Predicted trends across the commercial property sector in Q4 and beyond

At the outset of 2023, we were faced with the challenge of a moderate recession, accompanied by high inflation and rising interest rates, which were hindering the UK’s growth. Despite avoiding a full-blown recession, the economy is still grappling with the burdens of high inflation and interest rates, and the real estate sector has been particularly affected by increased debt costs, resulting in decreased investment and lending volumes.

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.

Here we take a look at how commercial property investment, lending and development is fairing thus far in 2023, and assess what the future may hold for the sector in Q4 and beyond.

The year to date

There are very few aspects of the wider economy which haven’t impacted the commercial property sector in recent times, since something as simple as a hike in interest rates designed to cool inflation must, by definition, impact on things such as consumer demand and wider business activity.

At the time of writing, the UK inflation figure had just dipped to 7.9%, a bigger drop than had been expected and one which prompted many commentators to speculate that the BoE would no longer be looking at pushing interest rates as high as 6% over the next 12 months.

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.

The relatively good news on inflation and interest rates is balanced out by the fact that the labour market remains constricted, with shortages in many key sectors and low general unemployment.

The acute nature of the labour shortage issues in a range of sectors was reflected by the fact that the UK government recently added a number of jobs to the official ‘shortage occupation list’ – a list of those jobs for which it is possible to qualify for a Skilled Worker Visa for the UK on 80% of the going rate – including many in the construction sector.

These factors, allied to on-going supply chain issues exacerbated by Russia’s invasion of Ukraine and the extra red tape ushered in by Brexit, have led experts to predict that UK growth at the end of 2023 and into 2024 will remain sluggish. Although, with the IMF upgrading its growth forecast for 2023 to +0.4% in May, it now looks as if the UK will avoid slipping into recession during 2024, and the consensus opinion amongst economists is that the UK should be able to hit 1.0% growth during 2024.

Emerging Commercial Property Trends

One of the key trends expected to continue into Q4 of 2023 is a consolidation of the prime rental levels being achieved by the best commercial properties across a range of sectors. The reason for this is the age-old gap between supply and demand. The supply, in this case, being of high-quality city centre office spaces and warehousing for distribution and last-mile delivery.

The shift to e-commerce, which accelerated and became more embedded during the pandemic, has helped to drive a rise in demand for commercial space from retailers and third-party logistics firms. This has happened at the same time as the exit from the EU, which has meant businesses are more likely to hold on to larger amounts on inventory to ensure the maintenance of their own supply chains.

These factors taken together mean that we can expect to see a continued uptick in the demand for both large-scale distribution warehouses and smaller and more urban distribution hubs.  In all cases, however, the rate of construction of such developments has been restrained by a combination of supply chain issues, rising material costs, a tight labour market, stubborn core inflation and on-going economic uncertainty.

With none of these issues due to be resolved in the short to medium term, there is little prospect of more construction to boost the stock available.

There are several other emerging market trends to be aware of, however, and here we assess the key ones:

• Investment and lending

The commercial real estate market has remained relatively steady in the early part of this year, following a significant decline in the latter half of 2022. 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.

Generally, in the first six months of 2023, our experience is that new lending deals (i.e. lending on new acquisitions or brand-new development sites) is notably down. Predominantly we are seeing mainly refinancing’s and, in some cases, extensions and restructurings. It reflects a general caution and “wait and see” approach, as property values and debt pricing are still to fully settle.

However, some may cautiously anticipate a gradual recovery in transaction and lending activity in the second half of this year. While some investors and lenders may take a wait-and-see approach, others may feel compelled to release or invest capital/debt as the year progresses.

It should be noted that any increases in capital values or market activity are likely to be irregular. Investor interest in residential, logistical, and operational assets is currently higher. Furthermore, across all sectors, there will likely be a difference in how well prime and secondary assets function.

• Biodiversity net gain

Many of the trends emerging in Q4 of 2023 are not solely financial, and are instead linked to the climate emergency and the steps being taken to mitigate the environmental impact of commercial property development. In November of this year, for example, biodiversity net gain (BNG) regulations are due to come into force across England and Wales.

As explained on the government’s own website, BNG refers to actions designed to contribute to the preservation or recovery of natural habitat during the development process. BNG will apply to land managers, developers and local planning authorities.

It will affect developments covered by the Town and Country Planning Act 1990, unless those developments have been declared exempt, and from April 2024 the same regulations will apply to smaller sites.

Developers working with the BNG regulations have to try to avoid any loss of habitat on a piece of land they plan to develop. If loss is unavoidable then new habitat needs to be created on the site itself, or off-site (off-site referring to other land owned by the developer, or units purchased from a land manager).

If the use of on or off-site land is impossible, then a developer will have to purchase statutory credits from the government. This route is intended as a last resort for which evidence will need to be presented, and the government will use the funds on habitat creation elsewhere in England.

The introduction of BNG regulations means that the environmental impact of any development will need to be factored in much earlier in the process and in greater depth than has perhaps previously been the case.

• Retail

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.

Despite the tough economic conditions, the number of businesses closing down has not been as high as it was during the worst of the pandemic. As a result, vacancy rates have remained stable. Returns for high streets and shopping centres have also stayed steady, although retail park profits have decreased due to more investors focusing on this sub-sector. However, it’s likely that we will see more businesses shutting down (e.g. a recent Begbies survey of retailers found that over 20% of retailers said they were not confident they would still be trading at the end of this year).

Successful retailers in strategic locations will continue to look for opportunities to expand, which will drive up rents and create competition. If interest rates stabilise as predicted by late 2023, the overall economic outlook will become clearer, and investor confidence in the retail market should improve.

• Office Space

At the height of the pandemic there were a great many articles written that proclaimed the death of the daily commute and working in the office and the rise of working from home as the norm. The reality, however, is that a hybrid model has been emerging, with workers and companies keen to develop an office-based culture across some days of every week, with working from home part of a more flexible approach on other days.

As such, corporates, which haven’t done so already, are looking to cut costs and increase productivity in Q4 of 2023 by analysing their real estate footprint and adjusting to take hybrid working into account.

The size of the commercial office space is not the only question corporates will be looking at. Being able to offer office space that is high quality, in terms of the environment and the facilities on offer, is seen as playing a key role in staff recruitment and development. Built-in flexibility will come to be regarded as a must by corporates keen to attract talent, which now want to be able to work remotely as and when it better fits with their lifestyle.

• Two-tier market

The push for high-quality office space will combine with the newly introduced Minimum Energy Efficiency Standard (MEES) Regulations. This will mean that the landlords of non-domestic buildings with a rating of F and/or G need to undertake works to improve this rating to an E or above, or cease letting the property (unless an exemption is granted).

Not only is this a legal requirement, but it also chimes with an increasing focus on highly ambitious ESG (Environmental, Social and Governance) aspirations. Many corporates are keen to be able to demonstrate to customers, business partners and potential employees that they are doing everything they can to operate in an ethical manner across a range of issues.

The commercial property from which a corporate operates will come to play an ever-more important role in delivering these aspirations. Businesses will seek out those properties which will help them in a company-wide push for sustainability, energy efficiency and a lower carbon footprint.

In addition to this, office spaces that are being sold to prospective employees as offering an adjunct to working from home, rather than an alternative, will need to offer a variety of facilities. These include coffee shops, lounges and even gyms, and in all cases, the office will need to be designed to offer the kind of collaborative environment that can never be replicated by a video call.

A key driver for people returning to the office will be the sociability offered by a shared workspace and newer office developments will need to be designed with this space in mind.   This emerging two-tier market highlights that those developments which offer the kind of facilities detailed above will be able to command premium rental rates; whereas those with more basic features will not.

For developers, the extra investment needed to design and build the top-tier office spaces will be seen as less of an expense and more of an investment aimed at delivering a higher rental yield and capital growth as the demands for sustainability and flexibility increase.

• Residential Development

Since the end of 2022, House prices in the UK have experienced a 1.4% decrease overall, with a 0.4% decrease specifically in London, as reported by the ONS. Furthermore, at the time of writing, Nationwide has reported that UK house prices dropped at their fastest annual rate for 14 years in July; dropping by 3.8% – the biggest yearly decline since July 2009.

On the other hand, since 2022, UK rents have seen a 2.1% increase overall, rising by 2.2% in London. These figures represent the highest annual growth levels ever recorded since the establishment of the ONS index in 2006.

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 constant 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.

• Operational real estate

Another trend to be conscious of is the continued rise of ‘operational real estate’ which refers to more specialised property developments where return on investment is linked to the performance of the specialised business at the purpose-built premises.

Sectors which might fall under this umbrella include self-storage, healthcare facilities, specialist residential facilities such as student accommodation, leisure facilities, educational facilities, co-working or serviced offices and technology infrastructure such as data centres.

One appeal of investments in commercial properties such as these (healthcare or student accommodation, for example) is that their performance in the economy can be countercyclical to other asset classes.

Take self-storage for example, which often performs equally well during an economic downturn due to the number of people downsizing their living space and needing somewhere to store excess possessions.

Entry into these types of property investments requires an understanding of, as well as a capability to manage, how the integrated businesses are run (or finding a commercial partner who does).

For lenders, landlords, occupiers, and developers in the commercial property and property finance sectors, Newmanor Law offer a fresh and bold approach.

We are committed to delivering the best outcomes for our clients. We do this using our significant legal knowledge and transactional experience, combined with cutting-edge technology to offer a service you can trust.

Please do not hesitate to contact us should you require a consultation or advice on any commercial property related matters.