High

Real Estate

As the economy recovers, the way we use and operate from property will evolve requiring innovative solutions and a pragmatic view from stakeholders.

Sector trends & challenges

  • Reduction in market rents

    A fall in occupancy rates, huge pressure on costs and turnover, particularly in commercial space, continues to reduce rental income. The moratorium extension until March 2022 exacerbates the frustration being felt by landlords.

  • Structural shift

    Consequences of the pandemic have the potential to create a long-lasting change in usage patterns and requirements, particularly retail and commercial space in urban centres. Urban centres may have to become multi-purpose.

  • Environmental credentials

    Real estate developers and owners need to be increasingly aware of the importance of environmental standards such as BREEAM ratings in order to secure ‘blue chip’ tenants. Demand for quality regional offices could increase.

Sector rating profile

The stress within the sector has gradually increased in recent years, as the steady transition to online shopping has created excess capacity. In 2022, COVID-19 continues to transform the sector and create real uncertainty, with the very purpose of urban centres as commercial hubs coming under question. Turnover based rent is becoming increasingly common which makes it extremely difficult for landlords to forecast cashflows.

Real Estate

To look at some of the challenges that continue to be faced in the sector by COVID-19 as we move towards the end of 2022, it’s worth looking back at some context from the previous financial crisis.

Residential property prices increased steadily year-on-year from 2010 to 2020 in line with historic averages. However the onset of the pandemic and the stamp duty ‘holiday’ have caused a significant increase in house prices. Prices are up a staggering 13.2% on average in the year to August 2021, inflated due to the stamp duty savings but the pandemic seems to have driven a demand for more space. Time will tell if prices will continue to rise, a lot will depend on whether current inflation levels are here to stay or simply transitory.

Commercial property pre-COVID

The commercial property market saw exceptional value growth in the period leading up to 2007, which was immediately followed by a significant price correction during and following the 2008 global financial crisis. Values remained relatively flat for a number of years thereafter before recovering from 2013 onwards. Commercial property has traditionally been considered an attractive asset class as part of a diverse investment portfolio, providing relatively long secure income with potential for rental and value growth depending on asset management opportunities.

The three main commercial property sectors comprising retail, office and industrial have differing market dynamics and are often counter cyclical.

Retail. Prior to the COVID-19 pandemic many retailers were faced with challenging trading conditions due to reduced consumer confidence, rising occupational costs and an increased shift to online shopping resulting in a reduction in demand for physical retail stores. This led to an increasing number of retailer CVAs and insolvencies, leaving units either vacant or with tenants paying a lower rent, which led to landlords suffering a reduction in their net operating income and ultimately a deterioration in property values.

Commercial. The value of office buildings across the UK has generally remained stable. Supply in some major cities is low, which has helped to maintain rent levels, and occupiers were delaying their relocation plans pending resolution of the UK’s exit from the EU. There are pockets of distress where local industry has experienced change, e.g. in Aberdeen where demand for offices has declined significantly following the recent collapse of the oil price.

Industrial. The development of industrial property has been relatively unfashionable in recent years, yielding low returns relative to other property classes. However, the shift to online retail has increased the demand for both large logistic distribution centres and last mile delivery units. Increasing rents and lease terms have resulted in industrial estates and units becoming institutional grade investments.

2021, 2022 and beyond

The impact of the measures imposed by the UK government throughout 2021 and now 2022 in response to the COVID-19 pandemic are likely to be felt in the real estate sector for years to come. Occupiers will increasingly reflect on their operational needs whereas property owners will assess the impact on their business and how they can adapt to these changing times.

Retail. In 2019, 19% of all retail sales were online versus only 11% five years earlier. This suddenly jumped to 30% in April 2020 following the enforced closure of all non-essential retailers in the preceding month. This dropped to 26% in August 2022 as physical shopping returned but it is still considerably higher than the pre-pandemic level. Even prior to COVID-19 the retail sector was adapting to an increase in online shopping, and by some estimates there was already a 30% oversupply of retail premises.

18 months on from the outbreak of Covid-19 the economy continues to recover, however the oversupply of commercial property has the potential to intensify. Whilst online shopping may not continue at the lockdown highs, there has almost certainly been a pivotal shift in the demand for retail space. We’re already seeing a greater prevalence of turnover rents, reduced investment and creating a closer connection between yields and performance of the wider economy.

Property owners and other stakeholders are now considering alternative strategies, including repurposing assets for alternative uses where there is a significant obsolescence factor. Whilst prime and super-prime “destination” schemes are likely to be more resilient, the secondary and tertiary schemes, where there is an oversupply of comparison goods and fashion retailers, are likely to see the highest loss of income and value reduction.

Office Commercial. Before COVID-19 we anticipated an increased demand for office space from professional services as well as the creative and technology sectors. However, as the majority of office workers embraced working from home and the benefits of technology, many businesses will now re-assess what space they need and how this is used in the future.
Although the COVID-19 lockdown measures saw a number of services and flexible office providers lose income streams rapidly, there is a sense that flexible office space may be part of the solution longer term as ‘hybrid working’ office requirements are mapped out. Office landlords may therefore need to adapt to shorter leases and increase the amount of space that is used by flexible office operators.
A common response from professional firms thus far has been to reduce rented office space by c.50% and adapt a ‘hybrid working’ rota. It’s impossible to say whether this system will continue to be implemented for years to come but the rapid evolution of technology means there is a strong possibility that it will.

Industrial. Industrial property values and rents have increased considerably over the past few years making development economically viable. Multi-let industrial schemes with asset management potential are likely to remain desirable investments particularly as we expect to see rental growth in the short term.

The demand for large distribution and logistics units is likely to continue, especially given the growth seen right across the logistics sector due to an increase in online shopping habits. In addition supply chains continue to seek greater resilience from post-Brexit border and trade disruption. Some investors are now even turning away from the sector as they consider the pricing has become too competitive.

 

Find Your Expert

Steve Absolom is Interpath Sector Leader for what we call the 'Property' sector. This includes Real Estate as one of three core segments. For a full list of our senior people with experience in this sector use the button below.

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