Carter Jonas - Commercial Market Outlook November 2022

COMMERCIAL MARKET OUTLOOK

24 November 2022

Economic outlook

• Chancellor of the Exchequer Jeremy Hunt has delivered his highly anticipated Autumn Statement, announcing tax increases and fiscal tightening, and also acknowledging that the UK is now in recession. The statement included major U-turns from September’s ‘mini budget’, emphasising the importance of restoring the UK’s credibility with financial markets and bringing down inflation.
• The supply side of the economy continues to be a cause for concern. Issues include ongoing disruption to global supply chains, Brexit-related challenges for UK exporters, and an undersupply of labour – although there are signs that some of these supply pressures are now beginning to ease. Supply constraints, together with the significant impact of global energy prices, continue to drive high inflation. CPI Inflation has climbed to 11.1% (12 months to October).
• Economic growth has stalled, and the Bank of England has warned that the UK ‘is expected to be in a recession for a prolonged period’. Output fell by 0.6% in September, a steeper fall than the 0.1% reported for August. The Office for Budget Responsibility (OBR) now expects UK GDP to fall throughout 2023, with a decline of 1.4%, a sharper downturn than previously projected. The latest treasury-compiled consensus forecast suggests a less severe -0.9%, whilst the OECD forecasts a more benign -0.4% (but still the worst performance of any advanced global economy).
• The Bank of England increased Bank Rate by 75 basis points to 3.0% in early November. Further rises in the Bank of England base rate are inevitable in order to bring inflation down. This is the eighth consecutive increase since December, pushing the rate to its highest level for 14 years.
• Households are facing rising mortgage costs, significantly higher prices for essential items, and a further rise in energy bills next year. The government has announced that support for energy bills will continue after the initial end period in April 2023. However, it will be means tested and many households will receive nothing. The ongoing cost-of-living crisis and gloomy economic outlook has weighted on consumer confidence which, although it increased slightly in November, is still near a record low. The labour market remains a bright spot from the point of view of households, with unemployment at a near-record low (though likely to rise).
• Other sources of demand in the economy are unlikely to fuel growth. Government public spending has come under immense pressure, with Hunt announcing that the government will grow it more slowly than the broader economy. Business investment will also remain subdued due to economic uncertainty coupled with elevated costs of capital. UK exports may benefit to an extent from the weaker value of Sterling (particularly against the US Dollar), but will continue to be hampered by Brexit-related constraints and weaker growth in many of our overseas markets.

Recent output trends

• GDP fell by 0.6% in September (month on month), driven predominantly by a fall in the services sector. The ONS estimates that at least half of this month’s fall in GDP was due to the bank holiday for the State Funeral. Unlike other bank holidays, there was not a shift to leisure and tourism activities resulting from business closures. Services fell by 0.8%, with output in consumer-facing services seeing a decrease of 1.7%.
• There were, however, very minor rises for production and construction, which grew by 0.2% and 0.4% respectively. Production saw positive growth in three of its four sub-sectors; this is the sector’s first growth since May 2022. Construction output has seen three consecutive months of growth. The main contributors in September were public housing repair and maintenance (11.3%) and infrastructure new work (2.8%).
• Many businesses have reported challenging conditions, with the price of energy and the price of fuel continuing to be the main areas of concern. Others reported an impact on their turnover following industrial action. Currency exchange rates, too, were cited as being problematic, with a weaker pound making it less affordable to import inputs.
• October’s S&P Global / CIPS UK Manufacturing PMI indicated that the sector contracted for the fourth successive month, posting a 29-month low of 46.2 in October, down from 48.4 in September. Stubbornly high cost inflation continues to be a key concern for manufacturers. Heightened by political and economic uncertainties, there was a steep drop in new work received, which fell by the greatest amount since May 2020. This, coupled with weak export demand and disruption to supply chains, has led to a decline in production and employment.
• The S&P Global / CIPS UK Services PMI dropped to 48.8 in October, down from 50 in September. The contraction was the first overall decline in output since February 2021. Business optimism has fallen to its lowest level since April 2020, with the turmoil caused by September’s ‘mini budget’ resulting in greater spending caution among businesses and consumers. Rising interest rates and business costs have led to a ‘wait-and-see’ approach to new projects and a sharp decline in new orders.
• Construction output saw a modest increase in October as the UK Construction sector PMI moved to 53.2, up from 52.3 in September. This was well above market expectations, signalling the fastest rise in the sector since May. An increase in construction activity was due to delayed projects coming to fruition, helping to boost input purchases and staff hiring. The expansion was led by commercial building reaching a five-month high, while residential work grew at a slower pace and civil engineering activity contracted for the fourth month. However, construction firms are increasingly concerned about their growth prospects for the next year.

Labour market

• The labour market remains tight, with the UK employment rate in the three months to September 2022 unchanged from the previous quarter at 75.5%. The unemployment rate rose slightly to 3.6%.
• The estimated number of vacancies, however, fell by 46,000 on the quarter, as employers rein in recruitment in response to the economic climate. But, despite four consecutive quarters of falling vacancies, the overall number remains at historically high levels.

• We expect that firms will be hiring less in the next year and possibly reducing employment to combat rising external costs. As a result, unemployment will rise further. The Bank of England’s latest projection suggests the rate could almost double to just under 6.5%, although this is well above the latest consensus view of 4.4% by the end of 2023. Whilst this is clearly bad news for household incomes and consumer confidence, it will translate into lower pressure on businesses to raise wages, and also help to ease labour shortages.

• As the labour market remains tight, pay has been growing rapidly, particularly in the private sector, where average annual regular pay growth was 6.6% in the three months to September 2022, compared with 2.2% for the public sector. This is the highest rate seen for the private sector and the largest ever difference between the private and public sectors (other than at the height of the pandemic). In real terms (adjusted for inflation), regular pay across the labour market fell over the year by 2.7%. The Bank of England’s concern is that pay rises will be funded by businesses raising their prices, creating an inflationary cycle.

Inflation

• CPI inflation has increased again, reaching 11.1% in the 12 months to October, up from 10.1% in September. The greatest contribution came from housing and household services, which saw annual inflation of 26.6%. Rising food prices were the second largest contributor. Transport (principally motor fuels and second-hand cars), however, had the largest downward impact, although offset by greater increases in other sectors.

• The Bank expects inflation to remain close to 11% throughout the rest of Q4, easing towards 10% in Q1 2023. The October consensus forecasts compiled by HM Treasury suggest CPI of 10.3% in Q4 this year, falling to 4.7% by Q4 2023, still well above the Bank of England’s 2% target.
• There is clearly much uncertainty over the future path of inflation, as it is highly dependent on global energy prices, and the extent to which economic output falls. Other uncertainties include global supply chain pressures, 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 75 bps to 3.0% in early November. Only two of the nine members of the Committee dissented, both preferring a lower increase. Although global energy and commodity prices remain a significant factor in high inflation, the MPC highlighted the tight UK labour market, with continuing signs of firmer inflation in domestic prices and wages.
• Normally, the Bank would be cutting interest rates to counter an economic downturn, and the reverse being true reflects the severity of the inflationary problem. Indeed, the Bank suggests the possibility of two years of falling economic output, with recovery pushed back to the second half of 2024 (although this is predicated on Bank Rate rising to around 5% in line with market expectations, well above where the Bank itself expects interest rates to peak).
• However, further rises in Bank Rate seem inevitable, probably to around 4%-4.5%, as the Bank tries to bring CPI inflation back towards its target of 2.0%. The next MPC meeting is scheduled for 15 December, when it will also take into account any inflationary impacts from the Autumn Statement.

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 cost of debt and high inflation, together with the ongoing long-term structural shifts in demand precipitated by the pandemic.
• The Autumn Statement contained a package worth £13.6 billion to help business rates payers, with a commitment to introducing new valuations of properties to reflect more recent market conditions from April 2023, plus a package of relief measures.
• In its Q3 2022 UK Commercial Property Survey, the RICS reports an aggregate net balance of -10% for tenant demand, a significant deterioration from the +17% in the Q2 survey and +32% in Q1. Occupier demand fell for both retail and office space, with balances of -37% and -22% respectively. However, industrial occupier demand remains in positive territory at +21%, albeit down from +49% in Q2.
• The survey reports that both the office and retail sectors continued to see a rise in availability, but supply in the industrial market continued to tighten, albeit modestly. Respondents to the RICS survey expect prime office rents to be broadly flat over the next year, but a significant balance expect a fall in secondary office rents. A significant balance expects a fall in retail rents, whilst a modest balance expects industrial rents to rise.
• 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 rose moderately in October 2022, rising by 0.6% after a fall of 1.5% in September. Increases over the month were seen across all of the main sectors apart from food stores, where sales volumes fell by 1.0% in October 2022. In the three months to October, however, sales volumes fell by 2.4%; this continues the downward trend seen since summer 2021. Year-on-year, sales volumes are down 6.1%.

• The GfK Consumer Confidence indicator increased three points to -44 in November. Although this is the second month of improvement, it remains near the historic low of -49 reached in September. All five components of the measure improved in November over the next year. However, the overall index remains 30 points lower than November 2021. The greatest difference is in expectations for the general economic situation over the coming year, which is 35 points lower than November 2021.
• The collapse in consumer confidence and falling retail sales 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), rising energy bills and a deteriorating economic outlook. With inflation set to remain high for some time, confidence is likely to remain weak.
• A further decline in real household incomes looks inevitable. Although the Government’s Energy Bills Support Scheme is helping, it is now scheduled to finish at the start of April 2023, with further support much more targeted. This will mean further significant rises in average household energy bills next year.
• 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 should fall by less than incomes, as some households (typically higher income ones) are 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 taking place online was 26.1% in October 2022, a slight decline on the previous month. Although this is still significantly higher than pre-pandemic levels (19.5% in January 2020), this is a noteworthy drop when compared to October 2021 (29.1%) and suggests a return, in part, to physical stores.
• Total UK footfall increased by 2.0% in the year to October 2022 (British Retail Consortium). High streets saw the greatest increase at 7.6%. Shopping centre footfall increased by 2.8% and retail parks decreased by 3.2%. All types of retail location, however, are seeing levels of footfall below those seen pre-pandemic.
• 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 17.4% below their 2018 peak (MSCI Monthly Index, October). However, the rate of decline has been moderating recently, and average all-retail rental values have seen a very modest rise over the last few months (+0.14% from March to October). 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 1.1% over the 12 months to October 2022 (MSCI).
• Average shopping centre rental values are 22.5% lower than five years ago (MSCI), but appear to have found a floor. Average rental values have been broadly flat since June 2022, which is notable considering the extent of the economic downturn. Average rental values for standard (high street) shops are still falling, by -2.8% over the last year (to October, MSCI) and by -0.4% over the last three months.

          Office occupier market

• Rising inflation is creating greater cost pressures for corporates, which is likely to further increase the focus on cost reduction and productivity. Although corporate real estate is the second highest cost after salaries for many businesses, the provision of high-quality space can also help to increase productivity. This, together with the longer-term impacts of the working from home revolution, means that many businesses continue to assess their real estate footprint, and are placing an ever-greater emphasis on smaller but higher quality space.
• Whilst there is a large quantity of office stock available, much of it does not meet the requirements of today’s occupiers, and a two-tier market is increasingly apparent. In many locations, a shortage of quality space rather than occupier demand is holding back take-up, and the modest amount of speculative development in the short-term pipeline is unlikely to change this picture.
• The flexible space market (or serviced office sector) continues to benefit as more occupiers are looking for flexible short-term leases due to the lack of certainty over future office space requirements, with many companies remaining cautious about committing to new space. This is encouraging flexible space operators to take more space.
• Despite uncertainties around future levels of office occupation, we have not seen any falls in prime rental levels in our key locations. Indeed, many major 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 only modest falls during the pandemic, average UK office rental values have increased by 1.2% from February 2020 to October 2022 (MSCI Monthly Index, October). Average office rental values have seen a steady increase over last few months, rising by 0.3% in the three months to October.
• Average rental value growth for standard offices in the 12 months to October 2022 was 0.1% in the City of London, 0.6% in London mid-town and the West End, flat in suburban London, 0.6% in the Outer South East, and 0.4% in the rest of the England (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 fuelled 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 resulted in some very high rates of rental growth, with average rental values peaking at 13.2% in August, according to the MSCI Monthly Index. However, growth is now decelerating rapidly. On an annual basis, it has reduced to 12.4% (12 months to October), but on a quarterly basis it is now 1.9% (three months to October), the equivalent of 7.7% over one year.
• 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.
• There remains competition for both existing product and new build product to be delivered, maintaining pressure on prime rental values. However, rental growth will decelerate further to a more sustainable rate.

          Investment market trends

Transaction volumes

• UK commercial property investment transaction volumes fell in Q3 2022, driven by the office and alternative sectors. However, activity in the industrial and retail sectors was resilient compared with recent quarters.
• £11.8bn was traded in Q3 2022. This was down 28% quarter-on-quarter, 17% below the five-year quarterly average and was the weakest quarter for investment since Q1 2021. Notably, thanks to three stronger previous quarters, the rolling annual total remained 21% above the five-year average, at £69.8bn.
• Investment in London (excluding multi-regional portfolio deals) accounted to 40.3% of the UK total, which was broadly on par with Q2 2022 but well below the five-year average of 51.3%. 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, accounting for 65.5% of the total, while in the regions, the share of overseas investment was 42.4%, an increase from 32.4% in the previous quarter. 59% of all investment took place in the regions in Q3 2022, above the five-year average of 50%.
• The office and the industrial sectors still accounted for the largest share of the quarterly UK total investment, with 26.2% and 30.3% respectively. However, investment in offices was further below the 5-year average than any other sector. Notably, investment in retail amounted to 16.9% of the total, the highest share since Q2 2019.

Investment performance

• All property equivalent yields bottomed out at 5.15% in June and shifted upward to 5.47% in September, according to the MSCI Monthly Index. However, October saw a further, more marked, upward shift of 45 basis points to 5.92% – although still well below the pandemic peak of 6.3% in July 2020.
• The UK 10-year gilt yield had been on an upward trend even prior to the Government’s ‘mini budget’, which was the catalyst for a marked upward shift, with yields peaking at 4.6%. As of 23 November, the 10-year gilt yield had fallen back to 3.1%, in line with levels seen just prior to the mini budget, but still in marked contrast to 1.0% at the start of 2022 and lows of under 0.2% in 2020.
• Gilt yields have shifted upwards more rapidly than property yields, and so the yield gap has narrowed. In October 2021, the yield gap was 460 basis points, which had fallen to 240 basis points as at the end of October 2022 (although the gap has probably now widened a little, assuming a further rise in property yields, together with a fall in gilt yields since the end of October).
• On the MSCI Monthly Index, all property capital values peaked in June, and have fallen rapidly since. In the three months to October, capital values decreased by 10.7%. This has been driven by the upward movement in yields, with rental values still rising (by 0.9% at the all-property level in the same period). Recent falls have now started to feed through to the annual figures, with a decrease in capital values of 0.1% in the 12 months to October, down from a peak of +19.3% per annum in May.
• Industrials have seen the largest yield movement, and therefore the greatest fall in capital values, at -15% over the three months to October (despite rental value growth of +1.9%). Capital value growth was -8.0% for retail and -7.4% for offices in the three months to October.
• Commercial property investment performance was never sustainable at the extremely high levels reached in spring of this year. The all-property annual total return peaked at 25.1% in May, and has since decelerated sharply to 4.6% per annum as at October (MSCI Monthly Index). With capital values now declining rapidly, we will see a further sharp fall in the annual rate over the coming months. The industrial total return is now 6.5% per annum (MSCI, October 2022), having fallen dramatically from a peak of 42.8% in April 2022. Retail returns are 7.5% per annum as at October (bolstered by 14.0% total retail in the retail warehousing subsector), down from 14.3% in September. Offices fell to -0.7% annual total return, down from 4.6% per annum in September.

Outlook

• A market correction has occurred over the last few months. Commercial property yields have moved sharply upwards, as investors reassessed their risk assumptions following the rapid rise in long and short-term interest rates. However, there is recent evidence to suggest that debt is getting cheaper. The SONIA rate has peaked and is now trending downwards, and we are likely to see further falls into the new year.
• Many domestic investors are once again adopting a ‘wait and see’ approach before taking decisions, and debt-backed buyers have found it increasingly difficult to compete due to the elevated cost of debt. However, more overseas buyers are considering opportunities, with the fall in Sterling combined with the recent fall in prices making UK assets look good value.
• Deals are still being agreed, albeit at discounted levels, depending on the sector and quality of the asset. This is set against the backdrop of what remains a fairly robust occupational market for prime stock in many markets.
• The industrial sector has borne the brunt of the pricing correction, despite the continued robust occupier market. Anecdotal evidence suggests that industrial yields have begun to stabilise for prime stock, and the occupational fundamentals remain sound for now. Likewise, the prime occupational office market is underpinned by a shortage of supply that will not be quickly replenished.
• Whilst we expect yields across much of the commercial sector to soften further, the current market will continue to present itself as a significant buying opportunity for some investors. The sharp movement in bond yields following the Truss administration’s ‘mini budget’ may have served to accelerate a correction that would have happened anyway, given the economic downturn. Having said this, we are beginning to see increased levels of positivity and therefore activity, which are yet to be translated into deals done.