COMMERCIAL MARKET OUTLOOK

OUTPUT

• Over the last three months, concern has shifted from Omicron to the rapid rise in inflation, and a weaker short-term outlook for UK and global economic growth. The UK’s economic output fell by 0.1% in March, following no change in February (revised down from +0.1%). The services sector declined by 0.2% on the month and this was the main contributing sector to the decline (with a large decrease in the wholesale and retail trade). On the other hand, construction sector output rose by 1.7%, while the production sector declined by 0.2%. 

• On a quarterly basis, output is still rising, by 0.8% in the three months to March, with the services sector being the main upward contributor. However, it is widely anticipated that this will probably be the high point for GDP growth in 2022.

• The S&P Global / CIPS Manufacturing PMI moved up slightly in April, to 55.8 from March’s 55.3 reading. Delivery delays were cited as having reduced from earlier in the year, while higher production rates were linked with new business intakes. Downward pressure has come from a subdued export market, the war in Ukraine and transportation issues including higher shipping costs and customs checks. 

• The UK Services PMI remains in very strongly positive territory at 58.9 in April, but this is well below March’s figure of 62.6, and there are signs that rising costs and the war in Ukraine will limit the pace of growth going forward. New business growth stalled sharply and is the weakest figure this year. Business confidence has also dropped to its weakest level in over 18 months, while input costs rose to their highest rate in the 26 years of this data series. 

• The UK Construction index also declined in April, down to 58.2 from 59.1 the previous month. This is still indicative of strong growth in the sector with new orders growing, albeit at their lowest rate this year. Rising material costs, higher borrowing costs and geopolitical uncertainty are all cited as placing downward pressure on future demand.

• The war in Ukraine has severe economic implications both globally and in the UK. In particular, the price of oil and gas, as well as many other commodities, has soared. This will exacerbate the headwinds facing consumers, who were already contending with higher energy prices, as well as April’s increase in National Insurance contributions and rising interest rates. Given the inflationary shock, historically low levels of consumer confidence, ongoing supply chain disruptions, and slower global growth, forecasts for UK growth in 2022 are being revised downwards. 

• The HM Treasury-compiled consensus published in December 2021 expected growth of 4.7% for 2022, which has fallen steadily to 3.9% as at May. The Office for Budget Responsibility April) expected 3.8% in its April forecast, compared with the 6.0% it expected in its previous October forecast. Although these 2022 growth projections still sound reasonably strong, most of the growth for this year has already occurred (in January), and in addition, it is comparing this year’s output with the whole of 2021, which suffered significant falls due to the pandemic. 

• With economic growth now stalled, and the combined headwinds of inflation, ongoing supply chain issues and a challenging global outlook, the broad picture for the rest of this year is one of relatively flat output but rapidly rising prices, so-called ‘stagflation’. At least one quarter of modestly declining output now appears likely.
  

   

LABOUR MARKET

• The UK labour market remains buoyant, despite the economic headwinds. The employment rate rose again to 75.7% in the three months to March 2022, compared with the low point of 74.6% during the pandemic, although still below its pre-pandemic peak of 76.6%. The unemployment rate fell further to 3.7% in the three months to March, its lowest rate in 50 years (since records began). 

• The number of vacancies rose again between February and April, to a new record of 1.295 million. Data shows that the pace of vacancy growth may be slowing, but 11 of 18 industry sectors are still displaying record high ratios of vacancies to employed persons. This emphasises the current very tight labour market conditions, resulting from an ongoing mismatch between vacancies and available skills, and the exit from the labour force of more than one million workers during the pandemic. 

• Regular pay is lagging behind inflation as wage growth reached 4.2% per annum in the three months to March (excluding bonuses). Adjusted for inflation this means wages fell by 1.2% over the period, as the cost of living continues to squeeze. Job-to-job moves are beginning to slow as consumer confidence falls and employees feel ‘safer’ staying put. As a result, this may be bringing the pace of wage growth down. 
  
   

• Inflation is now a primary concern for the economic outlook. UK consumer price inflation reached 9.0% in the 12 months to April, a significant rise over March’s figure of 7.0% and the highest rate in over 40 years, according to the latest data from the ONS. The sharp rise in energy prices in April were a significant contributor but other increases came from recreational and cultural activities, restaurant and hotel prices, food and non-alcoholic beverages and household goods. 

• Global supply chain problems for energy, food, and other commodities are likely to be further stretched by the war in Ukraine. We have seen significant additional price rises in global oil and gas markets since the start of the conflict, and April’s increase in National Insurance is now adding to the pressure (albeit somewhat mitigated by the increase in the National Insurance threshold announced in the Spring Statement). In addition, the value of Sterling has depreciated in recent weeks, further increasing the cost of imported goods. 

• In reaction to rapidly rising inflation, the Bank of England’s Monetary Policy Committee (MP) raised Bank Rate in May for the fourth consecutive meeting, by 0.25 percentage points to 1.0%. Three of the nine MPC members voted to raise rates by 0.5 percentage points, and a further rise in Bank Rate in the coming months appear highly likely. There is a clearly a limit to the Bank’s ability to control inflation through monetary policy, as inflation is currently so heavily influenced by global commodity prices. Changes in Bank Rate take time to have an impact, and are aimed more at controlling inflation in the medium term. The next MPC meeting will take place on 16th June.

• A key question is whether higher inflation will become entrenched or fall back relatively quickly. The Bank of England’s central outlook is for inflation to increase further, peaking at 10.2% in Q4 this year, before falling back to 3.6% in Q4 2023 and reaching the 2% inflation target by Q2 2024. The current consensus view is 7.8% by Q4 this year (see table). 

• There are clear risks around this inflation outlook. For example, higher inflation expectations in the current tight labour market could lead to a wage-price spiral, or Russia could disrupt gas supplies to more European countries, further increasing prices. 
  
   

^{Source: HM Treasury compilation of independent forecasts, April 2022 (forecasts); ONS, Experian, Carter Jonas (last 5 years)}

• The cost of living crisis and concerns about the economy are being reflected in a sharp fall in consumer confidence. The GfK Consumer Confidence Index fell for the sixth consecutive months in May, to a record low of -40 (the previous record low of -39 was set during the Global Financial Crisis). The index for the general economic outlook was -56 for the coming year.

• This collapse in consumer confidence reflects the rapid rise in inflation, which is creating the biggest fall in real household disposable incomes since the 1950s. With inflation yet to peak and set to remain high for the rest of the year, very weak confidence will continue for some time. On the positive side, disposable incomes should be cushioned to some extent by the ability of households to use some of the substantial savings accrued during the pandemic, or to increase borrowing. The buoyant labour market will also help.

• Retail sales volumes increased in April, up 1.4% compared with the month prior when a (revised) fall of 1.2% was experienced (ONS). Some of the increase may be reflecting consumers opting to stay in rather than going out, perhaps to save money due to rising prices, with the food and drink sector accounting for the majority of the increase in sales during the month. Given the low confidence and sharply rising prices, retail sales figures are likely to be less positive going forward. 

• Town centre footfall has responded positively to the lifting of pandemic restrictions, with city centres benefiting from the removal of guidance to work from home. However, overall footfall remains below pre-pandemic levels. 

• Average retail rental values had been declining for 18 months prior to the COVID crisis, a trend that accelerated sharply with the onset of the pandemic, and are now -17.6% below their 2018 peak (MSCI Monthly Index, April). The rate of decline has been moderating, and average all-rental values have now broadly levelled off. However, this masks significant differences, depending on the type of property and location. 

• The retail warehouse subsector has fared considerably better than most of the wider retail sector over the last year, with the fall in average rental values decelerating during 2021, and starting to rise during the first four months of 2022 (by 0.7%). 

• Average shopping centre rental values are still falling, but at a considerably slower rate than was the case in 2020 and 2021. Average shopping centre rental values have fallen by -1.1% in the first four months of this year, and by -2.6% over the last 12 months. Average standard retail rents have fallen by -0.6% in the first four months of this year, and by -4.2% over the last 12 months. 

• Rising inflation is creating greater cost pressures for corporates, which is likely to further increase the focus on cost reduction and productivity. Although corporate real estate is the second highest cost after salaries for many businesses, the provision of high-quality space can also help to increase productivity. This, together with the longer-term impacts of the working from home revolution, means that many businesses continue to assess their real estate footprint, and are placing an ever-greater emphasis on smaller but higher quality space.

• Across our regional ‘Commercial Edge’ cities (Bristol, Birmingham, Bath, Cambridge, Oxford and Leeds), total take-up in Q1 was 885,500 sq ft, on par with the same quarter last year, and only 11% below the 10-year quarterly average. Whilst there is a large quantity of office stock available, much of it does not meet the requirements of today’s occupiers, and a two-tier market is increasingly apparent. In many locations, a shortage of quality space rather than occupier demand is holding back take-up, and the modest amount of speculative development in the short-term pipeline is unlikely to change this picture.

• The flexible space market (or serviced office sector) continues to benefit as more occupiers are looking for flexible short-term leases due to the lack of certainty over future office space requirements, with many companies remaining cautious about committing to new space. This is encouraging flexible space operators to take more space. 

• Despite uncertainties around future levels of office occupation, we have not seen any falls in prime rental levels in our key locations. Indeed, most city-centres have seen prime rents continue to climb, and are above their pre-pandemic levels.

• The resilience of prime rents reflects the increasing focus of occupier demand towards top quality space, driven by the desire to create a vibrant and attractive work environment to encourage employees back to the office and assist with recruitment, retention and productivity strategies, as well as staff health & wellbeing issues. In addition, there is a greater focus on buildings that are sustainable and energy-efficient, as occupiers try to meet increasingly ambitious ESG aspirations. 

• The dearth of new development coming through will mean that upward pressure on prime rents will continue, and the gap with rents for poorer quality grade B stock is likely to widen.

• Many owners in smaller towns and city suburbs have been taking advantage of permitted development rights over the past decade and have converted empty secondary office buildings into alternative uses (especially hotels and residential), which has meant that many markets have lost office stock on a net basis in recent years. This trend is likely to continue, especially as new environmental regulations will make many office buildings unoccupiable in the coming years, and will reduce the overall supply. 

• According to the MSCI Monthly Index, average UK office rental values peaked in April 2020, but experienced only a modest fall of -0.8%, bottoming out in November 2020. In the year to April 2022, average UK office rental values increased by 1.3%, and are now 0.7% higher than their pre-pandemic peak. 

• Average rental value growth for standard offices in the 12 months to April 2022 was 0.6% in central London, 1.5% in suburban London, 2.1% in the Outer South East, and 1.7% in the rest of the UK. UK office parks saw growth of 1.9%. 

• A range of economic drivers continue to benefit the logistics sector. The accelerated shift to e-commerce brought about by the pandemic has fueled the expansion of retailers and third-party logistics firms, while the UK's exit from the EU single market and customs union is leading to increased inventory holding, resulting in the need for additional warehousing. These factors will help to sustain demand for large distribution warehouses and smaller urban distribution units. However, a continued lack of stock continues to put upward pressure on rents and land values. 

• There remains a severe shortage of well-located sites for distribution use, and also urban sites suitable for last mile delivery, waste recycling and open storage. Overall, it remains hugely challenging to satisfy occupier demand. 

• 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. 

• ESG concerns are playing an increasing role in occupiers' decisions. Following trends in the office market, ‘green' warehousing is increasingly favoured by occupiers. Around 30% of industrial space absorbed in 2021 was in BREEAM Very Good, Excellent or Outstanding-rated warehouses (the five-year average is 15%).

• We are likely to see an increasing number of larger transactions, with deals over one million sq ft becoming more commonplace. This is putting greater pressure on site availability, with limited sites of sufficient size coming forward. Eaves heights are also increasing in line with a greater use of automation and robotics.

• High levels of demand and constrained supply are resulting in some astonishing rates of rental growth. The Carter Jonas prime industrial index recorded an increase in prime rents of 21.5% across the UK in 2021. However, even this stellar performance was greatly outpaced by the increase in UK industrial land values, which rose by an incredible 33.6% during the year.

• According to the MSCI Monthly Index, average annual industrial rental value growth has accelerated rapidly, from 1.8% in September 2020 to 11.9% by April 2022. Over the three months to April 2022, the growth rate was 3.8%, the equivalent of 16.2% over one year, suggesting that the annual rate may have even further to rise.

Transaction volumes

• £14.5bn of commercial property was traded in Q1 2022. Although this was down 19% from an exceptionally strong Q4 2021, it was still 5% above the five-year quarterly average and was the third strongest quarter since the start of the pandemic. Notably, the rolling annual total hit its highest level since Q4 2018, nearing £60bn. 

• Strong demand for high-quality office space has supported elevated investment in London, which accounted for nearly 67% of all investment (excluding portfolio deals) in Q1, one of its highest shares on record and in contrast to the five-year average of just above 50%.

• Overseas investment totalled £7.5bn in Q1, its highest since Q4 2020. Spending by Far Eastern investors surged, totalling £2.6bn, primarily in London, buoyed by the £1.2bn acquisition of 5 Broadgate by NPS of Korea and the acquisition of The Scalpel by Ho Bee Land for £718m. US investment cooled in Q1 following two strong quarters, falling to £2.3bn, the weakest total since Q4 2020. 

• At £5.6bn, office investment volumes showed the strongest Q1 since 2017, and this was the only sector to be above the 5-year quarterly average in Q1. Strong demand for prime office space, especially in the City of London, has supported volumes. 

• Industrial investment was down by 50% quarter-on-quarter in Q1 2022, to £2.5bn. However, we believe that investor demand remains extremely strong, and the lower Q1 volume suggests that a lack of available stock has adversely affected transaction levels. 

• Retail investment totalled £1.5bn, the strongest Q1 since 2018, driven by the out-of-town market. The largest deal of the quarter was LaSalle Investment Management’s purchase of Cheshire Oaks Designer Outlet and Swindon Designer Outlet for £600m.

• Several student accommodation and hotel deals supported volumes in the alternative sectors during Q1, including CCP 5 Long Life Fund’s acquisition of a six-asset student accommodation portfolio for £400m. On the hotel side, Kings Park Capital paid £300m for the Inn Collection Portfolio.
  
   

Investment performance

• Having moved up by 33 basis points during the initial months of the pandemic, peaking at 6.3% in June 2020, the all-property equivalent yield has shifted downwards by 105 basis points to 5.18% as at April 2022 (MSCI Monthly Index). The three months to April saw a continued steady downward shift of 20 basis points, driven by the industrial, shopping centre and retail warehousing sectors. 

• Industrials saw a downward shift in average equivalent yields of 13 basis points in the three months April. The marked downward shift in shopping centre yields seen in late 2021/early 2022 has come to a halt, with little change over the last two months. The retail warehousing sector remains attractive, has continued to see strong downward yield movement of more than 50 basis points over the last three months (to April). 

• The UK 10-year gilt yield has been on a rising trend over the last year, on the expectation of higher interest rates. As of late May, the yield had risen to 1.9%, compared with 1.0% as the start of 2022 and the lows of under 0.2% seen in 2020. With gilt yields rising and property yields continuing to fall, the yield gap has narrowed, but remains substantial (with the all-property equivalent yield currently at 5.18%). Against a backdrop of rising interest rates and a scaling back of quantitative easing, we may well see further rises in gilt yields in 2022.

• All property capital value growth has continued to accelerate, reaching 19.0% per annum in April 2022 (MSCI Monthly Index). This reflects rising values across all of the main commercial sectors, although rates of growth remain very different. 

• Industrial property saw a rise of 37.3% in the 12 months to April, driven by double-digit rental value growth combined with the continued downward shift in yields. Retail capital values rose by 14.8% in the 12 months to April. However, this masks significant differences by subsector, with retail warehouse capital values rising by a remarkable 26.8%, but shopping centres falling by -1.9% and standard retail falling by -0.3%. Office capital values increased by 2.3% in the year to April. 

• The all-property annual total return has risen steadily over the last year, reaching 24.9% in April. The industrial return is now an incredible 42.8% per annum, and almost all key commercial sub-sectors are now in positive territory. 

• All-property returns over the short-term three-month measure peaked at 7.9% in December 2021, decelerating to 5.6% over the three months to March, and picking up a little in April to 6.2%. However, this 27% on an annualised basis, still slightly above the actual year-on-year rate.
  
   

Outlook

• We expect strong demand for the logistics and life science sectors to continue. The lack of stock in both sectors and competition for available assets are likely to put further upward pressure on pricing.

• Investors are likely to continue to prioritise prime and core investments, with competition for the best assets leading to further yield compression. However, the lack of available stock might push some investors up in the risk curve.

• Value-add investors and developers alike will continue to seek older in-town and out-of-town office buildings for conversion to far more valuable alternative uses such as industrial/logistics and residential.

• Investors will become increasingly attracted to the fact that retail is currently offering higher income returns than competing sectors. However, the road to recovery in this sector may be hindered in the short term by the current decline in consumer confidence.

• Property is traditionally seen as a hedge against inflation as it increases the rate of rental growth, and in turn property values. In addition, more leases are now indexed directly to inflation. This contrasts with the potential for lower returns for bonds and greater volatility in equities. As a result, property as an asset class tends to perform well in inflationary periods, a characteristic that will be important over the next 12 months.