COMMENT The impact of stubborn inflation and rising interest rates on commercial property transactions is stark. Investors spent £18.5bn on UK commercial real estate in the first six months of 2023, less than half the volume in the same period last year.
The second half should show a very marginal improvement. We expect total volumes for the year will reach £41bn – down by around a third on 2022 – before rising to £47bn in 2024.
Still, shifts are under way that will present opportunities for those with the skills and appetite to capitalise. These are the five themes I believe will draw the most investor interest in the coming months:
1. Clarity on retrofit or rebuild
Just under 20% of office space has a sufficient EPC rating to meet proposed MEES legislation due to come into force in 2030. Until now, owners of the remaining 80% were faced with three choices: reposition, refurbish or rebuild.
Secretary of state Michael Gove’s decision to deny Marks & Spencer its rebuild of its Oxford Street store has taken the third option away for many. It is now likely that the planning system will lean more towards protecting existing buildings on the grounds of embodied carbon.
The scale of the MEES challenge isn’t new, but Gove’s decision will prompt many of those lacking the necessary skills to sell up. Some developers have embraced the retrofit-first option from the outset and have a first-mover advantage owing to the technological challenges of the approach.
2. The long wait for a debt market reprieve
There is significantly less distress compared with previous downturns. Lenders are reluctant to call in badly performing loans that would require asset sales while conditions are tough. Healthier balance sheets and resilient rental growth in key sectors and locations will also keep covenant breaches relatively low.
That said, the reprieve in borrowing costs that we have seen in recent weeks is likely to have come too late for some. The five-year SONIA swap stood at 4.7% at the end of July, up from 2.1% at the same point last year, and respite on the horizon looks unlikely. The Bank of England’s latest survey of lenders suggested the availability of debt will worsen over the short term.
These conditions should drive some transactional activity. Institutions, though not distressed, will remain net sellers for the time being, while well-capitalised private investors are in a fantastic position to build portfolios for the next cycle.
3. Single-family rental portfolios
Legislation, taxation and retirement have prompted large numbers of residential landlords to sell up, squeezing supply and driving rental growth to the fastest pace for seven years. Build-to-rent investment volumes held firm in Q2, but development has been constrained by debt costs, which will further squeeze supply and underpin rental growth over the long term.
Pressure on housebuilders has prompted several to offload single-family homes to investors, and I expect this trend to accelerate. More than 75% of households in England and Wales live in houses. While investors have mostly focused on the urban BTR model, single-family renting is potentially the bigger opportunity.
4. The return to the office gathers pace
Larger corporates are making a concerted effort to bring employees back to the office three or four days a week. This is being made easier by slack emerging in the jobs market. The availability of staff has now risen for four consecutive months and the latest increase was the steepest since 2009.
Demand for the best space to support employees will drive 7.2% rental growth in the West End this year, and average 3.4% during the next five years. Rental growth in the City of London will close the year flat but will average 2.5% over the medium term.
5. Retail becomes a target
Inflation has remained high, in part due to the resilience of the consumer. Retail sales are rising, despite increased mortgage rates, and a protracted recession now looks very unlikely. Retail spend, meanwhile, has to some degree pivoted back to stores. Online’s share of average spending fell to 40% in the first week of July – down from the peak of 60% in February 2020, according to Revolut.
A turn is coming for retail property. Transaction volumes were a fifth above the five-year average in the first half, albeit rising from a low base. Investors are targeting assets anchored by strong covenants with pricing power. That includes subsectors with resilient spend and footfall, such as prime out-of-town retail parks.
The correction in values has also opened up opportunities to repurpose and reposition well-located properties, which is attracting more value-add investors. John Lewis Partnership’s tie-up with abrdn is a great example of investors repurposing assets to drive income while satisfying demand in supply-starved sectors.
Vanessa Hale is head of research and insights at BNP Paribas Real Estate
