Commercial Market Outlook

• The new Labour government’s large overall majority should now provide a period of relative political stability. Encouragingly, the Labour manifesto acknowledged the importance of economic growth and contains several positive initiatives. These include an industrial strategy delivered through a new statutory Industrial Strategy Council, and a National Wealth Fund targeted with attracting three pounds of private investment for every one pound of public investment.

• Taken with policies to help accelerate the upgrading of transport and utilities infrastructure, and to raise the rate of housebuilding, a Labour administration has the potential to impact positively. However, delivery will be extremely challenging. The Labour manifesto also proposes to replace business rates in England with a new system which would raise the same revenue as currently. The objective is to ‘level the playing field between the high street and online giants’ and reduce vacancy rates. However, there is, as yet, no detail on what is proposed, and it was not included in July’s King’s Speech.

• Economic growth in Q1 2024 was revised upwards to a strong +0.7%, its highest rate since Q2 2021 (at the tail end of the post-pandemic recovery period). This marked the end of a short and shallow technical recession in Q3 and Q4 2023. The latest monthly data showed no growth during April, but this was followed by +0.4% in May, leading to three-monthly growth of 0.9%, the strongest figure since January 2022. Construction output soared, with monthly output rising by 1.9%.

• All three Purchasing Managers Indices (PMIs) remain in expansion territory with figures above ‘50’, and business optimism remains positive. We therefore expect continued quarter-on-quarter growth this year, with another relatively strong performance likely in Q2, but falling back in Q3 (+0.7% and +0.3% respectively according to the July consensus forecasts). Overall, 2024 is forecast to see annual GDP growth of 1.0%, rising to 1.3% in 2025.

• CPI inflation has continued its downward trend, falling from 2.3% in April 2024 to the Bank of England’s target of 2.0% in May, and remaining at 2.0% in June. This compares with a peak of 11.1% in October 2022, and is the lowest rate since July 2021. CPI is forecast at 2.5% by Q4 this year, although it may well briefly dip below target in the coming months.

• The voting pattern of the Bank of England’s Monetary Policy Committee (MPC) saw no change at its latest (June) meeting, with two of its nine members voting to cut Bank Rate, and the other seven preferring to hold. However, the Bank’s signalling has become more dovish, describing the decision as ‘finely balanced’. This signposts an initial 25 basis point cut, possibly as early as the next meeting at the start of August, when the MPC will be guided by the Bank’s latest Monetary Policy Report. Given that wage and services inflation remain stubbornly high, the MPC will move cautiously.

Recent output trends and indicators

• UK gross domestic product (GDP) is estimated to have increased by 0.7% in Q1 2024. This represents a strong bounce-back from the mild recession at the end of 2023 (-0.1% in Q3 and -0.4% in Q3). Services grew by 0.8% on the quarter with widespread growth across the sector. Elsewhere, the production sector grew by 0.6% while the construction sector fell by -0.6%.

• GDP grew by 0.4% in May (month on month) according to the ONS’s latest figures. This is a marked improvement from the zero growth recorded in April and contributed to growth of 0.9% in the three months to May. This is also the highest three-monthly growth figure in over two years and means GDP has risen 1.5% so far this year. A surge in retail sales in the month helped push services output up 0.3%, while manufacturing GDP grew 0.4% and construction output grew a robust 1.9% month on month, probably as the rain eased enough to allow projects to begin or continue in earnest.

• Although the June Manufacturing PMI (S&P Global) fell to 50.9 from 51.2 in May, this still points to continuing growth. Both output and new orders expanded for the second month in a row. Although employment decreased slightly month on month, it is still above the low registered in February, and rising output should lead to renewed hiring. Looking ahead, expectations for the market were positive with businesses reporting planned growth strategies and product launches.

• June marked the eighth consecutive month of expansion in the UK services sector with the latest PMI reading of 52.1. Although this is down from 52.9 the month before, it still marks relative positivity in the sector. New business contracts rose, although they were more subdued than of late. Many firms noted a slowdown linked to the general election and its potential to deliver policy changes. The pace of new hires slowed this month and wage costs together with other operating expenses remain at historic highs. Having said that, the pace of input cost growth has slowed to its lowest level in three years.

• The UK construction PMI also remained in expansion in June, although at 52.2 this was well down from 54.7 in May. Slower growth was noted in civil engineering projects while housing construction fell back into contraction. There was a rise in new orders but this was slower than previously and again firms felt it was linked to election uncertainty.

Labour market

• Both the unemployment rate and the employment rate remained virtually unchanged from last month’s figures. Unemployment remained at 4.4% in the three months to May while the employment rate moved up slightly to 74.4%, from 74.3%. Once again, the labour market data should be treated with caution while the ONS grapples with low sample sizes. 

• The number of payrolled employees rose in June (provisional estimates), increasing by a robust 16,000 during the month. On an annual basis the total has risen by 0.8%, equivalent to 241,000 employees.  The largest annual increase was seen in the health and social work sector where 161,000 employees were added over the 12 months to June. The number of vacancies fell again in the three months to June, down 30,000 from the previous three-monthly period. This is the 24th consecutive quarter of declining vacancies.

• The annual growth in employee average regular pay (excluding bonuses) was 5.7% in the three months to May, down from 6.0% in the previous quarter. Public sector pay growth was stronger at 6.4% while in the private sector the average increase was 5.6%, the lowest from this sector since June 2022.

Inflation

• Annual CPI inflation remained at 2.0% in June, unchanged from May’s figure. The largest upward contribution has again come from services such as restaurants and hotels while the largest downward contribution came from falling prices of clothing and footwear. Services inflation remains high at 5.7%, again unchanged from last month and could play a part in the Monetary Policy Committee (MPC) interest rate decision in August. Core CPI (excluding volatile elements such as energy and food) was also unchanged in June, remaining at 3.5%.

• The latest consensus forecasts suggest that CPI inflation should remain close to the Bank of England’s 2.0% target this year and next, at 2.5% by Q4 2024 and 2.2% in Q4 2025. However, CPI could dip a little below the target in the coming months.

Interest rates

• Bank Rate was held at 5.25% in the latest (June) meeting of the Monetary Policy Committee (MPC). Seven members voted to hold with two preferring to cut the rate. However, the Bank’s signalling has become more dovish, describing the decision as ‘finely balanced’. This signposts an initial 25 basis point cut, possibly as early as the next meeting at the start of August, when the MPC will be guided by the Bank’s latest Monetary Policy Report. 

• With upward pressures on inflation, including the recent increase in the National Living Wage and strong wage growth and services inflation (both at 5.7%), plus ongoing geopolitical risks around global trade flows and energy prices, the MPC will proceed with caution.

Retail occupier market

• The volume of retail sales fell in June, down -1.2% on the month, following May’s rise of 2.9%. All major categories saw declines during the month with non-food sales down -2.1% and food sales down -1.1%. The below-average temperatures in June likely amplified the overall downturn. However, despite month-on-month volatility, the year-to-date trend shows an increase in aggregate retail sales.

• The recent gradual improvement in consumer confidence continued into July with the overall figure from GfK’s series moving to -13, up from -14 in June and a recent low of -30 in October 2023. Just two of the five sub-measures increased during the month with two staying the same and one falling. The Major Purchase Index rose seven points to -16, representing a marked improvement over the same month last year when this measure was at -32. The Personal Financial Situation (forward looking) is the only measure which fell, down one point, although this is also the only measure which is in positive territory (at +3).

• Many households are benefiting from this year’s reductions in National Insurance Contributions, and many lower income households are also benefiting from the recent 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.

• 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.

• Following three years of decline, 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 June 2024 was 0.8%, and has been within a range of 0.5% to 0.9% on this measure since October 2023. However, average retail rental values remain nearly 17% 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, this trend has reversed over the last year, with modest growth of 1.1% over the year to June 2024 (MSCI Monthly Index), albeit down from a peak of 1.9% per annum the previous month.

• Average rental values in the retail warehouse subsector are also rising, increasing by 1.4% in the 12 months to June 2024, slightly above the previous peak in annual growth seen in January 2023 (MSCI Monthly Index). On a quarterly basis, growth has been stable at 0.3-0.4% since August 2023 (currently 0.3%), broadly in line with the current annual rate.

• Average shopping centre rental values are still falling on an annual basis, by -1.3% over the 12 months to June 2024, but performance has steadily improved from a recent low of -2.4% in February 2024. The quarterly rate has also improved significantly, moving into positive territory over the three months to June 2024 at +0.3%, compared with a recent low on this measure of -1.7% in the three months to March 2024.

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 further tightening due in 2027.

• We are 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 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 of prime 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 cities such as Bristol, Birmingham, Leeds, and Manchester, whilst Oxford and Cambridge have seen strong rental growth due to limited prime stock and strong demand. 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 2.3% as at June 2024, down a little from a recent peak of 2.5% the previous month, but well ahead of the post-pandemic low of 0.8% in January 2023.

• There is an increasing geographical divergence, with the central London market pulling ahead of the south east and regional markets, boosted by strong performance in the West End. The West End / Midtown submarket saw average annual rental growth of 6.1% in June 2024, compared with 1.9% in the City of London. The rest of the south east recorded average rental growth of 1.3%, with the regional markets seeing a similar 1.4% (MSCI Monthly Index).

Industrial occupier market

• Industrial and logistics take-up has reduced following the exceptionally strong demand experienced during 2020-2022, which was 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 subdued in recent quarters, amid political uncertainty, elevated interest rates and subdued economic growth.

• However, occupiers may now be looking ahead to lower interest rates and an increase in consumer optimism and spending power. 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 recent 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 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 fairly subdued picture. 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% as at June 2024, well above general inflation. Average industrial rental values increased by 1.3% during the three months to June 2024, the equivalent of 5.4% on an annual basis (MSCI Monthly Index).

• The Q1 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 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, but 27% below the five-year quarterly average. The rolling annual total was marginally above the previous quarter, however, and was 34% below the five-year average of £54bn.

• Volumes increased in all of the main sectors except 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 just 17% and retail accounted for 12%.

Recent investment performance

• Since the market peak in June 2022, the industrial sector has seen upward yield movement of 190 basis points (equivalent yield, MSCI Monthly index), with a sharp correction in the second half of 2022 (in reaction to rising interest rates and gilt yields, political uncertainty, and occupier demand uncertainty), followed by a period of more gradual upward yield shift. Yields have stabilised in recent months across all the main commercial sectors, and the all-property equivalent yield has remained at 7.1% since February 2024.

• 10-year gilt yields stood at 4.2% at the end of June 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 June 2024, the gap with the all-property equivalent yield was therefore 290 basis points, compared with 350 basis points as at December 2023, and well below the 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 -4.7% per annum as at June 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 (and current relatively stable rental growth), capital values are now levelling off. Indeed, all property capital values saw a slight increase over the three months to June, of +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 June 2024 at +0.3%, according to the MSCI Monthly Index, with positive rental growth more than offsetting upward yield movement. This contrasts with capital growth of -4.9% for retail property and -14.2% for offices. Taking just the last three months, where yields have been broadly flat, industrial capital value growth performance was stronger at +0.6%, the equivalent of +2.5% on an annual basis. In contrast, retail has seen significantly improved performance recently, with capital values rising by +1.0% over the three months to June (annual equivalent +4.1%) whilst office capital values fell by -1.6% (annual equivalent -6.3%).

• 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 +1.0% in June, although easing slightly to +0.3% in May.

• The industrial annual total return is now +5.3%, compared with a low of -23.2% in June 2023. Retail annual returns turned positive in December 2023 and increased sharply to +1.9% in June 2024, compared with a low of -9.6% in July 2023. The total return for offices remains in firmly negative territory at -9.1% per annum in June 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, suggesting little change in overall buyer demand. However, industrial properties saw a net positive balance of +10%, contrasting with slightly negative net balances for offices (-9%) and retail (-18%).

• Although transaction volumes have remained subdued in the first half of 2024, we expect higher overall volumes in the second half of the year as lower interest rates in the UK, alongside currently reduced asset prices and increased post-election political certainty stimulate renewed confidence and market activity. However, volumes will remain below long-term averages.

• The low supply of offices considered prime in terms of both their location and the quality of the asset (including the correct green credentials) means they should benefit from rental growth in the short to medium term. Consequently, such properties should create interest from a growing range of buyers, and we therefore expect a positive adjustment in pricing. However, this is more likely to be in the smaller lot size range as institutional investors, who typically target the larger deals, are still in ‘sell mode’ and are, therefore, unlikely to return to the office sector soon. Offices that are not prime and without the correct green credentials will likely continue to fall in value until a point is reached where it becomes economically viable to either refurbish them or change the use.

• As with the office sector, many industrial occupiers are seeking well-located buildings with the correct green credentials, where enhanced rental growth will likely continue. This, in turn, will attract institutional interest, and is where yield compression is more likely. Investor appetite for secondary assets remains healthy, albeit slightly subdued compared to previous years. Yields have moved out and offer more attractive returns than previously obtainable. Falling interest rates will increase competition for assets of this nature as the buyer pool is expected to widen.

• Whilst households are still feeling the effects of the increased costs of living, the outward movement in retail yields (which in part is attributed to the associated occupational risk of tenant default) is at a level where it is once again looking attractive to experienced retail sector investors. Secondary neighbourhood parades let to local covenants continue to experience strong demand. We do not expect any significant change to the sector’s performance, but there is the potential for moderate growth when interest rates begin to fall.