COMMERCIAL MARKET OUTLOOK

• CPI inflation has fallen sharply from a peak of 11.1% in October 2022 to 4.6% in October 2023, albeit still well above the Bank of England’s 2% target. The latest Treasury-compiled consensus forecast (November) is for CPI to stand at 2.5% by Q4 2024. Wage inflation remains stubbornly high at 7.7% (excluding bonuses), and global energy prices are clearly vulnerable to geopolitical shocks and unpredictable global demand, so there are considerable risks to this outlook.

• The Bank of England’s Monetary Policy Committee (MPC) has held rates at 5.25% for two consecutive meetings, and the proportion of MPC members voting for an increase has fallen from four out of nine members in October to three out of nine in November. Given falling inflation, weak output growth, and subdued readings in recent business and consumer sentiment surveys, the base rate has probably now peaked. However, continued strong wage growth and other inflationary pressures mean that the base rate will also be slow to come down and the first reduction may not occur until well into 2024.

• High inflation has increased tax revenues, allowing some headline tax cutting measures in November’s Autumn Statement, including a 2% reduction in National Insurance Contributions. However, these tax cuts are relatively small compared with the increase in the overall tax burden in recent years.

• The unemployment rate remained at 4.2% in the three months to September and job vacancies fell for the 16th consecutive period, but remain elevated compared with pre-pandemic levels. These numbers suggest a continued tight, albeit weakening labour market. Consensus forecasts suggest a further modest rise in the unemployment rate to 4.6% by Q4 2024.

• The latest consensus view projects UK output growth at just 0.5% for 2023 and 0.4% in 2024, although November’s Office for Budget Responsibility (OBR) assessment for 2024 was somewhat more optimistic at 0.7%. All three S&P Global / CIPS PMI surveys (manufacturing, services, and construction) remain below the 50 mark (therefore indicating contraction). Given this weak outlook, there may well be one or more quarters of falling economic output over the next year.

• In its November report, the OBR downwardly revised its medium term estimate of the UK’s medium-term potential economic growth rate from 1.8% to 1.6% per annum. This was largely driven by a weaker forecast for average hours per worker (due to a greater proportion of younger and older age groups in the workforce, who tend to work shorter hours).

RECENT OUTPUT TRENDS

• Recent ONS revisions now show the UK economy to have recovered from the pandemic more rapidly than previously thought, and output was 1.8% above its pre-pandemic peak by mid-2023. Upward revisions provide a slightly more upbeat picture of the first half of 2023, with Q1 and 2 seeing output growth of +0.3% and +0.2% respectively.

• However, the preliminary estimate for Q3 2023 shows zero growth. There was a 0.1% fall in the services sector which was offset by an equivalent increase of 0.1% in construction this quarter, while production output was broadly flat.

• Looking at monthly output growth and GDP rose by 0.2% in September, up from (a revised) 0.1% in August. 

• The S&P Global/CIPS UK Manufacturing PMI rose only very slightly in October, moving to 44.8 from September’s 44.3 (still below the ‘50’ mark and therefore indicating contraction). Production declined for the eighth consecutive month while new orders fell for the seventh month in a row. Once again purchase prices declined which helped reduce the costs of materials, although selling prices also decreased, for the fourth month in the last five. Consumer uncertainty surrounding the economy, and the cost-of-living crisis generally, helped contribute to falling business optimism, which is at its lowest point in ten months.

• Meanwhile the UK Services PMI also moved marginally upwards to 49.5 in October, from 49.3 in September. This is now the third consecutive month where the figure has been below the ‘50’ expansion threshold. There was again subdued consumer demand with cost-of-living pressures and rising interest rates cited as exerting the most downward pressure. Job cuts in the sector continued while new orders fell, and the level of business optimism was the lowest it has been all year.

• As with the two other PMIs, the UK Construction PMI rose only very slightly in October, up 0.6 points over the previous month, to 45.6. This still marks the second lowest reading since May 2020, with housebuilding in particular showing clear signs of contraction amidst a lack of demand and cutbacks to new projects as a result. Civil engineering work also fell, at the sharpest rate since July 2022, while commercial work showed stabilisation on the month.

LABOUR MARKET

• The unemployment rate was unchanged in July-September at 4.2%, having risen from a low of 3.5% in 2022. Overall employment figures show a decrease of 0.1 percentage points this quarter, to 75.7%, although this marks no change from last month. 

• The number of payrolled employees rose by 33,000 in October, to 30.2 million, while the number of job vacancies fell by 58,000 in the three months to October. This is the 16th consecutive reading of falling job vacancies and the figure is down 5.7% from the previous quarter. Overall, the data suggests that the labour market is weakening a little, but labour supply remains tight. 

• Annual average earnings growth was 7.7% (three months to September). This is down slightly from 7.8% per annum the month before but is still amongst the highest annual growth rates since records began. Annual growth for the public sector was estimated as 7.3%, marking the highest-ever rate for this sector, while the private sector posted 7.8%.

INFLATION

• The pace of annual inflation slowed sharply in October 2023 to 4.6%, down from 6.7% the month before and well below the peak of 11.1% in October 2022. This marks the slowest rate of inflation since October 2021 with the largest downward contribution coming from a fall in energy prices due to Ofgem lowering the cap on household bills. The cost of housing and utilities, including gas and electricity, fell by the most since January 1989.

• Core CPI (excluding volatile elements such as energy and food) rose by 5.7% in the 12 months to October 2023, down from 6.1% in September, but still above all-items CPI.

• The latest consensus view (November) is for annual headline CPI to fall to 2.5% by Q4 2024. In its November report, the Office for Budget Responsibility now expects CPI to take until the Q2 2025 to return to the 2% target. Clearly, there is a high degree of uncertainty surrounding this outlook, with external factors such as the conflict in the Middle East having the potential to impact on global energy prices and consequently inflation in the UK.

INTEREST RATES

• The Bank of England’s Monetary Policy Committee (MPC) held interest rates again at 5.25% in November, unchanged for the second consecutive meeting, following 14 consecutive decisions to increase Bank Rate. 

• Given the recent sharp fall in inflation, together with the UK’s very weak economic growth, September’s base rate rise may have been the last in the current cycle. But with inflation still well above the Bank of England’s 2% target, core inflation at 5.7%, and the volatility of global energy and commodity prices, a further rate rise remains plausible. The MPC will want to make sure that inflation does not reignite. Therefore, given the plethora of inflationary pressures, the first reduction may not be until well into 2024. The next announcement from the MPC is scheduled for 14th December.

• Retail sales volumes fell by -0.3% in October, following a (revised) decline of -1.1% in September. The impact of bad weather meant auto fuel sales fell by 2% while food store sales were down -0.3%. Non-food store sales also declined, down -0.2%, clothing stores saw volumes fall -0.9% and household goods stores were down -1.1%. Annually, retail sales have fallen by -2.7%.

• Consumer sentiment has been weak but volatile in recent months. GfK's Consumer Confidence Index has been in a range between -30 and -22, with a reading of -24 in November, up from -30 in October. All five components that make up the index rose in November as consumers appeared more optimistic about their finances, with consumers’ outlook for their personal finances over the next 12 months up five points to -3, a 26-point rise compared to 2022. This improved positivity may reflect the recent rapid fall inflation, although many consumers are still facing considerable cost of living pressures. 

• In its November Economic and Fiscal Outlook report, the OBR forecast that real household disposable income per person will be 3.5% lower in 2024-25 than its pre-pandemic level. This is half the peak-to-trough fall expected in its previous report in March, but still represents the largest reduction in real living standards since records began in the 1950s.

• Discretionary spending is most under pressure, as households delay big-ticket and non-essential purchases. On the positive side, some households (typically higher income ones) are still tapping into savings accumulated during the pandemic or reducing the proportion of their income that they save. Many households will benefit from the 2% reduction in National Insurance Contributions from January, and from April 2024 many lower income households will also benefit from a nearly 10% uplift in the National Living Wage.

• The Q3 2023 RICS UK Commercial Property Survey shows a net balance of -25% for retail occupier demand, almost unchanged from last quarter’s reading of -26%, with respondents also continuing to cite an increase in overall vacant space.

• Following three years of decline, average retail rental values have shown very modest growth since early 2022, according to MSCI. The Monthly Index reports that average retail rental value growth in the year to October 2023 was 0.5%, with growth of 0.3% over the three months to October. However, average retail rental values are still 17% below their previous peak in 2018.

• The all-retail trend masks significant variation, depending on the type of property and location. The retail warehouse subsector has fared considerably better than most of the wider retail sector in recent years, with average rental values increasing by 0.9% in the 12 months to October 2023 (MSCI Monthly Index). Conversely, average shopping centre rental values have fallen by -0.7% over the 12 months to October 2023. However, short-term shopping centre performance has improved a little, with average rental values increasing modestly in the three months to October (at +0.2%).

• Average rents for standard (high street) shops were falling well before the pandemic. However, recent months have seen rents bottom out and begin to rise, according to the MSCI Monthly Index. From May 2018 to May 2023, rental values fell almost continuously, by circa 29%, whilst the last five months (to October 2023) have seen modest growth of 1.3%.
  
   

• High inflation is creating cost pressures for corporates, further increasing their focus on productivity and cost reduction. Indeed, more than 75% of contributors to the Q3 2023 RICS Survey expected pressure on corporate cash-flows to intensify over the next year. This, together with the longer-term impacts of the working from home revolution, means that many businesses continue to assess their real estate footprint, although the level of downsizing is highly business specific.

• Survey evidence suggests that the return to the office may have further to run. KPMG’s 2023 CEO Outlook (a survey of 1,300 global chief executives), found that 64% of those surveyed anticipate a full return to the office within the next three years, with 87% being likely to reward employees who come into the office regularly. 

• A recent survey by recruitment consultant Hays found that 43% of employees in office-based sectors are working from the office full time, up from 36% in 2022 (with 18% working remotely and the remaining 39% adopting a hybrid working pattern). The survey also suggests that this trend of increased working from the office may continue. Nearly a quarter of employers surveyed stated that they will require increased staff attendance in the office over next 12 months, and 57% of employees said they would accept a job offer which did not include hybrid working.

• Although corporate real estate is the second-highest cost after salaries for many businesses, the provision of high-quality space remains important to assist with recruitment, retention, and productivity strategies, as well as staff health & wellbeing issues. This is reflected in continued robust demand for high quality space.

• There is also a much greater focus on buildings that are sustainable and energy-efficient, as occupiers try to meet increasingly ambitious ESG aspirations. This is being accelerated by the changes to MEES regulations which came into force in April 2023. The regulations now require landlords of F and G rated buildings to undertake works to improve their energy performance to an E or better, or to cease letting the property (unless they are able to register a valid exemption).

• Our recent research found that only 31.6% of Britain’s office stock is in band C or better, which is where occupier demand is focused and is the proposed minimum MEES standard from 2027. Office properties within EPC bands F and G account for 17.2% of all offices, meaning that nearly a fifth of the stock potentially became unlettable from 1st April 2023, unless remedial action has been taken. In reality, the figure will be lower than this as exemptions will apply to some properties, some space may be in the process of being upgraded and re-assessed, and some may be vacant and awaiting a change of use.

• A mixture of changing occupier requirements and regulation means a lower overall quantity of office space will be required going forward, with a focus on high quality buildings that meet these corporate and legal requirements. The life sciences and technology sectors have been key in maintaining market momentum, and technology such as artificial intelligence will further increase the emphasis on offices as high-quality environments.

• We are also seeing continued strong demand for serviced and co-working space from established businesses that wish to lease short-term space, pending a move to longer-term conventional office space once the economic outlook becomes more certain.

• The Q3 2023 RICS UK Commercial Property Survey shows a negative net balance of      -19% for office occupier demand, marginally improved from -21% in Q2, but well below the -6% reported in Q1. Respondents also continued to cite an increase in overall vacant space.

• Prime rental levels have proved highly resilient, reflecting the focus of occupier demand towards top quality space of which there is little available stock. Therefore, we have not seen any falls in prime rental levels in key city centre markets despite uncertainties around future levels of office occupation. Indeed, many major city centres have seen prime rents continue to climb, exceeding their pre-pandemic levels. The current dearth of new development will mean continued upward pressure on prime rents, and the gap with rents for poorer quality grade B stock is likely to widen further.

• Average UK office rental values fell only modestly during the pandemic, by -0.8%, and have increased by 4.0% since bottoming out in late 2020. Average annual rental value growth for all offices has accelerated to 2.0% as at October 2023, from a post-pandemic low of 0.8% in January 2023. Annual growth to October 2023 was 2.7% in central London, 1.3% in the rest of the South East, and 2.3% in the rest of the UK (MSCI Monthly Index, October 2023).

• The very strong industrial and logistics take-up experienced during 2020-2022 can be regarded as exceptional, driven by pandemic-specific requirements as well as accelerated change in global supply chains. This year has seen the market for logistics space (and online requirements in particular) cool noticeably, but the overall level of requirements remains robust, and take-up is strong relative to the average over the decade prior to 2020. A lack of stock will continue to act as a constraint on take-up in some key locations.

• Amazon has formed a substantial proportion of big shed take-up in recent years, but the online retailer has been scaling back its requirements and disposing of surplus space in some locations. Given this, it is not surprising that overall take-up has reduced, with fewer transactions at the larger end of the spectrum in particular. The heavy reliance of the market on one occupier was never ideal, and demand is now spread more evenly across a diverse range of firms and sectors.

• The Q3 2023 RICS UK Commercial Property Survey shows a net balance for industrial occupier demand of +3%. Although still in positive territory, it is the weakest reading since Q2 2020, down from +10% in Q2 and a peak of +49% in Q2 2022.

• The supply of new units is very limited across most key markets, and the development pipeline will remain restricted, given the constraints on developers, including higher funding costs and elevated building costs. On the positive side for supply, more good quality ‘grey’ space is coming onto the market as a sublease.

• Intense competition amongst occupiers for existing and new build product has helped maintain upward pressure on rental values despite the subdued economic outlook. Average annual industrial rental value growth peaked in August 2022 at 13.2% according to the MSCI Monthly Index, and has since decelerated to a still-robust 7.0% (October 2023). On a quarterly basis growth is 1.6% (three months to October) and has been within a range of 1.5% and 2.0% on this measure for the last 12 months, suggesting the market has settled down to a relatively stable rate of growth.

• The Q3 2023 RICS UK Commercial Property Survey reports an expectation for further rental growth. A net balance of +46% of survey participants expect a continued pick-up in prime industrial rents over the year ahead, up slightly from +42% in Q2, but below the recent peak of +58% in Q1.

• Developers have been challenged by sharply rising build costs and supply chain problems, together with the rising cost of debt, and broader economic uncertainty. Although now improving, these factors continue to impact negatively on development activity, and with ongoing healthy occupier demand, the market for prime space will remain tight. 

• As developers retreated in 2022, the development land market struggled, precipitating a readjustment in industrial land values, accentuated by an upward movement in industrial yields. However, the industrial land market has now largely adjusted to the new build cost and interest rate / inflationary environment, and industrial land values have levelled off, with some recovery in values in some locations.

• We believe that the often-overlooked open storage sector will continue to see huge demand amid a shortage of sites. This follows strong growth over the last two years, most notably for the highest quality ‘class 1’ sites which are available on leases of two years or more. Indeed, the accelerated evolution of the sector has provided additional impetus to the broader industrial market, with several funds entering the open storage sector over the last six months, which has helped to compress yields in some locations.

Transaction volumes

• Investment in UK commercial property continued to fall in Q3 2023 as transaction volumes fell further in all but one of the main sectors. However, investment activity in the office sector saw a marginal uptick quarter on quarter. 

• £7.6bn was traded in Q3 2023. This was down 16% quarter-on-quarter, 45% below the five-year quarterly average, and was the weakest quarter for investment for more than a decade. The rolling annual total also fell notably compared to the previous six quarters and was 33% below the five-year average at £57.4bn. 

• The industrial and the office sectors accounted for the largest share of the quarterly UK total, at 30.3% and 28.6% respectively. Notably, the industrial sector recorded volumes closest to the five-year quarterly average. Spending on the alternative property sectors amounted to 24.9% of the total, while retail investment accounted for 16.2%.

• Overseas investment in UK commercial property totalled £2.5bn in Q3 2023, down 37% quarter-on-quarter and 60% below the five-year quarterly average. Unlike previous quarters, spending by overseas investors in the regions notably outweighed that in the capital.

• US investment cooled in Q3 2023 to around £1.5bn following a strong second quarter, but still accounted for the highest share of total overseas investment. Spending by Far Eastern investors in Q3 2023 picked up from a weaker second quarter to £700m but remained 63% below the five-year quarterly average. However, Far Eastern investors still accounted for the second-highest share of overseas investment.
   

recent Investment performance

• All property equivalent yields experienced a downward shift from 6.3% in mid-2020 to 5.15% by June 2022 (MSCI Monthly Index), led by the industrial sector as it experienced burgeoning occupational demand amid limited supply. This trend then reversed, as investors reassessed their risk assumptions following the rapid rise in interest rates and gilt yields, together with a weaker outlook for economic growth, and the greater uncertainty around occupier demand in some commercial sectors. Average commercial property yields have shifted upwards to 6.84% as at October 2023, a rise of nearly 170 basis points since June 2022 (MSCI Monthly Index). 

• Over the last six months the modest upward shift in the all-property equivalent yield has broadly matched that of 10-year gilt yields, with a gap of circa 230-240 basis points, compared with a gap of more than 400 basis points during the low interest rate environment following the global financial crisis. 10-year gilt yields stood at 4.5% as at the end of October.

• Yield movement has been the main driver of a pronounced capital value cycle. On the MSCI all-property index, values rose by 23% from October 2020 to June 2022, driven by the industrial sector and post-pandemic recovery. This trend then reversed sharply, with capital values falling by 22.9% from June 2022 to February 2023, as rising interest rates forced an upward shift in property yields. This fall in capital values was most pronounced in industrials (despite continued strong rental growth in this sector).

• Since February 2023, the MSCI Monthly all-property capital value index has fallen a little further (-2.4% as at October 2023), as yields have moved out, partly offset by modest rental growth. However, the trend by sector has diverged. Industrial capital values began to rise from February, increasing by 2.3% to October (albeit with a -0.1% fall during October itself), driven by continued robust rental growth. The retail sector has seen a further capital value decline at -1.9% between February and October 2023, whilst the office sector has seen a significant fall in values of -11.5% (despite modest rental growth in both of these sectors of 0.4% and 1.6% respectively). These figures reflect highly differentiated investor sentiment towards the different sectors. However, there is also significant differentiation by quality which is not reflected in the average figures.

• On an annual basis, all-property capital value growth had deteriorated to -21.2% by June 2023, reflecting a sharp fall in values in late 2022 / early 2023, but has since recovered to -12.8% by October 2023. Annual industrial capital value performance is currently -11.5%, with offices at -20.4% and retail at -10.4% (MSCI Monthly Index, October).

• The all-property annual total return peaked at 25.1% in May 2022, and then decelerated sharply to 4.6% per annum by October 2022, turning negative in November 2022 at -3.4%, as the fall in capital values accelerated. Performance fell further to -16.9% per annum in the year to June 2023, but has since improved significantly to -7.9% per annum in October 2023 (MSCI Monthly Index).

• The industrial annual total return is now -7.1% (MSCI, October 2023), having risen from a low of -23.2% in June 2023, but compared with a dramatic peak of +42.8% in April 2022. The total return for offices was -16.0% per annum in October 2023, down from a peak of +7.7% in May 2022. Retail annual returns were -4.1% as at October, down from a peak of +23.1% in May 2022. 

INVESTMENT outlook

• The Bank of England’s decision of maintain interest rates at 5.25% for the last two meetings has marked the removal of a layer of uncertainty that has pervaded for some time. Although the consensus suggests that a decrease in rates is unlikely until later in 2024, there is an expectation for an uptick in investment activity during the year, especially if interest rates have indeed peaked.

• Whilst investment volumes are currently well below average, there are a range of buyers who have capital ready to be deployed and are seeking to take advantage of falling values and lack of competition.

• Investor interest is expected to be broad in 2024, including domestic investors with significant capital ready for deployment. Strong interest is also anticipated from overseas, notably from US-based private equity and investors from Asia. Unsurprisingly, the industrial sector continues to attract strong investor interest, a trend we expect to continue.

• Pricing for prime assets in desirable locations with solid ESG credentials is starting to stabilise, and this is where investor demand will continue to be focused. Values will continue to fall for assets that do not match these criteria, particularly in the office sector.

• Investors refinancing this year will encounter risks due to higher debt costs, declining values, and stricter ESG requirements, especially for older office buildings.

• We expect commercial real estate returns to be based on genuine income return rather than on the prospects for capital value growth.