Commercial Market Outlook

• Economic growth has bounced back strongly from the very mild technical recession in the second half of 2023. Q1 2024 saw growth of +0.7%, its highest rate since Q2 2021 (at the tail end of the post-pandemic recovery period), followed by +0.6% in Q2.

• Growth is likely to slow somewhat in the second half of this year. However, with the path of interest rates now downwards (albeit gradually), much improved consumer confidence, and strong levels of business confidence being reported in recent PMI surveys, the outlook is for further robust rises in output. The latest (August) consensus expects +0.4% in Q3 and +0.3% in Q4. Overall, 2024 is forecast to see annual GDP growth of 1.1%, rising a little to 1.3% in 2025.

• Annual CPI inflation increased slightly to 2.2% in July, up from the recent lows of 2.0% recorded in May and June, as last year’s declines in energy prices fall out of the annual comparison. Therefore, we have now probably passed the bottom of the current cycle. Whilst a further uptick in inflation is likely this year, this should only be modest. The consensus forecast is for CPI to reach 2.5% by Q4, whilst the Bank of England now expects around 2.75% in the second half of this year.

• The Bank of England’s Monetary Policy Committee (MPC) voted to reduce Bank Rate by 25 basis points to 5.0% at its August meeting. This marked a major turning point, following 14 successive rises since December 2021. However, the decision was finely balanced, with four of its nine members preferring to hold Bank Rate at 5.25%. Inflationary risks do remain, and the MPC will therefore continue to act cautiously, noting that monetary policy will need to be restrictive for sufficiently long to keep CPI inflation at the 2% target. Another 25-basis point cut looks likely before the end of this year.

• The Labour government’s large overall majority should provide a welcome period of relative domestic political stability. Encouragingly, its manifesto acknowledged the importance of economic growth and contains several positive initiatives, including developing an industrial strategy, and policies to accelerate the upgrading of key infrastructure and to raise the rate of housebuilding. However, delivery will be extremely challenging, and the government is clearly signalling that a further rise in taxation will be announced in the forthcoming Budget on 30th October. This will need to be carefully targeted if it is to avoid adversely impacting confidence and growth.

Recent output trends and indicators

• UK GDP is estimated to have increased by 0.6% during Q2 2024, following 0.7% in Q1. This represents a strong bounce-back from the mild technical recession at the end of 2023, despite the continued elevated level of interest rates and domestic political uncertainty. Services grew by 0.8% during Q2, offsetting falls of 0.1% in both the production and construction sectors. There were increases in government consumption and household spending, partially offset by falls in net trade.

• The latest monthly data for GDP reveals a small -0.1% fall in services during June, largely due to a fall in retail sales of -1.2%, although it is worth noting that professional services saw a strong 1.0% rise. The overall fall in services offset a 0.8% increase in industrial production and a 0.5% rise in construction output, resulting in no overall change to GDP during the month.

• All three S&P Global UK PMIs remain in expansion territory, reflecting an overall strong level of business confidence. They also suggest that firms are recruiting again following last year’s technical recession. In addition, the ONS reports that firms put orders on hold during the general election campaign, which has fuelled additional output in July and August.

• The Manufacturing PMI rose to 52.5 in August 2024 from 52.1 the previous month (a reading above 50 indicates expansion). This is the fourth consecutive month of expansion and the highest reading in more than two years. Input cost inflation eased to its lowest in nearly four years, despite higher shipping bills and raw materials costs.

• The Construction PMI rose sharply from 52.2 in June to 55.3 in July, indicating a strong expansion, and the highest reading since May 2022. All three categories within construction experienced an increase in activity during July. Housing saw a return to growth and commercial activity also saw a solid increase, whilst civil engineering saw the fastest rate of expansion in more than two years. Both activity and new orders rose rapidly during the month, and staffing levels increased for the third consecutive month. Higher demand for inputs led to supply chain pressures and a faster increase in input costs.

• July marked the tenth consecutive month of expansion in the UK services sector with August’s PMI reaching 53.3, up from 52.5 the month before, its strongest reading since April. New orders and employment increased robustly, with activity driven by both business and consumer spending.

Labour market

• The UK’s headline unemployment rate was estimated at 4.2% in April to June 2024, having recently peaked at 4.4%. The employment rate was estimated at 74.5% in April to June 2024, up slightly from a low of 74.3% in February to April, but below a recent peak of 75.5% in spring 2023. It is important to note that ONS Labour market data should be treated with caution due to ongoing issues with low sample sizes.

• The number of job vacancies in the UK decreased in May to July 2024 by 26,000 to 884,000, the 25th consecutive period of decline. However, vacancies are still above pre- pandemic levels. With PMI surveys reporting an increase in hiring, the labour market will remain tight.

• Annual growth in average weekly earnings (excluding bonuses) decelerated to a 5.4% in June, still well above general inflation, from an upwardly revised 5.8% in May. Public sector pay growth was 6.0% compared with 5.2% in the private sector.

Inflation

• Annual CPI inflation increased slightly to 2.2% in July, up from the recent lows of 2.0% recorded in May and June. The largest upward contribution to the monthly change came from housing and household services, where energy prices fell by less than last year. The largest downward contribution came from restaurants and hotels. Services inflation fell from 5.7% in June to 5.2% in July, but is still well above the general inflation figure. Core CPI (excluding volatile elements such as energy and food) also fell, from 3.5% in June to 3.3% in July.

• Inflation has now probably passed the bottom of the current cycle, with last year’s declines in energy prices now falling out of the annual comparison. The consensus forecast is for CPI to reach 2.5% by Q4 this year, whilst the Bank of England now expects around 2.75% in the second half of this year.

Interest rates

• Following 14 successive rises since December 2021, the Bank of England’s Monetary Policy Committee (MPC) voted to reduce Bank Rate by 25 basis points in August, to 5.0%. However, the decision was finely balanced, with four of the Committee’s nine members preferring to hold Bank Rate at 5.25%.

• The MPC expects falling headline inflation to feed through to weaker pay and price-setting dynamics, and wage inflation continued its downward trajectory in July. However, the Committee notes the risk that inflationary pressures from these ‘second-round effects’ will prove more enduring in the medium term. It will therefore continue to act cautiously, and policy will need to remain restrictive until the risks to inflation returning sustainably to the 2% target in the medium term have dissipated further. On balance, another 25-basis point cut looks likely before the end of this year.

Retail occupier market

• Retail sales have been highly volatile this year, impacted by factors such as the unpredictable weather and the general election. Sales volumes rose 0.5% during July, a significant improvement on the (upwardly revised) -0.9% during June. Department store sales surged by 4.0% month-on-month, and other non-food stores rose by 2.5%. The overall trend in sales volumes is one of gradual improvement. Taking the three months to July, volumes rose by 1.1%, the second-strongest rate in almost three years.

• GfK’s Consumer Confidence series was unchanged in August at -13, but nonetheless remains at its highest level in almost three years. The index for personal finances improved, likely helped by August’s base rate reduction, although consumers remain downbeat about the broader economy.

• Households are benefiting from this year’s reductions in National Insurance Contributions, and many lower income households are also benefiting from April’s uplift in the National Living Wage of nearly 10% (though this is adversely impacting costs for many businesses, most notably the retail and food & beverage sectors). In addition, wage growth continues to be well above inflation, and the energy price cap continues to fall. This is all positive for household disposable income. However, tax increases are likely to be announced in October’s Budget, although it remains to be seen where the burden will fall.

• The Q2 2024 RICS UK Commercial Property Survey shows a net balance of -5% for retail occupier demand, a noticeable improvement on -10% in Q1 2024, -18% in Q4 2023, and -25% in Q3 2023. Respondents continued to cite an increase in overall vacant space.

• Average retail rental values have shown very modest growth since 2022, according to MSCI. The Monthly Index reports that average retail rental value growth in the 12 months to July 2024 was 0.9%, and has been within a range of 0.5% to 0.9% on this measure since October 2023. However, average retail rental values remain 16.5% below their previous peak in 2018.

• The all-retail trend masks significant variation, depending on the type of property and location. Average rents for standard (high street) shops fell almost continuously from May 2018 to May 2023, by circa -29%. However, growth has returned over the last year. Annual growth accelerated to 1.9% by May 2024, although it slowed to 1.0% over the year to August 2024 (MSCI Monthly Index). Growth is being driven by the London market.

• Average rental values in the retail warehouse subsector are continuing to rise, by 1.4% in the 12 months to July 2024, unchanged from June 2024 and slightly above the previous peak in annual growth seen in January 2023 (MSCI Monthly Index). On a quarterly basis, growth increased a little to 0.5% in the three months to July 2024, a little above the equivalent annual rate.

• Average shopping centre rental values have also returned to growth in recent months, rising by +1.0% in the three months to July 2024. This has not yet fed through to the annual figures, although July’s decrease of -0.5% was a significant improvement on the fall of -1.3% recorded in June 2024, and the slowest rate of decline since May 2023.

Office occupier market

• The longer-term impacts of the working-from-home revolution mean that many businesses have been assessing their real estate footprint, although the level of downsizing is highly business-specific and has now declined noticeably. Indeed, occupancy rates have broadly levelled off, and the three-day office week has emerged as the new normal.

• 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 to enhance staff health & wellbeing. 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, with the next round of tightening due in 2027.

• We are seeing continued strong demand for serviced and co-working provision 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 Q2 2024 RICS UK Commercial Property Survey continues to show a positive net balance for office occupier demand at +7%, up slightly from +6% in Q1, and a considerable upturn on the negative balances reported throughout 2023. This upturn in sentiment has been largely due to a marked improvement in central London, and in prime office markets more generally.

• Prime rental levels have proved highly resilient, reflecting the focus of occupier demand towards top-quality space of which there is little available stock. Recent development schemes have set new benchmarks in several central London districts and regional city centre markets. The gap with rents for poorer quality grade B stock is likely to widen further.

• Average annual rental value growth for all UK offices was 2.2% as at July 2024, compared with a recent peak of 2.8% in March 2024, but well ahead of the post-pandemic low of 0.8% recorded in January 2023 (MSCI Monthly Index).

• There is an increasing geographical divergence in rental performance. Central London is pulling ahead of the south east and regional markets, boosted by strong performance in the West End, with healthy demand for grade A stock amid a very low supply of prime space.

• Average annual rental growth in the West End / Midtown submarket reached 6.7% in July 2024 on the MSCI Monthly index, up from 6.1% in June, and the highest rate since August 2016. In contrast, the City of London saw annual growth of 1.6% in the year to July 2024, down from a recent peak of 2.3% in May. The rest of the south east recorded average annual rental growth of 0.9% in July, continuing a deceleration from 2.0% in January. Average rental growth in the regional markets was 1.3% in July, down from 1.4% in June and a peak of 2.4% in January (MSCI Monthly Index).

Industrial occupier market

• Industrial and logistics take-up has reduced following the exceptionally strong demand experienced during 2020-2022, driven by pandemic-specific requirements as well as accelerated change in global supply chains. Longer-term structural change continues to generate occupier demand, most notably the influence of e-commerce, with ‘last mile’ units for urban delivery being a key area.

• Occupier demand for larger distribution units has been somewhat subdued in recent quarters, amid political uncertainty and elevated interest rates. However, occupiers may now be looking ahead to lower interest rates, more sustained economic growth and an increase in consumer optimism. The Q2 2024 RICS UK Commercial Property Survey showed a net balance for industrial occupier demand of +10%, compared with a recent low of +3% in Q3 2023, although still well below the peak of +49% in Q2 2022.

• Vacancy rates have been rising over recent quarters, due to a combination of slowing demand and rising supply. However, the supply of high quality, energy efficient new units is very limited across many key markets, which is where demand is focused, particularly as many logistics operators are promoting their ability to maximise their clients’ sustainability credentials within the supply chain. Whilst new schemes are coming forward, the overall development pipeline remains restricted, and so the relative shortage of large high-quality units will continue.

• Competition amongst occupiers for existing and new build product has helped maintain upward pressure on rental values despite the overall lower demand levels. Average annual industrial rental value growth peaked in August 2022 at 13.2% and has since decelerated from this very high rate, but remains strong at 6.3% in July 2024 (unchanged from the May and June figures), still well above general inflation. Average industrial rental values increased by 1.3% during the three months to July 2024, the equivalent of 5.4% on an annual basis (MSCI Monthly Index).

• The Q2 2024 RICS UK Commercial Property Survey reported a net balance of +59% expecting prime rents to rise over the next 12 months, almost unchanged from the Q1 reading. A net balance of +22% expected secondary rents to increase (unchanged from Q1).

Transaction volumes

• Investment in UK commercial property picked up in Q2 2024, with £9.6bn traded. This was 13% up quarter-on-quarter, up 8% year-on-year, although 27% below the five-year quarterly average. The rolling annual total was marginally above the previous quarter, but was 34% below the five-year average.

• Transaction volumes increased in all of the main sectors in Q2 with the exception of retail, which saw a notable contraction quarter on quarter.

• Circa 33% of all investment (excluding multi-regional portfolio deals) occurred in the capital in Q2 2024, which is below both the five-year average of 51% and the 45% share recorded in the first quarter. Investors targeted assets in the living sectors, such as hotels and built-to-rent, as well as retail assets in prime locations. Overseas capital continued to support volumes in London, accounting for 57% of the total.

• Conversely, investment in the regional markets (UK excluding London) accounted for 67% of the total, above the 55% recorded in Q2 2024. The South East recorded the highest level of investment outside the capital, with circa £830m purchased in Q2 2024, followed by the East Midlands with just under £500m.

• The alternative sectors accounted for the largest share of the quarterly UK total at 52%, recording volumes closer to the five-year quarterly average than any other sector. The industrial sector accounted for 18% of the total, whilst offices amounted to 17% and retail accounted for 12%.

Recent investment performance

• Property yields have been relatively stable in recent months across all the main commercial sectors, and the all-property equivalent yield has remained at 7.1% since February 2024. This follows the sharp correction witnessed during the second half of 2022 (in reaction to rising interest rates and gilt yields, political uncertainty, and occupier demand uncertainty), and a more gradual upward shift in yields during 2023.

• 10-year gilt yields stood at 4.0% at the end of July 2024, compared with a recent low of 3.4% at the end of 2023, and a recent high of 4.4% in May 2024. As at the end of July 2024, the gap with the all-property equivalent yield was therefore 310 basis points, compared with 290 basis points in June, 350 basis points in December 2023, an average of more than 500 basis points in the decade to the end of 2020.

• Yield movement has been the main driver of capital value change during the current cycle. Although values have continued to fall year-on-year at the all-property level, capital value performance has improved significantly over the last year, standing at -4.2% per annum as at July 2024, compared with -21.2% per annum at the bottom of the cycle in June 2023 (MSCI Monthly Index). However, with the stabilisation of yields, plus relatively healthy and consistent rental growth (currently +3.6% pa), capital values are now levelling off. Indeed, all property capital values have increased slightly since March 2024, albeit by only +0.2%.

• Capital growth performance varies considerably across the main commercial property sectors. Industrial capital value growth was in positive territory (just) in the 12 months to July 2024 at +0.3%, according to the MSCI Monthly Index, with positive rental growth more than offsetting upward yield movement of 25 basis points. This contrasts with capital growth of -4.8% for retail property and -12.8% for offices. Taking just the last three months, where yields have been broadly flat, industrial capital value growth performance was stronger at +0.7%, the equivalent of +2.9% on an annual basis. Retail has seen significantly improved performance recently, with capital values rising by +0.8% over the three months to June (annual equivalent +3.4%) whilst office capital values fell by -1.6% (annual equivalent -6.2%).

• The all-property annual total return peaked at 25.1% in May 2022, and then decelerated sharply, bottoming out at -16.9% per annum in the year to June 2023. Performance has been in positive territory during 2024, reaching +1.4% pa in July, up from 1.0% in June.

• The industrial annual total return is now +5.4%, compared with a low of -23.2% in June 2023. Retail annual returns turned positive in December 2023 and increased sharply to +2.1% in July 2024, compared with a low of -9.6% in July 2023. The total return for offices remains in firmly negative territory at -7.6% per annum in July 2024, but performance has steadily improved in recent months, and is now well above the recent low of -18.9% in August 2023 (MSCI Monthly Index).

Investment outlook

• The Q2 2024 RICS UK Commercial Property Survey shows a net balance for investor enquiries of -4%, unchanged from Q1. However, industrial properties saw a net positive balance of +10%, contrasting with negative net balances for offices (-9%) and retail (-18%).

• While transaction volumes remained muted in a historical context in Q2, sentiment is now focused on when the market will start to improve rather than on concerns of further disruption. August’s 25 basis point reduction in the base rate provides a positive signal that the market is improving, and debt costs should start to ease. We anticipate this resulting in the beginning of an upward trend in pricing, albeit a gradual upturn. Many investors will now be readying themselves for increased opportunities and activity in Q4 2024 and into 2025.

• The industrial sector has continued to be impacted by a lack of stock, and as a result, transaction volumes remain muted. However, significant investor appetite remains, as demonstrated by the strong pricing recently achieved on some reversionary multi-let and mid-box assets. That said, the stronger pricing evidence being created is somewhat narrow, being focused on opportunities that are of interest to private equity and institutional investors. We anticipate that August’s base rate reduction will result in greater investor confidence and a narrowing of the pricing aspiration gap between vendors and purchasers that has been present in other parts of the market.

• Having undergone a period of price discovery and a softening of yields, investors are generally approaching the office sector with caution. However, we have identified an increasing number who see significant potential in the sector. The change in Permitted Development rules, removing the size restriction on conversion to residential, came into effect in August, and is also unlocking several more secondary and tertiary assets which remain unviable as offices. In addition, investors are now turning their attention back to ‘grey belt’ land for potential development, reviving previously abandoned projects.