Mat Oakley examines the challenges and opportunities for investment across the office, logistics and retail sectors in the face of debt, inflation and growth shocks.
CAPITAL VALUE FALLS AND RENT RISES – BUYING OPPORTUNITY AHEAD?
With the inflation shock now largely past, the market is rapidly adapting to the beginning of an era of higher interest rates. While younger readers may not remember it, the commercial property market throughout most of the 1980s and 1990s functioned happily with the cost of borrowing being higher than the entry yield.
The second half of 2022 saw the most rapid repricing of market yields that we have ever recorded, and this sets us up for a return of activity and then a period of price stability in 2023. The long post-GFC cycle is over, and investors will have position themselves for a new era when income returns and rental growth will be the primary drivers of total returns.
RENT RISES IN A RECESSION?
The combination of high employment levels and significant government support for households through the energy crisis will mean that the UK recession is shallow, but fairly long, dragging through much of 2023. Given that GDP growth is pretty much the best correlated economic driver of both commercial property yields and rents, how can we suggest that rents might rise in 2023?
The evidence that this is possible comes from the very recent past, through the deep Covid-related recession. For the first time ever we saw prime office and logistics rents rising through an economic recession, due the undersupply of high quality space.
Our view is that this undersupply remains and has intensified due to the rising cost of borrowing and general lender caution towards speculative development. Development starts are being delayed, and this trend will continue through 2023. This must mean that whatever the short-term demand trends, the medium term outlook will be one of tightening prime supply.
As businesses begin to expand out of this latest recession the competition for staff and heightening occupier focus on the carbon impact of its buildings will lead to a rising tenant bias towards “green” and “prime”. This recovery in demand will come at a moment when development completions are at a cyclical low, and will lead to above trend rental growth.
LOGISTICS VACANCY TO INCREASE MODERATELY
The logistics sector is not immune to a recession, though the story of Christmas 2022 could well be one of unsold stock piling up inside warehouses and supporting demand. However, a weak consumer environment in 2023 will lead to lower sales and a softening in occupier demand for logistics.
While the global supply chain pressure that built up during Covid and the Ukraine conflict has eased in recent months, our view is that the trend towards near-shoring and shortening of supply chains is a key theme for the next five years. This will support demand for both logistics and manufacturing space in the UK, ably assisted by corporate concerns about the still not finalised Brexit trade environment.
Logistics development activity is cooling, but a slight increase in the overall vacancy rate in 2023 (albeit from near record lows in 2022) feels inevitable. This will be enough to cool rental growth in the short term, though as the economy returns to growth the undersupply of prime space will lead to accelerating rental growth again.
The most challenged part of the logistics market will be second-hand space, where technical obsolescence will be accelerated by the need to decarbonise supply chains. We remain unconvinced that the rental uplifts from refurbishing second-hand space in some locations will be enough to compensate for the extra capital expenditure required.
RETAIL RENTS HAVE ABASED AND THE SECTOR IS PRICED FOR RECOVERY
A household spending crisis seems a bad time to be suggesting that investors should be looking at retail, but we feel that there is less uncertainty around where yields might settle in this sector than in the others. Retail capital values have been falling since before Covid, and the high yields on offer at present need less correction to reflect the new era of high base rates.
Spring 2023 will definitely be tough for UK retail, especially once the energy price cap ends for some households and interest rate rises drag on mortgaged homeowner’s disposable incomes. However, as we move into summer we expect to see vacancy rates return to the downward trend that we were seeing in 2022, and some rental growth also beginning to emerge.
Parts of the retail sector will also get a significant boost in affordability from the rating revaluation.
Bulky goods retail warehousing, one of our top picks of the last three years, is more exposed to a consumer recession than other parts of the market due to its dependence on the sale of big-ticket items. However, the high income return on offer will mean that this sector delivers some of the best commercial property total returns over the next five years.
Another part of the retail market that is likely to outperform is high street shops in suburban and commuter towns. There is clear evidence that agile working is leading to higher footfall and spend in these locations, and we expect this to remain a trend for the foreseeable future.
DO RELUCTANT COMMUTERS MATTER FOR THE OFFICE OUTLOOK?
While agile working has had less of an effect on office demand than it could have, the pending recession might well see some of the impact of offices being half empty finally being felt in terms of rising subletting. However, the overwhelming tone of the office market over the next five years will be one of an undersupply of offices with high environmental ratings, and hence accelerating prime rental growth towards the back end of our forecast period.
Greening the bulk of the UK office market remains a logistical and policy challenge, which is being further intensified by the tightening of the debt market.
Q2 2023 LIKELY TO BE THE BEST TIME FOR CONTRA-CYCLICAL BUYERS
Worsening economic news in the Spring and early summer will lead to another pricing adjustment, and this should represent the nadir for prime capital values. Opportunistic buyers are already massing globally, and we expect them to call the cycle around that time.
Secondary prices will continue to drift downwards until the entry price is low enough to support refurbishment or repurposing.
Investors who follow structural trends will become comfortable that the occupational dynamics have not changed. This will mean that “beds, sheds and meds” remains a common strategy.