The commercial sector in the UK has absorbed some major shocks over the past couple of years with first Covid, then supply problems and inflation followed by rapidly rising interest rates.
2023 started with a moderate recession, depressing property values and hindering the UK’s growth. Although the country has avoided a full-blown recession so far, the economy is still under the cosh of higher inflation, stubbornly refusing to come down quickly, and still higher than some other countries. Interest rates at their highest for some years
The commercial property sector has been particularly badly hit with reduced property values and rents, and increased lending costs, which have together resulted in decreased levels of investment and lending volumes.
As property law specialist, Karen Mason of Newmanor Law says,
“Against this complex background, it is no wonder that property investors and lenders, construction specialists, developers, and commercial occupiers are tackling their own specific obstacles, with varying levels of success.”
Newmanor Law took an in-depth look – with their wide experience in the commercial property market - at the future of how commercial property investment, lending and development might pan out in 2024.
The UK inflation figure edged up to 4% in December from a low of 3.9% a month earlier but is expected to fall gradually to reach around 3% this year, though many economists think it could even return to the Bank of England's 2% target by April or May - sooner than in other countries.
That would also be far earlier than the BoE forecast at the start of November when it predicted inflation would stay above target until late 2025.
However, Newmanor Law says:
“What this doesn’t mean, of course, is that prices are coming down or are likely to start coming down any time soon. Nor does it mean anyone can look forward to a return to the kind of negligible interest rates developers and investors were able to enjoy between 2008 and December 2021.”
This good news on inflation is offset by a labour market beset by strikes and constricted in other ways with labour shortages in many key sectors and low general unemployment driving up pay settlements.
Ongoing supply chain shortages are also affected by the current unstable geo-political situation with ongoing conflicts between Russia and Ukraine, Israel and Palestine and the knock-on effects with Yemen and the shipping blockages through the Red Sea and Suez. And while the country is still adapting to the extra red tape brought about by Brexit, and the uncertainty of a probable election this year, experts predict that UK growth will be sluggish.
But if the UK can avoid going into a slowdown and recession in 2024, barring further economic shocks, Savills Director of Commercial Research Mat Oakley says”
“We believe that the factors that drove the recent collapse in commercial property values and confidence will all improve in 2024. However, as the storm surge of high inflation and interest rates recedes, some new (and old) rocks will be exposed to challenge investors in certain sectors.
“While we do expect that borrowing costs will fall over the next two years, they will not return to the levels that we were used to in the pre-Covid decade. This will mean that not only will prime yields not return to 2019 levels, but also that stronger than normal levels of rental growth will be needed to support some investment and development decisions.
“Parts of the UK commercial property market look set to continue to deliver strong rental growth, but even this positivity may not be enough to convince some investors to return to the market when other regions of the world are continuing to experience falling values and distress.”
Newmanor Law has identified some salient trends in the UK commercial property marketplace:
The major structural shift to e-commerce, accelerated and becoming embedded during Covid, has driven a rise in demand for some types of commercial space, for example from retailers and third-party logistics firms. The UK’s exit from the EU has meant that businesses have been more likely to hold larger amounts of inventory in order to ensure their ability to maintain their own supply chains, helping sustain a healthy demand for space.
Large-scale distribution warehouses and smaller and more urban distribution hubs are likely to continue to be in demand, though as Newmanor Law points out in, new developments and construction are being constrained by a combination of supply chain issues, new regulations, rising material costs, and a tight labour market coupled with stubborn core-inflation and on-going economic uncertainty.
Newmanor Law sees none of these issues being resolved in the short to medium term, and they think there is little prospect of more construction to boost the stock available.
“While real estate yields have stabilised, government bond yields have been volatile, reflecting the uncertain future of inflation and interest rates. Transaction activity has experienced a significant decrease, with only £8.1bn of investment property transactions taking place in Q1 2023, compared to £10.3bn in Q4 2022 and £21bn in Q1 2022,” says Newmanor Law.
However, some in the industry anticipate a gradual recovery in transaction and lending activity while other investors and lenders will take a wait-and-see approach. Capital values or market activity are likely to be irregular in some sectors, but investor interest in residential, logistical, and operational assets is likely to be higher. Furthermore, there is likely to be a discernible divide between how well prime and secondary assets function.
Many of the trends in 2024 in the UK commercial property market will relate to climate emergency and environmental considerations. The Minimum Energy Efficiency Standard (MEES) and biodiversity net gain (BNG) regulations, are coming into focus across England and Wales. Both are having a major impact on the occupancy of existing buildings and new developments. Biodiversity regulations, designed to contribute to the preservation or recovery of natural habitat during the development process, the regulations and extra bureaucracy involved, are affecting the time scales and costs for land managers, developers and local planning authorities.
“Consumer confidence has been steadily improving in 2023. While overall footfall in retail has remained stable at 12% below 2019 levels, sales have exceeded expectations, with volumes only slightly below 2019 levels,” says Newmanor law.
This is despite the tough economic conditions. The number of businesses closing down has slowed from the rate of closures during the worst phase of the pandemic. Vacancy rates have remained relatively stable but a recent Begbies survey of retailers found, over 20% of retailers say they were not over confident of remaining trading.
However, there are successful retailers in strategic locations who will continue to look for opportunities to expand. This will help drive up rents and create competition. If interest rates stabilise as predicted, the overall economic outlook will become clearer, and investor confidence in the retail market should improve, says Newmanor law.
A two-tier market in the office sector looks very likely according to Newmanor law. A likely tightening of the MEES regulations in the future appears to be driving the office sector to become a two-tier market.
As businesses try to achieve their ambitious Environmental, Social and Governance targets, they will seek spaces that include the best amenities and the highest green credentials. This change and willingness to pay higher rents, suggests the office sector will continue to provide opportunities for investors looking for quality properties to acquire.
However, what it means for the long-term prospects of older, poorer quality office stock is unclear. Would it even be viable, in the current market, to commit the level of capital expenditure needed to upgrade older units to meet greener expectations, and if not, will this inability to fund the necessary improvements diminish the sale value of the property should a landlord wish to sell it on?
Many people have speculated about the death of the daily commute and working from home (WfH) becoming the norm. In reality, however, it is a hybrid model that has been emerging as the standard working pattern. With, in most cases, both workers and companies keen to develop an office-based culture across just some days of every week, working from home will be part of a more flexible approach.
Corporates, therefore, are looking to adapt their property requirements accordingly, which if they haven’t done so already, means looking to cut costs and increase productivity. Many will be adjusting their real estate footprint to take hybrid working into account.
Reducing the size of their commercial office space is not the only issue corporates will be concerned with. They will be looking to offer space to their employees of high quality, in terms of the environment and the facilities on offer. This will be playing a key role in staff recruitment giving them built-in flexibility to attract talent.
According to Karen Mason of Newmanor Law, Rental demand is expected to remain significantly higher than supply. Factors such as rising mortgage costs and high inflation are driving demand for rentals, but BTR (build to rent) investment still stands at 21% lower than 2022 figures, meaning there is gap in the market for savvy investors who are able to weather the economic storm.
One of the main issues is planning application delays, which are still causing development projects to be stalled or abandoned, as local authorities struggle to recruit and allocate resources. According to research conducted by the Royal Institute of British Architects (RIBA), planning delays have directly resulted in 22% of architect practices abandoning projects in Q2 alone, compared to just 7 % in 2021.
Additionally, 47 % of practices have reported delays of six months or more, a significant increase from the previous year’s 30 %. This concerning trend threatens the progress and success of development schemes, demanding urgent attention and action.
There is a strong correlation between housing market activity, market strength, and housing starts. Developers will undoubtedly be hesitant to construct new homes in a weak housing market. With the recent mortgage cost increases and declining house prices, transaction levels are expected to decrease. Many buyers will find themselves priced out of the market until prices stabilise and borrowing becomes more affordable, impacting on the culmination of new deals and projects being green-lit.
Considering these factors, we anticipate a significant decline in new housing starts this year and into early next year. This leaves policymakers facing the challenge of addressing both the shortfall in housing delivery and access to homeownership. However, the supply and demand does mean that those that can find the margins and survive the downtown could ultimately reap the rewards (to varying degrees) in the next 12 to 18 months.
Karen Mason, is co-founder of specialist real estate law firm Newmanor Law. She is a highly experienced commercial property lawyer, with a knack for working out what the real commercial issues are on any transaction, and an outstanding track record of looking after her clients and getting things done.