Commercial Market Outlook

• Inflation is headed firmly back towards the Bank of England’s 2% target, with CPI falling from 4.0% in January to 3.4% in February, and the latest Treasury-compiled consensus forecast anticipating a further decline to 2.1% by Q4 2024. Indeed, the rate may well dip below the target for a time during the middle part of this year.

• The Bank of England’s Monetary Policy Committee (MPC) has now held the base rate at 5.25% for five consecutive meetings, with no members now voting for a rise (although only one member currently favours a cut). With wage inflation and core inflation both above CPI at 6.1% and 4.5% respectively, the MPC will remain cautious not to cut too early. However, it will now come under increasing pressure to do so as inflation heads further downwards, in order to boost economic growth.

• Following a fall in output during the third and fourth quarters of last year (signifying a technical recession), UK economic growth got off to a good start in 2024 with a healthy rise of 0.2% during January. Although not too much should be read into one month’s figures, when combined with recent positive forward-looking indicators such as the services PMI, it suggests that the economy has returned to growth in Q1. 

• The manufacturing and construction PMIs remain just shy of growth territory, but they have been improving, and whilst consumer confidence remains weak, optimism about personal future finances has also improved. Together with the prospect of lower interest rates – potentially as early as May – the UK economy should see further growth this year. However, this will continue to be rather weak, with the latest HM Treasury-compiled consensus suggesting 0.3% for 2024 as a whole (compared with 2023), rising to 1.2% in 2025. On a quarterly basis, growth should accelerate to around 0.2% to 0.3% this year.

Recent output trends and indicators

• Monthly GDP grew by 0.2% in January 2024, up from -0.1% the month before and in line with market forecasts. The largest upward contribution came from a rise in the services sector (+0.2%) including retail, human health and education. The construction sector also grew sharply while industrial output fell by -0.2%. Over the three months to January, GDP declined by -0.1%.

• February’s manufacturing PMI (S&P Global) reached 47.5, up from 47.0 in January and the highest figure since April 2023. Despite this improvement anything below ‘50’ still signals contraction, where this indicator has been for 19 consecutive months. Challenges from deliveries and disruptions due to the Red Sea crisis as well as new orders falling at the sharpest rate since October contributed to the weak performance this month.

• Meanwhile the services PMI ticked down to 53.8 in February, from 54.3 the month before. Nevertheless, there was a steady rise in business activity during the month, including a rise in new orders and employment levels. Increased wage pressures and shipping costs resulted in rising input prices, but encouragingly, future growth optimism rose to its highest level in 24 months.

• Business optimism in the construction sector has continued to improve for the third consecutive month, reaching its highest level since January 2022, according to the latest Construction PMI (S&P Global). This, combined with rising new business growth and stable output levels, led the latest index figure to rise to 49.7 in February, the highest level in six months.

Labour market

• Data from the Labour Force Survey should still be treated with caution due to low sample sizes achieved by the ONS over recent months. Nevertheless, latest estimates show the unemployment figure moved up to 3.9% in the three months to January from 3.8% the previous quarter. Total employment meanwhile remains unchanged at 75.0%. 

• The number of payrolled employees rose by 15,000 in the month to January, reflecting an annual increase of 1.3% or 386,000 people. While this figure continues to rise, the rate of growth is slowing. Early estimates for February suggest an increase of 20,000 but this is likely to be revised. 

• The number of job vacancies fell yet again, for the 20th consecutive quarter, declining by 43,000 to 908,000 vacancies. This represents a 4.5% decline over the previous quarter and reflects a 224,000 fall year on year. Despite this, the figure is still 107,000 above pre-pandemic levels.

• Annual growth in employees’ average weekly earnings (excluding bonuses) moved down only very slightly, with the latest estimates showing a 6.1% rise (November 2023 to January 2024), down from 6.2% in the previous quarter. Earning growth is likely to rise again this spring with the National Living Wage due to increase by 10% from April. But most surveys suggest that overall wage growth will slow throughout the remainder of the year.

Inflation

• CPI inflation was 3.4% in the 12 months to February, down from 4.0% in January, and the lowest rate since September 2021. There was a slowdown in price increases from food, restaurants and hotels while upward contributions came from housing, utilities and transport. Ofgem has announced a 12% fall in the energy price cap in April. The new cap of £1,690 remains well above the pre-crisis level of circa £1,200, but this reduction will exert further downward pressure on inflation.

• Core CPI (excluding volatile elements such as energy and food) rose by 4.5% in the 12 months to February 2024, down from 5.1% the previous month, and still well above the headline rate.

• A further rapid fall in headline CPI is likely, with the rate expected to fall below the Bank of England’s 2% target over the summer (Experian forecasts suggest a rate of 1.6% in Q2 this year), before rising again modestly to a little over 2% by Q4, and remaining slightly above target during 2025 (but below 2.5%). Clearly, there is much uncertainty surrounding this outlook, with wage growth still well above CPI, and heightened geopolitical risks around global trade flows and energy prices.

Interest rates

• As expected, the Bank of England’s Monetary Policy Committee (MPC) held the base rate at 5.25% in March, for the fifth consecutive meeting (following 14 successive rises to subdue inflation). Eight of the nine MPC members voted to hold rates, with one member preferring a decrease. This represents a further shift towards policy loosening since the previous meeting in February, when two members were still voting to increase Bank Rate. Given the rapid fall in headline CPI inflation from a peak of over 11% to 3.4%, a cut in the base rate is widely expected over the summer, and potentially as early as May.

• There are still considerable supply constraints in the economy, and given the relatively small output gap, the MPC will want to make sure that inflation does not reignite, especially with core CPI still above 4%. Wage rises are now well above headline inflation, and the National Living Wage is due to rise by nearly 10% in April which will add further inflationary pressure. The MPC will therefore proceed cautiously.

Retail occupier market

• Retail sales volumes were flat during February 2024, following a 3.6% rise in January. Volumes fell by 0.4% in the three months to February 2024 when compared with the previous three months, and by 1.0% when compared with the three months to February 2023. Sales volumes remain 1.3% below their pre-pandemic level in February 2020.

• The GfK Consumer Confidence Index was unchanged in March 2024 at -21. Although this is up from a recent low of -30 in October 2023, it remains a relatively weak reading, but encouragingly, consumers’ optimism about their own future finances recorded a two-year high.

• Many households are benefiting a little from the 2% reduction in National Insurance Contributions introduced from January. From April 2024, a further reduction of 2% comes into effect, and many lower income households will also benefit from a nearly 10% uplift in the National Living Wage (though this will adversely impact costs for many businesses in the retail and food & beverage sectors). In addition, wage growth is now above inflation, so wages are rising in real terms, and the lower energy price cap also comes into effect in April. This is all positive for household disposable income.

• The Q4 2023 RICS UK Commercial Property Survey shows a net balance of -18% for retail occupier demand, an improvement on the -25% reported in Q3. 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 early 2022, according to MSCI. The Monthly Index reports that average retail rental value growth in the 12 months to February 2024 was 0.6%, and has been within a range of 0.5% to 0.8% in over the last five months. 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. The retail warehouse subsector has fared considerably better than most of the wider retail sector in recent years, with average rental values increasing by 1.1% in the 12 months to February 2024 (MSCI Monthly Index), a rate which has been broadly stable in recent months. 

• Average shopping centre rental values have fallen by -2.4% over the 12 months to February 2024. This represents a sharp acceleration in the rate of decline, from -1.7% in January 2024 and -0.7% in December 2023. The change over the last three months suggests that the annual figure may decelerate further, with a fall of -1.3% from November 2023 to February 2024, the equivalent of -5.2% per annum.

• Average rents for standard (high street) shops were falling well before the pandemic. From May 2018 to May 2023, rental values fell almost continuously, by circa -29%, but some growth was recorded over the summer months of last year, with the result that annual growth is now in positive territory (+1.0% as at February 2024). However, more recent data suggests a stalling of growth, with the index almost unchanged over the last six months.

Office occupier market

• High inflation has been creating cost pressures for corporates, further increasing their focus on productivity and cost reduction. This, together with the longer-term impacts of the working from home revolution, means that many businesses have been assessing their real estate footprint, although the level of downsizing is highly business specific, and appears to have been declining in recent months. Indeed, recent data suggests that office occupancy rates have broadly levelled off over the last year and the three-day office week appears to have 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 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, 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 Q4 2023 RICS UK Commercial Property Survey shows a negative net balance of -12% for office occupier demand, improved from -19% in Q3 and -21% in Q2, but still below the -6% reported in Q1. Respondents also continued to cite an increase in overall vacant space.

• Take-up in 2023 was just over 3.5 million sq ft across the Carter Jonas regional ‘Commercial Edge’ cities, almost identical to the 2022 figure. However, demand levels remain some way below the average of 4.5 million sq ft per annum recorded over the five years prior to the pandemic. Oxford and Cambridge outperformed in 2023 compared with 2022, with both cities seeing an increase in take-up of more than 40%, driven by strong demand from firms in the life sciences sector.

• 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 corporate and legal requirements.

• 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 annual 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 offices was 2.3% as at February 2024, up from a post-pandemic low of 0.8% in January 2023. Annual growth to February 2024 was 2.9% in central London, 1.9% in the rest of the South East, and 2.3% in the rest of the UK (MSCI Monthly Index).

Industrial occupier market

• The UK logistics backdrop has been one of subdued consumer confidence and the near flatlining of household expenditure. However, this year should see an improvement, with wages rising in real terms and some consumers soon benefiting from lower energy bills and the rise in the National Living Wage. 

• Following the 2020-2022 demand boom, 2023 saw take-up levels more akin to the five years prior to the pandemic (which were still above longer-term averages). 2024 should see similarly robust demand, especially as the largest player, Amazon, is back in the market following a hiatus last year.

• Occupying buildings with the right specification will be ever more important, as occupiers adapt to new requirements. For example, the government recently introduced legislation to allow longer lorries, following a trial period. This permits semi-trailer combinations of up to 18.55 metres, 2.05 metres longer than the standard size. Whilst clearly beneficial in terms of HGV capacity, the size / shape of some warehouse yards is proving challenging, and this will be a greater consideration going forward.

• The Q4 2023 RICS UK Commercial Property Survey shows a net balance for industrial occupier demand of +6%, up from a recent low of +3% in Q3 2023, although still well below the recent peak of +49% in Q2 2022.

• The supply of new units is very limited across many key markets, and the development pipeline will remain restricted, given the constraints on developers, including elevated funding and construction costs. On the positive side for supply, more high-quality stock should come onto the market as subleases as occupiers release surplus space, a welcome boost to supply in key locations where vacancy is low.

• 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, decelerating to 7.0% by October 2023. Growth has since continued at broadly this rate, with the latest reading (February 2024) also at 7.0%. On a quarterly basis growth decelerated a little to 1.3% in the three months to February, from 1.9% the previous month, the lowest rate since March 2021 and the equivalent of 5.3% per annum.

• The Q4 2023 RICS UK Commercial Property Survey reports an expectation for further rental growth. A net balance of +48% of survey participants expect a continued pick-up in prime industrial rents over the year ahead, almost unchanged from Q3 2023 although below the recent peak of +58% in Q1 2023. For secondary industrial property, the balance on this measure is also positive, albeit a much lower +14% in Q4 2023.

• 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.

Transaction volumes

• £7.4bn was traded in Q4 2023, marking the weakest quarter for investment in more than a decade, down 9% quarter-on-quarter and 46% below the five-year quarterly average. The rolling annual total also fell notably compared to the previous six quarters and was 37% below the five-year average at £56.2bn. All of the main commercial sectors saw volumes continue to fall in Q4, whilst activity in the alternative sectors saw a notable uptick.

• Just over 60% of all investment (excluding multi-regional portfolio deals) occurred in Greater London in Q4 2023, well above the five-year average of 52%. Investors continued to target high-quality offices in prime locations and assets in the living sectors such as student accommodation. 

• By sector, the ‘alternatives’ accounted for the largest share of the quarterly UK total at 40% and, notably, recorded volumes closer to the five-year quarterly average than any other sector. The office sector accounted for 26% of the total, whilst industrials amounted to just shy of 25% and retail accounted for 9%.

• Overseas investment in UK commercial property totalled £6bn in Q4 2023, accounting for more than 80% of total purchases. The overseas total was broadly in line with the five-year average, in contrast to the volume for UK purchasers, which was 56% below the average. US investors had the highest share of overseas investment in Q4 2023, totalling around £2.15bn, a 67% increase quarter-on-quarter but 32% below the five-year quarterly average.

Recent investment performance

• All-property average equivalent yields have been shifting upwards since mid-2022 in reaction to rising interest rates and gilt yields, political uncertainty and elevated occupier demand uncertainty. This rate of upward movement peaked in late 2022 but has continued at a more modest pace during 2023 and into 2024. The all-property equivalent yield reached 7.1% as at February 2024, a rise of 190 basis points since June 2022 (MSCI Monthly Index), and 14 basis points over the last three months.

• Since June 2022, the office sector has seen the largest upward yield movement at 240 basis points, with industrial at 209 basis points and retail at 144 basis points. Offices continue to see the strongest rate of upward yield shift, at 26 basis points over the three months to February 2024, compared with just over 10 basis points for industrials and retail.

• 10-year gilt yields stood at 4.1% at the end of February 2024, compared with 3.8% a month previously and a recent low of 3.4% at the end of 2023. The gap with the all-property equivalent yield is now 295 basis points, compared with 350 basis points as at December 2023. This remains wider than the average for 2023 of 270 basis points, but is 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 in the current cycle. All-property rental value growth was +3.8% in the 12 months to February 2024, but the sharp upward movement in yields seen during 2023 has resulted in a fall in all-property capital values of -4.9% over this period (MSCI Monthly Index). The annual fall in capital values is now well past its peak, having improved from a low point of -21.2% in June 2023.

• Capital growth varies considerably across the main commercial property sectors. In the 12 months to February 2024, retail capital values fell by -5.1% (similar to the all-property rate), whilst office values fell by a significant -16.5%. In contrast, industrial capital value growth was in positive territory at +1.5%.

• 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. In recent months, the improvement in performance has been rapid and the all-property annual total return turned positive in January 2024 at +0.3%, rising to +0.7% in February (MSCI Monthly Index).

• The industrial annual total return is now +6.5%, compared with a low of -23.2% in June 2023. Retail annual returns turned positive in December 2023 and stood at +1.6% in February 2024, compared with a low of -9.6% in July 2023. The total return for offices remains in firmly negative territory at -11.7% per annum in February 2024, but still an improvement on the recent low of -18.9% in August 2023 (MSCI Monthly Index).

Investment outlook

• We expect higher investment transaction volumes in 2024 relative to last year, but still below long-term averages. The path of interest rates this year will be key in determining the timing and speed of the recovery in transaction volumes.

• With a general election later this year, we believe that a change in government is unlikely to cause a significant market correction. Instead, we expect a slowdown in activity during the few months before and after the election, as many investors hold off making material decisions. Previous changes in government have not shown a dramatic change in investor sentiment – unlike Brexit, the pandemic, and various geopolitical events that we have recently experienced.

• Offices considered prime in terms of both location and the quality of the asset (including the correct green credentials) are currently low in supply and should benefit from rental growth in the short to medium term. Consequently, such properties should raise interest from a growing range of investors, 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 throughout 2024. 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. Any further falls in 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 expect the retail sector's performance to be similar to 2023, but with potential for moderate growth when interest rates begin to fall.