Carter Jonas - Commercial Market Outlook September 2022

Economic outlook

Recent weeks have seen a marked deterioration in the UK economic outlook, crystallised by rises in Bank Rate during August and September totalling 100 basis points. The short-term outlook is now a combination of declining or stagnant output together with high inflation - so-called ‘stagflation’.
The Government’s ‘Mini Budget’ on 23 September saw an array of tax-cutting measures. This included reversing April’s increase in employers’ and employees’ NI contributions, as well as reversing the proposed increase in corporation tax to 25% (which will remain at 19%). The 45% additional rate income tax band will be abolished from April 2023, and the proposed 1p-in-the-pound reduction in the basic rate of income will be brought forward 12 months (to April 2023). House buyers will also benefit from an immediate increase in the threshold for Stamp Duty Land Tax.
The Mini Budget represents a major stimulus package and comes on top of the Energy Price Guarantee Scheme for households and the Energy Bill Relief Scheme for businesses, which will add a significantly greater amount to the UK’s national debt. Concerns over the burgeoning level of UK debt have precipitated turbulence in the foreign exchange markets, with the value of Sterling initially falling by more than 6% against the US Dollar.
There remain many supply-side constraints to economic growth, including ongoing disruption to global supply chains, Brexit-related challenges for UK exporters, and an undersupply of labour. The Government’s Mini Budget also signalled an increasing focus on addressing supply side issues, although there was little detail.
A key concern is that fiscal and monetary policy appear to be pulling in opposite directions, with tax cuts aimed at stimulating demand and rising interest rates aimed at dampening it to reduce inflation.
UK GDP is estimated to have fallen by 0.1% in Q2, and it is likely that Q3 will also show a decline (the latest consensus forecasts expect -0.3%), in part due to September’s additional bank holiday. The UK is therefore likely already in a technical recession. High inflation, rapidly rising interest rates, a sharp decline in real household incomes, low consumer confidence and slowing global growth is likely to mean further falls in UK output, despite September’s fiscal stimulus and the cap on energy bills.
There are reasons to be positive, however. Unemployment is historically low at just 3.6%, and although this figure will rise, it is not expected to reach the levels seen during the Global Financial Crisis. In addition, many households still have significant savings accrued during the pandemic. These factors, plus the Government’s Cost of Living Support package, will help to cushion the impact of rising prices and interest rates on the consumer.

Output trends

July’s GDP growth of +0.2% follows a decline of 0.6% in June (which was impacted by the additional Platinum Jubilee Bank Holiday). In July, services sector output grew by 0.4% and was the main driver of GDP growth, while production fell by 0.3% and construction by -0.8%. Output in the energy sector has been falling as consumers and businesses cut back on their consumption patterns amid skyrocketing energy costs.
August’s S&P Global / CIPS manufacturing PMI for the UK fell again for the fourth consecutive month, however this month saw a sharp decline to 47.3 (below the 50-mark indicating expansion). This marks the first contraction in this sector since May 2020 with output, new business and new export orders all falling, while jobs growth stalled. The rate of input inflation slowed to its weakest level since November 2020 but is still high in relative terms across all the main inputs of commodities, containers, energy, packaging, raw materials, etc. On the plus side, supply chain issues continue to ease.
Inflationary and cost of living pressure has also impacted the UK Services sector PMI which moderated to 50.9 in August, down from 52.6 the month prior. Although this is still in grown territory, it is the weakest activity in the sector for 18 months as domestic and overseas demand declined, and new business orders rose at a much softer rate. There was a surge in output cost levelled at clients due to increasing input costs in the month although the labour market remained strong as firms continued to hire.
The UK Construction sector PMI (CIPS / S&P Global) for August indicated a slight improvement to 49.2, up from 48.9 the month prior. Nevertheless, this is the second month in a row where the construction sector has shown contraction, with demand languishing as cost rises and inflation adding to uncertainty. Activity in the commercial and civil engineering sub-sectors is falling, and although housebuilding was a little more resilient, this is expected to decline in the coming months as the cost of borrowing rises.

Labour market

Once again, this month’s labour market survey data points to an extremely tight labour market. Although the employment rate decreased very slightly to 75.4%, the unemployment rate of 3.6% is the lowest figure since July 1974.
The number of job vacancies in June to August 2022 was 1.27 million, a decrease of 34,000 from the previous quarter (the largest quarterly fall since June to August 2020). However, this is still slightly higher than total unemployment (1.22 million).
Wage growth has risen steadily over the last few months, to 5.2% (annually, May-July, excluding bonuses), up from 4.3% in May and 4.7% last month. High inflation means this still reflects a fall of 2.8% in real terms. Average private sector pay growth reached 6.0% compared with 2.0% in the public sector, the largest recorded gap between the two sectors. With struggling consumer confidence and worries over cost inflation, job moves will likely begin to decline meaning that businesses will soon feel less pressure to raise wages.

Inflation

Inflation remains at a 40-year high, with CPI at 9.9% in August, down only marginally from 10.1% in July (the first fall in annual inflation since September last year). This month’s largest upward contributions came from electricity, gas and motor fuels, although motor fuels inflation is easing sharply, and this contributed to this month’s inflation decline compared with July.
The Bank of England now expects CPI inflation to peak at a little under 11% in October, compared with its previous expectation of 13.3%, due to the introduction of the Energy Price Guarantee. The September consensus forecasts compiled by HM Treasury suggest CPI falling to 4.5% by Q4 2023, still well above the Bank of England’s 2% target.
There is clearly much uncertainty around the level at which inflation will peak and how long it will take to fall, as this is highly dependent on the path of global energy prices. Other uncertainties include the extent to which global supply chain pressures will ease, possible further significant movements in value of Sterling (which affect the cost of imports), and the risk of a wage-price spiral developing.

Interest rates

The Bank of England Monetary Policy Committee (MPC) raised Bank Rate by 50 basis points to 2.25% in late September. Three members of the Committee voted in favour of a 75 basis points increase (which would have been in line with the US Federal Bank’s September rise). A further significant rise is inevitable – the next planned meeting is in early November, although the MPC could move earlier to provide emergency support to Sterling if required.

Normally, the Bank would be cutting interest rates at the start of an economic downturn to boost demand. The reverse being true reflects the severity of the inflationary problem, and its causes (rising energy and commodity costs rather than an overheating economy). There is clearly a limit to the Bank’s ability to control inflation through monetary policy, as inflation is currently so heavily influenced by global energy and commodity prices. Changes in Bank Rate take time to have an impact, and are aimed more at controlling inflation in the medium term.

Commercial property outlook

The commercial property sector is operating within the context of the second economic contraction in three years, a rapid rise in the costs of debt, and high inflation, together with the ongoing long-term structural shifts in demand precipitated by the pandemic.
In its Q2 2022 UK Commercial Property Survey, the RICS reports an aggregate net balance of +17% of respondents seeing an increase in tenant demand during Q2, down from +32% in Q1. Occupier enquiries fell for retail space and only grew modestly for offices, whilst industrial demand remained very strong at +49%, albeit below recent highs. Both the office and retail sectors continued to see a rise in availability, with net balances of +22% and +27% respectively, but supply in the industrial market continued to tighten, with a balance of -35%.
Respondents to the RICS survey expect prime and secondary industrial rents, as well as prime office rents, to rise over the next 12 months (although expectations are less buoyant than in Q1). Unsurprisingly, secondary office rents, prime and secondary retail rents are expected to fall, and again, the outlook has deteriorated compared with Q1.
Overall, the commercial market remains characterised by a dearth of the quality supply that occupiers now require in sectors such as offices (key city centres), last mile delivery and distribution warehousing. With developers facing elevated building costs, supply chain challenges and economic uncertainty, we do not expect a significant increase in construction levels, and the lack of stock will continue to act as a constraint on take-up.

Retail occupier market

Retail sales volumes are trending downwards, and have fallen in 10 of the last 12 months. August’s retail sales volumes fell by 1.6% over July, following a rise of 0.4% in July. All main sectors (food stores, non-food, non-store and fuel) experienced a decline, the first time this has happened since July last year. There were sharp declines in department store sales as well as household goods (-1.1% in non-food) while food store sales also fell by 0.8%. It is likely that consumers are beginning to restrict spending due to food price inflation and the rising cost of living more generally.
Consumer confidence continues to slip, moving down five points to -49, the lowest Index score since the GfK Consumer Confidence Index began in 1974. The two sub-indices which look ahead were worryingly low including the personal finance index at -40 and the economy over the next 12 months at -68. In all, all five sub-indices either remained flat (the Major Purchase Index stayed at -38) or fell.
This collapse in consumer confidence reflects the rapid rise in inflation, which is creating the biggest fall in real household disposable incomes since records began in the 1960s, as well as rising interest rates (which will increasingly feed through to significantly higher mortgage payments for many homeowners) and a deteriorating economic outlook. With high inflation set remain for some time, confidence is likely to remain weak.
A further decline in real household incomes looks inevitable, although the Government’s Cost of Living Support package, together with rising wages and the low rate of unemployment will help to cushion the impact. The Bank of England is forecasting real household income to fall by 1.5% this year and by 2.25% in 2023, only returning to modest growth in 2024.
This will inevitably impact consumer spending levels. Indeed, a recent ONS survey reported that just over 60% of households were already spending less on non-essentials, and almost 50% were spending less on food. On the positive side, consumer spending will fall by less than incomes, as some households (typically higher income ones) will be able to tap into savings accumulated during the pandemic or reduce the proportion of their income that they save. Discretionary spending will be most under pressure, as households delay big-ticket and non-essential purchases.
The proportion of retail sales online fell to 25.7% in August 2022 from 26.3% in July; despite this fall, it remains significantly above pre-coronavirus levels (19.8% in February 2020). Over the medium term, online sales are likely to resume their upward trend as a proportion of total sales.
UK town centre footfall remains circa 10% below its pre-pandemic levels, due mainly to the higher level of the remote working. This now appears to be a structural shift, to which retailers will need to permanently adjust. On the positive side, many local high streets continue to benefit, but at the expense of larger town and city centres.
Average retail rental values had been declining for 18 months prior to the pandemic, a trend that accelerated sharply during the lockdowns, and rental values are now 17.5% below their 2018 peak (MSCI Monthly Index, August). However, the rate of decline has been moderating recently, and average retail rental values have now broadly levelled off. This does mask 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. Average rental values saw only a modest fall during the pandemic, and have been rising steadily, by 0.9% over the 12 months to August 2022 (MSCI).
Average shopping centre rental values are nearly 23% lower than five years ago (MSCI), but appear to have found a floor. Indeed, average rental values increased by 0.7% over the three months to August 2022. Average rental values for standard (high street) shops are still falling, by -4.5% over the last year (to August, MSCI) and by -1.0% over the last three months.

Office occupier market

Rising inflation is creating greater cost pressures for corporates, a trend 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.
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. WeWork has recently reported that its office occupancy is finally back to pre-pandemic levels.
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 current dearth of new development will mean continued upward pressure on prime rents, and the gap with rents for poorer quality grade B stock is likely to widen further.
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.
Following a modest fall of just -0.8% during the pandemic, average UK office rental values have increased by 1.8% (from November 2020 to August 2022) and are now 0.9% higher than their pre-pandemic peak (MSCI Monthly Index, August).
Average rental value growth for standard offices in the 12 months to August 2022 was 0.9% in central London, 1.0% in suburban London, 1.9% in the Outer South East, and 1.9% in the rest of the UK. UK office parks saw growth of 1.4% (MSCI).

Industrial occupier market

Occupier demand remains strong across a broad spectrum of business sectors. However, there is a continued shortage of immediately available high specification industrial stock in many markets. With developers facing elevated building costs and supply chain challenges, we do not expect a significant increase in construction levels, and the lack of stock will continue to act as a constraint on take-up.
Structural change will continue to drive demand despite the mounting economic headwinds. 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.
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.
The rating revaluation will add significantly to costs for industrial occupiers from 1 April next year, as it is based on the change in rental values between April 2015 and April 2021, a period during which the industrial sector saw much stronger rental growth than the commercial market as a whole. Corporate occupiers are also facing significant cost increases across the board, most notably energy costs. Ongoing supply chain issues and labour market constraints add to the picture.
High levels of demand and constrained supply have resulted in some astonishing rates of rental growth. This is reflected in the Carter Jonas Industrial Index, which shows that prime industrial headline rents increased by 9% during the first six months of this year. However, the H1 2022 growth rate is a marked deceleration from the stellar 20.8% recorded over the previous six months to December 2021, and the total increase of 31.6% over the last 12 months has significantly outpaced the level of general inflation.
Looking at average industrial rental value growth, and the MSCI Monthly Index reports growth of 13.2% over the 12 months to August 2022, up from 12.9% in July, and another record high. However, growth is now slowing noticeably. Over the three months to August average rental values increased by 2.8%, compared with a peak of 4.0% in the three months to December 2021.
Although occupier demand remains strong and structural change will continue to drive demand, the sector will not be immune from the mounting economic headwinds, including the slowdown in economic growth, the income squeeze on households, and historically low consumer confidence, which will impact retail sales volumes, particularly for discretionary spending. Higher business costs will also act to dampen rental growth.
We expect some upward pressure on rental values to be maintained due to the ongoing supply/demand imbalance, but rental growth should decelerate further to a more sustainable rate. The annual rate (based on the MSCI index) is likely to be sub-5% by the year end, but the market is unlikely to go into reverse.

Investment market trends

Transaction volumes

Investment in UK commercial property dipped in Q2 2022 as spending fell in all sectors, most notably in retail and industrial.
£12.4bn was traded in Q2 2022. This was down 28% from a strong Q1 2022, 44% below the five-year quarterly average and was the weakest quarter for investment since Q1 2021. Notably, thanks to two strong previous quarters the rolling annual total remained 18% above the five-year average, totaling £67.6bn.
Unlike the previous quarter, investment was driven by the regional markets. Just under 55% of all investment (excluding portfolio deals) took place in the regions in Q2 2022, above the five-year average of 50%. The South East was the region which recorded the highest level of investment outside the capital with circa £1.1bn purchased in Q2 2022, followed by West Midlands with just under £800m.
Conversely, investment in London fell to 45.1% of the total, a notable decrease from 67% in Q1 2022 and below the five-year average of 50%. The “flight to quality” accelerated by the pandemic continued to be a theme in the capital, especially in the office sector. Overseas capital drove volumes in London and in the regions, accounting for a 59.7% share of the total investment, an increase from 54.9% in the previous quarter.

Investment performance

All property equivalent yields moved downwards from a pandemic peak of 6.3% in July 2020 to 5.15% in June 2022, according to the MSCI Monthly Index, a shift of 115 basis points. However, this trend has now reversed, with an upward shift of nearly 20 basis points to 5.33% during July and August 2022.
The UK 10-year gilt yield has been rising over the last year, a trend which has accelerated sharply over the last two months. As of late September, the 10-year gilt yield was 4.1%, compared with 1.0% at the start of 2022 and lows of under 0.2% in 2020. With gilt yields rising and property yields only just starting to move upwards, the yield gap has narrowed significantly (with the all-property equivalent yield currently at 5.3%). Against a backdrop of rising interest rates, a reversal of quantitative easing, and increasing gilt issuance to fund the national debt, we may well see yet further rises in gilt yields over the coming months.
With property yields now moving upwards and rental growth slowing, capital value growth has reversed quite sharply, and all property capital values are now falling. On the MSCI Monthly Index, values peaked in June, and have fallen by -2.6% in the two months to August. It will take a few months for falling values to be reflected in the annual figure, which is still recording an increase of 13%.
Looking at recent performance by sector, and MSCI data suggests that over the three months to August capital growth was -3.9% for industrials, -1.0% for retail, and -0.9% for offices.
Commercial property investment performance was never sustainable at its recent extremely high levels. The all-property annual total return peaked at 25.1% in May this year, and has since decelerated sharply to 18.3% per annum as at August (MSCI Monthly Index). With capital values now declining, we will see a further sharp fall over the coming months. The industrial total return is now 27.9% per annum (MSCI, August 2022), down from a peak of 42.8% in April, whilst retail returns are now 18.8% per annum (buoyed by very strong performance of 28.3% in the retail warehousing subsector) and offices are at 6.6% per annum.

Outlook