Market in Minutes: UK Commercial

The UK commercial real estate market is facing headwinds

For the third month in a row, the average prime yield remained static showing only a four basis point fall during this period. Commercial real estate, as with most asset classes, is looking at the headwinds of inflation and recession. For the UK, the speed and scale of interest rise rises is now the conundrum for the Bank of England.

The notable change during the past month is the removal of downward trend arrows on five of the sectors. The High Street and Shopping Centre retail sectors retain downward trend arrows but are still much higher than pre-pandemic levels by 75 and 100 basis points, respectively. South East Offices saw yields move lower and are now back at the 5.3% average recorded for the past ten years - some funds have come back to the market with requirements for this sub-sector.

During the past year, the relationship between commercial real estate and inflation has become a key discussion. The chart shows the annual inflation rate and the month-on-month change in UK ‘All Property’ capital values. The real estate market moves in line with economic growth, and inflation has tended to lag the economic ‘event’, as seen with the global financial crisis, the EU Referendum decision, or the Covid-19 pandemic. Given the speed and extent of interest rate movements and the higher percentage of investors buying prime real estate than in previous cycles, we are expecting yields to soften in the short term.

Where is the current level of business confidence?

Business and consumer sentiment and confidence is a key driver of the real estate investment markets, given the importance of occupier occupational demand. The economic outlook and the resulting willingness for corporates and households to spend is intertwined. The state of the consumer economy, which has implications for the retail and residential real estate markets is dominant in the news headlines, but it’s also important to review the sentiment of corporates, which influences the prospects for the office sectors.

There are many surveys and barometers of corporate sentiment, but the Deloitte survey of Chief Financial Officers (CFOs) is a leading authority and it’s worth a more detailed review of the data for the first quarter of what is turning out to be a ‘tricky’ 2022. Of course, the ‘headwinds’ for CFOs have increased significantly during the past few months as they have had to focus and deal with all the issues that have arisen but remain focused on their corporate strategy. Navigating their business through the current period is likely to be one of their toughest challenges to date. Therefore, it is encouraging to see that the focus remains on growth and not just survival.

Q2 is expected to show weaker financial prospects, but as we have seen before, given the resilient nature of the UK, the sentiment will show a ‘bounce’ towards the end of this year

Steven Lang, Director, Commercial Research

As shown in the chart below, their opinion of financial prospects, for the next 12 months, is buoyant, with over half saying they remain the same or have become more optimistic. Additionally, cost reduction is a strong priority for a third of the UK CFOs, but this will be tempered by the inevitable rise in salary costs. Overall, we need to know what their real estate occupation will look like in the short to medium-term. The fact that two-thirds still expect capital expenditure to remain a priority is encouraging. The ‘flight to quality’ by occupiers for their office space is testament to this.

The next big question is what will Q2 look like for the data sets below? It is expected to show weaker financial prospects, but as we have seen before, given the resilient nature of the UK, the sentiment will show a ‘bounce’ towards the end of this year.

Sticking with an inflationary theme, the cost of oil has moved back to a level on par with the first half of 2014. The summer of 2014 saw the oil price slump and remain low for a couple of years. Surprisingly, there is a relatively low correlation to petrol cost for consumers – petrol prices do not fall back to lowers levels during an oil price fall. The current cost is the highest for 30+ years and if they remain high, there may be an impact on real estate investment decisions.

Longer term, the shift to hybrid and fully electric vehicles will reduce the impact of higher fuel prices, but in the short term, the logistic costs for all areas of the supply chain will increase for retailers and with additional costs passed onto the consumer. Savills survey of office workers has shown that 49% (outside of London) commute by car. Therefore, public transport accessible office locations should become more favourable for investors, which includes town/city centres.