Our Thoughts
Mon, 07/08/2023 - 12:00
· 6 min read

Offices | A Full Recovery is Out of Reach, But Conditions are Ripe for Some Investors to Capitalise

From retrofit-first to the impact of the loosening jobs market on office occupancy, BNP Paribas Real Estate' head of research and insights, Vanessa Hale, shares her views on what will be the dominant themes in commercial real estate during the second half of 2023. 

At the start of the year, I said that interest rates would soon stabilise and the pricing of commercial property would fall more in line with buyers’ expectations, setting the stage for a gradual recovery in deal volumes beginning in the second half of the year.

A meaningful recovery however for the second half of this year now looks unlikely, because whether you were watching from our Aldermanbury Square headquarters or the Governor’s office on Threadneedle Street, we were all wrongfooted by inflation.

April and May’s figures came in so hot that it opened the door to the possibility the UK was an outlier – that for some reason the economy had changed and inflation might not subside the way it has in the US. Financial markets priced in a peak base rate of 6.5% next year. Borrowing costs spiked.

Mercifully, June’s figures signalled that the worst-case scenarios will not come to pass. After hiking the base rate to 5.25% on Thursday, the Bank of England said it expected inflation to fall significantly over the remainder of the year to an annual rate of about 5%.

Nevertheless, the impact on commercial property transactions has been stark. Investors spent £18.5 billion on UK commercial real estate in the first six months of 2023, less than half the volume in same period last year and a third below the ten-year average.

The second half should show a very marginal improvement. We expect that total volumes will reach £41bn – down about a third both on last year and the long run average – before rising 15% to £47 billion in 2024.

That would represent a distinctly lacklustre two years, but peak Bank Rate – which we anticipate will be 5.75% by year end - is unlikely to prompt a flurry of activity. Though we expect the first rate cuts to arrive in the second quarter of next year, many investors will be tempted into waiting for borrowing costs to fall further before acting. The next UK General Election will loom larger in investors’ minds as the months of 2024 tick by. That vote must take place by January 2025, so it could be called as late as mid-December 2024.

Still, shifts are underway that will present opportunities for those with the skills and appetite to capitalise. We think they can be condensed into five themes that will draw the most interest from investors through the second half of the year:

 

Clarity on Retrofit or Rebuild

Just under a fifth of UK office space has a sufficient EPC rating to meet proposed Minimum Energy Efficiency Standards (MEES) legislation due to come into force in 2030. Until now, owners of the remaining 80% were faced with three choices: reposition, refurbish or rebuild.  

Michael Gove’s July decision to deny Marks & Spencer its plan to demolish and rebuild its Oxford Street store has taken the third option off the table for many. It’s now likely that the UK planning system will more regularly lean towards protecting existing buildings on the grounds of embodied carbon.

We’ve known about the scale of the challenge that MEES presents for years, but Gove’s decision will prompt many of those lacking the necessary skills to sell up. Some developers have embraced the retrofit-first option from the outset and have a large first-mover advantage due to the technological challenges of the approach.

 

The Long Wait for a Debt Market Reprieve

We’ve seen significantly fewer distressed sales during the past year than in previous downturns. Lenders are clearly reluctant to call in badly performing loans that would require asset sales while conditions are tough. Healthier balance sheets and resilient rental growth in key sectors and locations will also keep covenant breaches relatively low. 

That said, the reprieve in borrowing costs that we’ve seen in recent weeks has likely come too late for a small number of owners. The 5y SONIA swap stood at 4.7% at the end of July, up from 2.1% at the same point last year, and there are few chances of respite on the horizon. The Bank of England’s latest survey of lenders suggested that the availability of debt will worsen over the short term.

These conditions should drive some transactional activity. Institutions, though not distressed, are also likely to remain net sellers for the time being. Well capitalised private investors are in a fantastic position to build portfolios for the next cycle. 

 

Investors Begin Building Single Family Rental Portfolios

The Build-to-Rent (BTR) sector enjoys both long and short-term tailwinds. Legislation, taxation and retirement have prompted large numbers of residential landlords to sell up, squeezing the supply of rental properties and driving rental growth to the fastest pace for seven years. Sector investment volumes held firm in the second quarter, but development has been constrained by debt costs, which will further squeeze supply and underpin rental growth over the long-term.

Pressure on the housebuilders has prompted several to offload single family homes to investors, and we’d expect that to accelerate in the second half of the year. While investors to date have mostly focused on the urban BTR model, single family renting is potentially the bigger opportunity. More than three quarters of households in England and Wales live in houses rather than apartments.

 

The Return to the Office Gathers Pace

Larger corporate occupiers are now making a concerted effort to bring employees back to the office three or four days a week.

The demands of occupiers are being made easier by slack emerging in the jobs market. The availability of staff has now risen for four consecutive months and the latest increase was the steepest since 2009, according to Recruitment and Employment Confederation (REC) data. Job security is a sensitive issue but it will influence this debate – wall-to-wall coverage of the threat of Artificial Intelligence (AI) to knowledge workers will also play a role.

This will gather momentum through the second half and into next year. Demand for the best space to support employees will drive 7.2% rental growth in the West End this year, and average 3.4% during the next 5 years. Rental growth in the City of London will close the year flat but will average 2.5% over the medium term. 

 

Retail Becomes a Target

Inflation has surprised in part due to the resilience of the consumer. Retail sales are rising despite surging mortgage rates, and a long-protracted recession now looks very unlikely. Retail spend, meanwhile, has to some degree pivoted back to stores. Online’s share of average card spending fell to 40% in the first week of July – higher than the 25% registered at the outset of the pandemic, but down from the peak of 60% in February 2020, according to Revolut.

Retail property has suffered recently but a turn is coming. Transaction volumes in the retail sector were a fifth above the five-year average in the first half after rising from a low base. Though we don’t expect central London rental growth to return until 2025, investors are targeting assets anchored by strong covenants with pricing power. That includes subsectors with resilient spend and footfall, such as prime out-of-town retail parks.

The correction in values has also opened up opportunities to repurpose and reposition well-located properties, which is attracting more value-add investors. John Lewis Partnership’s tie-up with abrdn to redevelop shops and warehouses into rental homes is a great example of investors repurposing assets to drive income while satisfying demand in supply-starved sectors.

 

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    Offices | A Full Recovery is Out of Reach, But Conditions are Ripe for Some Investors to Capitalise