The ending of pandemic era restrictions brought relief to the lives of millions of Britons, but also brought into sharp focus questions around the future of commercial property in the UK.
Even prior to the pandemic, changes to working habits, demographics and environmental concerns were changing the landscape for property investors.
The pandemic and its aftermath may have accelerated some of those trends, and just as investors began grappling with the implications of those futuristic trends, the more traditional challenges faced by property investors of rising interest rates and economic slowdown have begun to emerge.
But as the hardships of the pandemic era recede into the distance, speculation is starting to give way to reality regarding the prospects for the market.
The most noticeable feature is there is a flight to quality.
Matthew Howard, manager of the CT Property Trust, says the biggest change is that “prior to the pandemic, all property sectors moved basically in line with each other and in line with where the economy was, but now, it’s divergent.
“Different geographies and different sectors are performing in different ways. A lot of it is a function of Covid-19 having sped up long-term trends. But I think the most noticeable feature is there is a flight to quality.
“Employers are taking the view that they may need less space now with remote working, but they want offices that are environmentally friendly, and have facilities perhaps like gyms and eating spaces within the offices.
“With those sorts of offices there is actually rental growth right now. But a good example of what it is like in other areas of the market is HSBC have announced they are reducing the amount of space they want in Canary Wharf by about half, and moving people to a more modern office in the City.”
He says that the number of “voids” – that is, tenantless premises – is around the same level today as it was during the global financial crisis, but that in the GFC there was not the same divergence, as all property did equally badly.
Safety first?
Andrew Singh is head of real assets research at Isio, which has large financial institutions among its clients.
He says the other factors that have negatively impacted commercial property valuations in recent years include the economic uncertainty of Brexit, and the liability-driven investments pensions issue.
This mattered to commercial property investors because such funds ascribe a future value to the the rental income on a property, and discount this against the yield available on government bonds.
Building owners will be more likely to refurbish their existing premises than build new offices, and that could mean supply stays relatively limited.
As pension funds sold off gilts in the wake of the “mini”-Budget, the price of those assets fell, pushing up the yields, as the capital value of a property is calculated relative to gilt yield, this caused the value of commercial property assets to fall.
But Singh says this drop in valuations was not the result of a significant drop in demand from tenants, and that with commercial property down 20 per cent, it may be that the trough in valuations was reached in the third quarter of 2022.
He agrees that a unique feature of the market right now is that divergence between sectors, but says valuation also played a role in this, as some of the better performing sectors sold off in the wake of the “mini”-Budget as investors sought to raise cash.
But with property values having, in his view, stabilised, he says that divergence is returning.
When it comes to offices, Singh says he believes the “flight to quality” is not merely a function of investors being cautious and so choosing to invest in blue chip assets, but a function of company management taking the view that headquarters will need to be high end and modern; regional offices may no longer be needed as staff work from home.
Singh says: “The supply of those high-quality offices, especially those that are compliant with energy efficiency regulations, is actually quite small, and companies are happy to pay up for them.
“The other thing you will see is that building owners will be more likely to refurbish their existing premises to make them premium than build new offices, and that could mean supply stays relatively limited.”
Now there are lots of alternative property companies where you can invest just in the bits you like.
With this in mind he says the long-term trend is for premium locations to do well, and regional locations to do poorly.
Howard says the other area that has performed well of late is commercial warehouses used by online retailers such as Amazon.
He says this is the part of the market with the lowest level of un-let property in the UK right now, while high street locations remain the area with the highest level of vacant properties.
Dan Gollance, who runs multi-asset portfolios at Close Brothers Asset Management, says a key difference for investors looking at commercial property right now is the far larger number of potential investments.
He says: “Even in the GFC, you had a small number of large companies such as British Land and Land Securities and not much else. So you had to like the asset class.
“But now there are lots of alternative property companies where you can invest just in the bits you like. And for us, that is where all of our commercial property exposure is, in real estate investment trusts that invest in things such as supermarket premises.”
Of the more conventional part of the property market, he says: “In common with other asset classes, higher bond yields and therefore valuations hit demand. I’m not sure anyone is particularly interested in owning offices with a 5 per cent rental yield right now, but if prices fall enough that it’s a 12 per cent, then people will be interested.”
Martin Towns, deputy head of real estate at M&G, says that while demand for the higher quality offices has rebounded more quickly, the proportion of workers returning to all offices has also been increasing, which he says will boost the investment case for the rest of the market.
The long view
Longer-term, Matthew Norris, head of real estate securities at Gravis, says there are several mega-trends that will determine property investment returns in future years.
He lists these as: “Ageing populations, digitalisation, urbanisation and generation rent.”
His view is that as people live longer, so will demand grow for doctor’s surgeries and care homes, so among the assets he owns are property companies that develop these.
Norris’ generation rent idea centres on the idea that people who are unable to buy a property to live in will instead rent premium apartments, and cites the example of student housing as an example of where this is already happening.
His digitalisation theme is around the rise of e-commerce, and the durability of this asset investment opportunity is something that appeals to Howard as well.
He says the relatively wealthier cohorts of society tend to do more online shopping, and as this group are more likely to be able to keep spending, it should mean demand in this part of the property market remains strong.
David Thorpe is investment editor of FTAdviser