A FORWARD OUTLOOK 3 ON THE UK PROPERTY MARKET
THE FUTURE OF RESIDENTIAL 4 REAL ESTATE
RETAIL PROPERTY SECTOR 6
TOPIC OF THE MONTH 8 The Industrial and Logistics Sector
UK OFFICE SPACE AND THE 10 FLIGHT TO QUALITY
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The UK has a fascination with property; homeownership continues to be a widespread aspiration and an investment property portfolio is widely seen as a route to wealth. With inflation higher, but cooling, and interest rates set to climb further and peak in 2023, the future path of property prices is a frequent discussion topic. Alongside their own home, many also invest in property either directly or through an investment product, be it a Real Estate Investment Trust (REIT) or commingled investment fund. With multiple markets coming under the property banner, the sector and location are key considerations underpinning future returns. Four sectors are up for discussion, each with their own characteristics, outlooks, and legislation to consider.
The Private Rental Sector (PRS) is the one most will deal with in their lifetime. The sector currently has a chronic supply problem which, when combined with rising costs of borrowing for landlords and high house price to median income ratios, provides a tailwind for strong rental growth going forward. Throw into the mix new government legislation requiring a minimum Energy Performance Certificate (EPC) rating of C or above by 2025, and the supply issue is likely to worsen. Marrying the increased demand for rental properties at the hands of higher mortgage rates and squeezed incomes with supply constraints, rental growth figures are likely to remain strong for the foreseeable future. Having been in the pipeline for some time, institutional investors are drawn to the sector, seeking to capture the returns on offer from ‘generation rent’ with housing estates of high-grade properties or top end city centre apartment blocks.
Industrials have been the darling sector in recent years with the tailwinds of urbanisation and e-commerce driving capital values. In no subsector has this been more noticeable than within Big Box warehousing, where vacancy rates remain low and supply is constrained on the back of limited land availability and a time-consuming planning process. With demand outstripping supply, capital values soared, compressing rental yields from the 6% range in 2012 to around 3.5% in mid-2022. Asset management opportunities are limited for what are essentially giant sheds, resulting in the Big Box sub-sector story being one of capital growth as opposed to rental growth. In 2023, the trends look set to persist. Vacancy rates remain low, demand outstrips supply and development pipelines continue to be pre-let, with rising input costs being assumed through increased rents.
The UK’s office market varies greatly across regions. In London it is a tale of two cities, with a recent research meeting with Derwent London highlighting the relative underperformance of the City of London and Canary Wharf in relation to the areas around Fitzrovia and the tech belt running from Kings Cross to the Old Street roundabout. Similarly to PRS, regulations are set to impact the UK’s office market. Minimum Energy Efficiency Standards (MEES) regulations require a minimum EPC rating of B by 2030, resulting in an estimated 80% of London’s stock requiring
an upgrade. Add heightened demand for higher quality office space from companies to attract talent and meet sustainability goals, and the future for prime London office space looks strong.
Retail has been the more volatile sector, battling the headwinds of a shift to online retailing and multiple COVID-19 lockdowns through 2020 and 2021. More recent challenges remain, with the rising cost of energy and inflation limiting consumer discretionary spend. Amidst the difficulties, retailers have been consolidating their real estate, closing underperforming stores in a bid to save costs. A bone was thrown in the Autumn Budget with the most generous in-year business rates relief package for nearly 30 years, outside the COVID-19 relief package. While helpful, the outlook for retail remains challenging, with consumer expenditure and input cost inflation two important metrics for overall retail performance.
The most common access point for individual investors remains the REIT, with a wide offering across specialist sectors and diversified portfolios. The aftermath of September’s mini budget sent share prices sharply lower, with higher government bond yields signalling the widening of underlying portfolio yields and expected drop-off in net asset values. Both internal calculations and research team discussions with company managements conclude the share price declines indicate wider investment yield shifts than may reasonably be expected. As a result, there looks to be value on offer both in the underlying property markets and the REIT structures. While positive, there could prove to be stumbling blocks should the sector and geography be out of favour.
“The UK has a fascination with property; homeownership continues to be a widespread aspiration and an investment property portfolio is widely seen as a route to wealth.”
December 2022 saw house prices contract by 1.5% and marked their fourth consecutive month of decline. With a long, drawn-out recession still a very real possibility and interest rates likely to remain high, 2023 could be a tough year for residential real estate in the UK.
Analysts are generally predicting that property prices will experience a 5% to 12% drop throughout the year. Despite this, dynamics are in place for strong rental growth. Investors are increasingly looking towards senior living and, Build to Rent (BTR), in an attempt at catering to both the country’s ageing population and the younger generations who have been priced out of the housing market. The effects of the looming recession are likely to be muted due to the prevalence of fixedrate mortgages and the increased regulatory requirements placed on mortgage providers since the 2008 financial crisis. On top of this, changes to Energy Performance Certificates
It makes sense for us to first look at the headline-grabbing prediction that house prices are expected to fall by an estimated 5% to 12% this year. Tightening policies implemented by the Bank of England have created a challenging environment for buyers. High interest rates are likely to price many first-time buyers out of the market, or at the very least make them consider postponing until rates are on the way back down. These issues are compounded by the fact that the government’s help-to-buy scheme is coming to an end and, with no effective policy alternative yet in place, many young people will once again find themselves trapped in the rental market. With Deutsche Bank now predicting rates will peak at 4.5% in May, it is reasonable to assume that we will see some further cooling in the housing market as
mortgage rates move up in tandem. Even with the base rate currently at 3.5%, 670,000 UK households spend 70% of their income on their mortgages, making them vulnerable to defaulting on payments, and this will only worsen as rates rise higher. Some people will be forced to sell and this, combined with the fact that there will be fewer buyers in the market, is what is expected to drive prices down.
However, things are not quite as bad as they seem, as mortgages have become significantly less risky since the financial crisis in 2008. Thanks to the work of the Financial Policy Committee, virtually no new mortgages have loan-tovalue ratios of over 90% and they are seldom issued without proof of income and significant stress testing. This, along with the wider prevalence of fixed-rate mortgages, makes it unlikely that we will see a repeat of the 15% drop in house prices that we saw in 2008. Some analysts are predicting a drop as low as 2% and even the Office for Budget Responsibility, which by nature favours a conservative outlook, is predicting a return to house price growth by 2025.
You might assume that falling house prices would also lead to falling rents but, in this climate, it looks likely that the effect will be the opposite. As would-be buyers postpone their plans, they are often forced to look at the private rental sector where there is already a significant supply shortage. Landlords will also be hit by increasing borrowing costs and will likely look to pass these on to renters. This combination of factors has analysts predicting that rents will rise by 5% in 2023 and 4% in 2024, even as house prices start to fall. The combination of falling prices and rising rents could make the private rental sector look appealing to cash buyers or professional letting companies with money to spare.
rise, meaning BTR could well be a beneficiary of our current economic environment.
The property market for seniors is also well worth keeping an eye on in the coming years. The supply of properties aimed at senior citizens has been increasing, with 7,500 dedicated units built in 2021, marking a 12% increase on the previous year.
The property market for seniors is also well worth keeping an eye on in the coming years. The supply of properties aimed at senior citizens has been increasing, with 7,500 dedicated units built in 2021, marking a 12% increase on the previous year. Yet, with the total number of people aged over 65 in the country projected to reach over 14m in the next five years, demand well outstrips supply. Knight Frank, a specialist in the real estate sector, expects the supply of housing for Integrated Retirement Communities (IRCs) that provide housing with care to increase by 46% over the next five years. This compares with an increase of only 4% in the age-restricted real estate sector over the same period. It appears that within this specific niche there is a substantial opportunity for investment. This will come as no surprise to anyone who has tried to find a space for a loved one in a care home or an assisted living facility in recent years and it is expected that there will be a shortage of 58,000 beds across the sector by 2035. The number of senior housing units per 1,000 of the population is expected to drop to 120 by 2025 from 137 in 2010 in real terms due to the increasingly ageing population. This indicates that despite the ongoing investment, the supply and demand imbalance isn’t going anywhere. As a result of this, senior real estate looks set to become an increasingly attractive proposition in the future.
This increased professionalisation of the private rental sector is a trend that is likely to continue. Individual landlords are exiting the market as an increasing regulatory burden and tax reform limit their potential income. With the average house price now more than seven times the average household income, many people find themselves unable to get on the property ladder. The decreasing number of private landlords and the emergence of ‘generation rent’ has led to the rapid expansion of a new ‘Build to Rent’ (BTR) sector that presents an interesting investment opportunity. The properties are high quality, designed exclusively for let on a long-term basis, and are professionally managed. 2022 saw a 22% year-on-year rise in the number of BTR homes that started construction and, by 2032, BTR properties are expected to represent about 8% of all rental homes built. With wouldbe buyers being pushed out of the property market, the demand for high-quality rental accommodation is likely to
Lastly, there is one piece of legislation currently making its way through parliament that could have a huge impact on residential real estate: the Minimum Energy Performance of Buildings Bill. Should it pass in its current form, it would require all properties to obtain an EPC rating of C or above by 2025. It is predicted that the average cost for landlords to upgrade their rating from an E to a C would be £4,700 and the burden of this increase has led to 20% of landlords openly admitting that they are considering exiting the market. The following reduction in available housing would drive rents even higher while providing opportunities for property management companies to extend their reach as they are more likely to be able to stomach the costs associated with the renovations. This bill could, therefore, contribute to the further professionalisation of the private rental sector.
So, even though house prices look set to take a step back over the next year or two, there are still plenty of long-term investment opportunities within residential real estate that we should be cognizant of. From population demographics to the historically high house-price-to-earnings ratio, many factors are forcing change in the sector. What connects them is the fundamental imbalance between the supply and demand of appropriate housing and, as long as this persists, there will be plenty of opportunities within the residential sector.
In recent years, the retail property sector has endured a series of crises, arriving one after the other. This has been too much for some companies; in June 2020, the UK’s largest shopping centre owner Intu fell into administration after its rental income streams dried up as the first national lockdown forced its tenants to close their doors. Following on the heels of COVID-19, Russia’s invasion of Ukraine, soaring inflation, rising interest rates and continued competition from e-commerce giants such as Amazon and Asos have compounded an already grim picture.
Looking ahead to 2023, the landscape for the sector can charitably be described as challenging. A report from the Centre for Retail Research found that 17,000 shops in the UK closed last year, the highest figure in five years.
The predominant force behind the closures is rationalisation – the process of closing branches which are unprofitable, too large, or poorly located – rather than insolvency. The consequences may not be a net loss, as retailers are likely to open new units at locations better positioned for growth. Marks and Spencer has announced it will remove 67 of its larger stores over the next five years, while at the same time opening over 100 Simply Food units. This forms part of its growth plan to increase grocery sales by selling a wider offering in dedicated food stores. Professor Joshua Bamfield, director of the Centre for Retail Research, said that he expected this trend to continue into 2023.
There are some glimmers of hope for the sector, however. Chancellor Jeremy Hunt’s autumn statement threw high street retailers a lifeline when he announced a revaluation of commercial properties which awarded bricks and mortar premises a reduction in their business rates. Department stores and large supermarkets were the chief beneficiaries of the reduction. Conversely, rates for large warehouse and logistics facilities have been substantially raised. This goes some way to address an understandable complaint from traditional retailers that they pay an unfair share of business rates while leaving the online giants with a much smaller burden. Property consultants Altus have calculated that the rateable value of Oxford Street’s Selfridges will fall from £30.5m to £16.8m – a reduction of almost 45%.
The benefit of the downward revaluations will also be felt
sooner than expected. Downward transitional relief is usually phased in over three years, but the planned changes will take place in one fell swoop on 1st April this year. Small shops will also see a benefit, as the business rates discount for smaller retailers will increase from 50% to 75% and be extended for a year.
Another potential tailwind for the sector has been surprisingly strong Christmas results from a variety of high street chains. The likes of Next, Boots and The Perfume Shop have all reported comfortable increases in like-for-like sales in the final quarter of 2022. These statements are not the complete picture, however, as they are unaudited and are something of
a platform for retailers to put out whatever message they might want to send.
Convenience stores saw a boost during the COVID-19 lockdowns as consumers stayed local, but trade fell back to pre-pandemic levels as public life returned to normal. Convenience store chain McColl’s could not survive, however, and fell into administration in May last year, with senior creditors being owed £160m. A bidding war followed, with Morrison emerging victorious over EG Group, a petrol station chain partly owned by the Issa brothers who also own rival supermarket Asda. Morrison announced plans to close 132 lossmaking stores and bring most of the remainder under its
of all shapes and sizes – from digital natives looking to ‘test the waters’, through to large, established names wanting to inject new energy into their brand experience.’
While the headwinds may be varied and substantial, looking ahead there are opportunities in the retail property sector. All the major supermarkets are looking to open new convenience branches, while challenger discounters Aldi and Lidl plan to open 100 and 200 stores respectively over the next two years. The value end of the sector is growing, with the likes of Greggs, Home Bargains and B&M all looking to increase their presence in 2023 as they benefit from consumers reducing their household expenditure. At the other end of the scale,
‘Morrisons Daily’ brand. Asda also has plans to open 300 new convenience stores over the next four years, mostly in the South where its presence is smaller. A forecast from the Institute of Grocery Distribution predicts that the sector is set to grow by 13% in five years.
Commercial landlords have begun to offer more flexibility in their leasing agreements with tenants. Landsec, owners of Bluewater and Trinity Leeds, has launched a suite of lease options, with terms as short as one day. Nik Porter, Head of Retail Brand Management at Landsec, said ‘A traditional, onesize-fits-all leasing model is no longer fit for purpose. Our new products reflect this new reality. There is something for brands
the outlook for high-end goods is promising as wealthier consumers can weather the cost of living crisis and continue to spend as before. Sephora, the French cosmetics retailer backed by luxury goods giant LVMH, is making a return to London after 18 years. With many challenges to contend, both retailers and their landlords will have to be agile and adaptable when navigating consumer behaviour as they consider the uncertain year ahead of them.
Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned.
In recent years, the industrial and logistics sector in the UK has been growing in importance and gaining increasing popularity among real estate investors. Following Brexit and the pandemic, the extent to which logistics is a critical element of the UK’s infrastructure which underpins the UK’s economic output became increasingly apparent. Ranging from highly automated large-scale fulfilment centres to small urban or lastjourney warehouses, these distribution assets continue to underpin the UK’s economic output by playing an integral role in safeguarding the integrity of supply chains and supporting business functionalities. However, the modern logistics market is still in its relative infancy, with multiple powerful and long-term structural trends underpinning demand for these assets.
A main driver for demand in these assets is related to consumers’ growing demand for flexibility, accessibility, and convenience in retail shopping. This, combined with the decline in the high street and retail footfall, has led to a
continued rise in e-commerce in recent years, with online sales accounting for 27% of total retail sales in the first half of 2022. To fulfil this demand, businesses are having to develop extensive and increasingly complex supply chains, in which logistics real estate plays a fundamental role. Online retail supply chains require more warehouse space than traditional high-street models, with logistical assets playing a crucial role in storing, transporting and delivering online deliveries. Research from Knight Frank and UKWA suggests that every £1bn of additional online sales typically generates between 0.8m and 1.4m sq ft of demand for new logistics property.
Current economic conditions, with high inflation and pressures on consumer finances, are resulting in increased pressure on company margins with the need to not only grow revenue and expand market share, but to optimise supply chains with a focus on resilience, efficiency, and a reduction of costs. With warehouse rents making up a small share of total costs, the consolidation of smaller disparate or retail units into a larger distribution centre will not only offer
economies of scale but the ability to optimise staffing and stock levels. This results in the best-located units, which are close to the consumer and in dense urban markets, becoming more important, with such sites offering higher efficiency while also helping to mitigate rising costs associated with labour and transportation.
There is currently a worldwide drive to enhance sustainability performance, with government targets and regulations ensuring the transition of the UK towards net zero by 2050. Consumers are becoming increasingly conscious of the environmental impact of goods they purchase, with organisations under pressure to actively seek warehouses that meet environmental criteria. These modern assets feature enhanced insulation, LED lighting and large roof spaces
this supply chain disruption have led to some businesses looking to nearshore manufacturing closer to the point of retail. Manufacturers are also under pressure to resolve ESG concerns regarding globalised supply chains, with current production in economies that have lower worker and environmental protections; both factors continue to drive demand for logistical space within the UK.
Despite this strong demand, the supply of these prime, large-scale logistical centres remains constrained. The key component to constructing these assets is the location, with limited land able to accommodate these large buildings, and becoming even more scarce in key locations. ‘Big Boxes’ also require a large local labour pool, with some assets employing more than 3,500 people during peak times. The large scale of these assets requires significant planning permissions, with many requiring rearrangements to traffic routes and, therefore, taking years to obtain the required consents.
Another challenging factor relating to the location of these assets is the availability of and access to power. The supply of energy to sites via the national grid is finite, however, occupiers need to obtain substantial power to meet the future growth of automation and the advancement of electrical transportation. Developers are alive to the issues, with many schemes offering alternative renewable energy provisions and power-saving initiatives to occupiers looking to futureproof their business, with these trends expected to continue through the next few years.
The tight monetary policy experienced in the UK has led to rising interest rates driving up borrowing costs, and inadvertently driving up the ‘all in’ costs of finance for developments. This has also affected the purchasing ability of leveraged buyers, leading to a reduction in the number of speculative builds following the increased risks.
capable of accommodating solar panels. Grade A buildings are currently the most attractive for occupiers, as they will not require refurbishment to meet the anticipated future regulatory requirements, such as the minimum rating of B for Energy Performance Certificates. Occupiers will place a greater weight on meeting these higher Environmental Social & Governance (ESG) standards that can save costs and reduce the carbon output of warehouse operations.
Supply chains have been the lifelines of globalisation, delivering lower costs and greater efficiencies to the manufacturing sector over previous decades. However, the pandemic, rising geopolitical tensions and a sustainability drive have exposed the limitations of the just-in-time supply model, such as supply chain disruption, and have led companies to prioritise resilience within supply chains. Resilience can be built into supply chains by shifting to a just-in-case inventory management model, which holds more stock, requiring greater warehouse space, to minimise losses if delays in supply do occur. However, concerns around
In recent years, there has been a resurgence of occupiers looking to build-to-suit developments that can meet the increasingly bespoke occupier requirements. The economic conditions have led to a reduction in speculative units due to weaker developer risk appetite, following the rising ‘all in’ cost of debt finance, increasing construction costs and higher exit yields which will further impact supply.
The constrained supply and increasing demand have led to an imbalance in the market and have resulted in the vacancy rate within the logistics sector reaching record lows of 2.9% in 2022. The continued demand above long-term averages and vacancy levels remaining critically low with a lack of speculative builds are estimated to lead to continuing rental growth. This growth rate, although expected to be moderate compared to the double-digit growth experienced through 2021 and early 2022, will lead to the logistics sector reinforcing its position as a major contributor to the UK economy, and one of the most attractive locations for favourable returns within real estate investment.
The UK office real estate market has been heavily impacted over recent years, both by the impact of COVID-19 on the dynamics of working life and by the changing economic environment for tenants and landlords pushing up the costs of borrowing, building and renting office space.
Yet, further pressures are also looking likely to increase the pressure on office stock going forward, following the minimum energy performance regulatory requirements coming into effect in the spring of 2023. With an array of potential roadblocks for property investors and management companies it is likely that we will see a transition within the office space, to adapt to trends and provide more services to remain attractive to new and retained businesses throughout the transition of ‘flight to quality’ within the office market.
Looking forward to 2023, one of the biggest potential headwinds is the Minimum Energy Efficiency Standards (MEES) regulations, which are a key part of the strategic approach of the UK government to significantly reduce carbon emissions, of which commercial property are some of the biggest emitters of CO2. Current MEES regulation has been in place since 2018 and requires buildings with new tenancies to achieve a minimum EPC rating of E before they can be let to new tenants; from April 2023 the same rule will apply to existing tenants. The issue here is that almost 10% of London’s office stock currently has an EPC rating of F or G, meaning that as of April 2023 landlords will not be able to let new leases if the property doesn’t meet the required standards. This is likely to have an impact on investors due to the capital spend needed to improve rating levels to an E or better. Further regulatory tightening is yet to be had, with new minimum requirements stating an EPC rating of B or C by 2030. However, around 80% of London’s office buildings are below this minimum standard and will need to be upgraded by 2030, an equivalent of 15m sq ft per annum.
With much of the market likely to face strong headwinds over the next seven years, A grade office space looks to be well positioned within the market going forward. Following a focus in ‘flight to quality’ buildings over recent years, premium office space has become some of the most soughtafter property across the UK. Much of the demand comes as a result of high-quality, tailored fit-outs, allowing companies to lease space that aligns with company culture and provides an attractive, modern and exciting place to work, while promoting collectivism through group work areas. A further selling point are the additional services provided, such as concierge, security, corporate discounts to businesses within the surrounding areas, and other benefits. Finally, properties that hold strong EPC ratings, which A grade offices do, are likely to yield lower energy bills, a smaller need for renovations and thus less disruption to tenants, longer lease life for tenants as they remain happy with the high-quality characteristics of the property and, finally, often a greater alignment to tenants’ environmental goals in reducing their carbon emissions.
Because of this, A grade properties are able to command greater rents and tend to attract premier tenants, with limited default risk of rental payments. Further market conditions within the space suggests that due to a supply and demand imbalance, grade A properties are likely to see an uptick in prelet agreements, with 35% of space under construction being pre-let, and this is expected to increase as the year progresses.
At the other end of the spectrum, lower quality property such as Class B and C stock could possibly see a slowdown in leasing due to the poor quality and undesirable characteristics of these properties. Furthermore, depending on the EPC rating of these properties, a large amount of capital will likely have to be spent on not only improving standards of the properties, but also the attractiveness for future tenants given the competitiveness of the market. Following recent data, expectations for the average length of unoccupancy within the second-hand market is expected to increase in 2023 as demand looks weak against current supply levels for the lower quality property.
A further focus point for the year ahead from an investor standpoint will be prime yields, which is the annual return from property investments. In 2022, most UK office markets experienced an outward shift in prime yields, partly because of continued growth in prime rents drawing from the disparity within supply and demand and also from increased property upgrades allowing property managers to warrant an increase in rent due to greater quality office space. Despite positive uplifts in yields, capital values declined by 12.1% in 2022 following an unfavourable economic environment for property markets and rising borrowing costs as implemented by the Bank of England, following the rise in interest rates. Therefore, given the level of market uncertainty over 2022, it has been estimated that approximately, only 30% of total potential investments in office real estate will transact within the current market conditions, with capital investment volumes expected to be 20% down year-on-year in 2023. If we are to see a recovery within the commercial office space in 2023, it is likely that we will also need to see interest rates reduce with inflation, office upgrades and increased EPC quality, continued demand for high quality stock and improved investor sentiment in order to see valuations increase and market growth to push forward.
Historically, office real estate has been an attractive opportunity for strategic investors to diversify a portfolio and capture healthy returns from their strong underlying fundamentals and long-term lease agreements. But, with valuations falling off considerably last year, it will be interesting to see how the office space fares over the next year, particularly in terms of yield movements, property valuations, and investor sentiment. If the UK economic environment settles and interest rates look to turn the other way, it could be quite possible to see a recovery across the industry as confidence levels rise, property prices gain stability and investment volumes return more positively.
