The UK commercial real estate sector has faced significant challenges recently due to home working trends, slow economic growth, online shopping and rising interest rates. Some of these factors have led to reduced demand for space, lower rents, and declining valuations depending on the sector you are looking at.
However, going off recent reports in the Financial Times (FT) and a Royal Institution of Chartered Surveyors' (RICS) report signs are emerging of a possible recovery. Highlighted by RICS is a 4% increase in tenant demand, particularly in the industrial sector.
The industrial sector – particularly warehousing - has come through Covid and the cost-of-living crisis better than retail, leisure and the office sectors.
High-quality properties are now showing signs of price stabilisation according to these publications, with some investors returning to the market, driven by clearer interest rate expectations – there are positive signs that interest rates are still on a downward trajectory.
But despite this optimism, certain areas, like the office sector in Canary Wharf, will continue to struggle. The commercial sector generally is being revived largely influenced by interest rate stability, with increased merger and acquisition activity also reflecting investor optimism.
Experts warn that cautious investment is advised, especially for properties with significant debt exposure. European investments and infrastructure are recommended to institutional investors as potential diversifiers. So, while the sector isn't fully recovered yet, there are some positive indicators of stabilisation.
The commercial real estate sector is tied very closely to the economy as a whole. So, with UK GDP growth improving steadily in recent years - UK GDP in Q2 2024 was 2.3% above its pre-pandemic level of Q4 2019. This compares with Eurozone GDP being 4.0% higher, with GDP in Germany up by 0.3%. The US had the highest GDP growth among G7 economies over this period at 9.4%.
However, growth in Britain is set to outstrip every other major European economy next year, the International Monetary Fund has predicted, in a sharp bounce back from the recession in 2023.
The UK’s GDP will grow by 0.7pc this year, the IMF has said, upgrading the forecast from its previous prediction of 0.5pc after government statisticians described the economy as “going gangbusters” in the early months of this year.
In 2025, growth is forecast to more than double to 1.5pc. That is faster than the 1.3pc projected for Germany and France next year, and the 0.9pc anticipated in Italy. Such strong growth figures will boost the new Labour Government and it dispels Labour’s argument that they inherited a sick and declining UK economy.
Rachel Reeves, the Chancellor, has said:
“While it’s welcome that the IMF is forecasting growth to pick up this time, I am under no illusion to the scale of the challenge facing the economy and the inheritance this new government faces. That is why we are already taking the tough decisions to fix the foundations of our economy, so we can rebuild Britain and make every part of our country better off.”
However, despite the optimistic forecast from the IMF, it still means that as things stand, the UK will fall short of Labour’s optimistic manifesto pledge “to secure the highest sustained growth in the G7”, as the US and Canadian economies are growing even faster.
So, is the commercial real estate in the IK out of the woods?
Mark Allan, chief executive of Land Securities, told the FT that the market for higher quality UK commercial property is improving.
“Macroeconomic signals look more encouraging than they have for a while. . . absent any further macro shocks, we think the value of high-quality assets has largely bottomed out and will start to grow in the foreseeable future as rents rise.”
His comments are encouraging but they don’t rule out the problems that still exist, particularly in some office areas. In Canary Wharf for example, the office, Five Churchill Place in February was sold at a 60 per cent discount to its last sale price. This sale becomes something of a bellwether for the difficulties in that office market.
Historical value declines across the sector
Across the retail sector, for example, in aggregate capital values slipped by a further 4.2% last year, this extending a decline of 8% the year before which followed the largest decline in values in the office sector, which amounted to up an 11.5% drop over 2023 preceded by a 12% decline back in 2022.
An interest rate stabilisation and an increase in takeover activity in the City this past year shows that some company acquirers are rushing in to take advantage for depressed prices. Marcus Phayre-Mudge, TR Property Investment Trust says that as the interest rates trajectory becomes clearer, “investors are beginning to differentiate between the less desirable elements of the sector and those companies that own quality assets”
Mr Phayre-Mudge has said:
“These false dawns have led to many investors remaining on the sidelines, awaiting harder evidence of base rates falling. Our central case is that this point is drawing ever closer, but crucially, our positioning and optimism is not dependent on major reductions in interest rates. The companies we own have balance sheets which can withstand rates remaining at current levels.
“The spike in takeover activity this past year shows acquirers are rushing in to take advantage, where public markets have left quality assets languishing at significant discounts.”
In its report, RICS had said that tenant demand also reflects this bifurcated [divide into two branches or forks] market: “Tenant demand is becoming more split across location. In London, office demand significantly increased this quarter while elsewhere in the UK the picture is either flat or slightly negative.
"Retail demand is also showing stronger momentum in London than other parts of the UK. Industrial property demand remains steady, with most regions reporting positive demand sentiment."
It’s a market where investors need to be careful. Where property companies have debt, they will need to refinance at considerably higher rates when that debt expires. ‘Problem’ debt is rising in the sector, and this is another reason to stick firmly to the higher quality end of the market, says the consensus.
The TR Property Investment Trust is a good indicator of the trend in what has been a relatively stable but tough commercial property market. Its net asset value has grown substantially over the past year by 21.6 per cent, but its current valuation remains at a 3.73 per cent discount to NAV. It has exposure to Europe, which has helped diversify its portfolio.
Cohen & Steers European Real Estate Securities invests in a portfolio of European-listed REITs’ manager Leonard Geiger is optimistic:
“An end to central bank tightening tends to be followed by notable strength in listed real estate. In addition, cash flows generally remain sound, and we anticipate healthy earnings growth in 2024.”
Given these more optimistic soundings, the commercial property sector should be able to look forward to a source of steady, inflation-adjusted income and stable capital growth. But with Covid and Ukraine and the other systemic shifts pointed out above, the sector has been through an unusual and difficult period. Hopefully, this is about to come to an end.
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