property could possibly achieve. But in some cases, demolition may not be an option either, depending on the buildings’ location and in its relationship to adjacent buildings. Demolition would be a highly controversial issue.
However, it is also a fact that retaining existing structures is the most sustainable option overall as it avoids the carbon emissions created when producing and transporting new materials such as steel, bricks, concrete and glass, not to mention the energy consumed in new construction.
Despite the gloom there’s still room for optimism in commercial real estate and it’s too easy to say “it will be different this time”. Depressed markets revive and there’s no reason to think it will be different this time, despite the problems noted above.
As Ian Humphreys CEO of Brickflow told Mortgage Introducer that the:
“Acute shortages in UK housing supply continue to create a favourable environment for investors and developers.
That implies repurposing buildings, usually conversions from commercial to residential use.
“The requirement for commercial property finance remains strong. Auction activity remains strong with motivated sellers, or their lenders, seeking a quick exit, so those with the ability to transact swiftly are benefitting, and bridging finance is undoubtedly flavour of the month right now.”
There are undoubtedly opportunities for those in the right space to take advantage of depressed values.
Perhaps there’s never been a better time to convert commercial buildings into residential. That’s the view of Matthew Robinson, a senior architect as reported for regeneration magazine writing for newstartmag.co.uk.
Mr Robinson argues that there’s never been a better time to convert commercial buildings to residential use. That, he says, is because of changes to Class MA permitted development rights.
What are Permitted Development Rights?
The General Permitted Development Order (GPDO) introduced Class MA conversion rights in August 2021. Class MA is a permitted development right that allows the change of use of a building from commercial to residential without going through the usual full change of use applications.
It enables developers with commercial buildings (Use Class E) to convert to residential use (Class C3) using the permitted development (PD) rights order. Later amendments to the order were published in February 2024 commencing from the 5th of March this year have removed previous restrictions on the size of buildings to be converted, as well as the three-year vacancy rule.
This legislative change, argues Robinson, has created new opportunities for owners of some larger commercial buildings and those still in use, to convert them for residential use.
The issues facing some commercial property landlords will not go away as research shows that commercial buildings across the globe contribute 26% of carbon and energy emissions, according to the International Energy Agency. International agreements through COP commit countries to accelerating their efforts to achieve net zero and to double the rate of energy efficiency improvements by 2030.
Consequently, UK commercial landlords are facing new deadlines to upgrade their buildings to meet stringent energy efficiency standards by 2030. But, according to research a significant proportion of commercial buildings did not meet their energy rating targets last year, and Mr. Carney has warned property investors and owners that it is unlikely that deadlines will be extended.
“There will be people. . . who either implicitly or explicitly think that these timelines are going to shift, or that somehow or another it is not going to become a binding constraint. But that is a big risk to take,” Mr Carney had said.
Financial institutions are beginning to apply pressure to property owners who fail to address their environmental responsibilities. According to one report, Dutch bank ING had warned thousands of its largest borrowers, including developers and landlords, that it would withhold financing unless they could show that they were making significant progress towards reaching their environmental targets. ING has said that commercial real estate has been one of the slowest sectors to action reducing emissions.
A further issue highlighted by Mark Carney, who is currently chairman of Brookfield Asset Management and Head of Transition Investing at the $725 billion Canadian investment company, a company is focusing on investments in real estate, renewable power, infrastructure, credit and private equity, has highlighted the issue of developers and landlords having to incorporating biodiversity into urban environments. The drive to bring nature into city settings is becoming an important part of urban planning. This has significant implications for development costs.
The value of commercial property assets declined substantially over the last few years due to the causes outlined above. Those commercial property investors who are highly geared to start with will face a challenging future. They face having to upgrade their buildings when the cost of money (interest rates) is substantially higher than when they first took out their loans, at a time when they need more capital to invest in their buildings.
Some investors in commercial therefore will find themselves in a precarious position, heavily borrowed already and needing more money to refurbish or repurpose their buildings. Some of these buildings, particularly older buildings, won’t lend themselves to easy conversions and may be in locations where rents will not justify further investment.
In a speech he gave recently in London’s Dockland, Mr. Carney said he is confident that the financial sector would not come under undue pressure because of the challenges, and he said the process of working through these “troubled assets” has already begun:
“I am very sanguine about commercial real estate risks in the financial sector as a whole, because the risk is more broadly spread, there is less liquidity pressure than would have come in a bank-based commercial real estate sector,”
Despite these risks and hurdles Mark Carney said he “remains optimistic” about the real estate sector's ability to adapt and revive. He highlighted the increasing demand for modern more energy-efficient buildings and that those landlords who take the initiative early to upgrade their property portfolios will win out.
The property sector, Mark Carney thought, was at a crossroads in Europe, with the potential to adapt and revive while leading the way in sustainable development, if only investors can meet the challenges of hitting the net zero targets.
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