Sector trends & challenges
Reduction in market rents
The likely fall in occupancy rates, increasing costs and pressure on turnover, particularly in retail and commercial space, is likely to reduce rental income, see a shift to more turnover rent and increase the need for incentives.
The pandemic has the potential to create a long-lasting change in usage patterns and requirements, particularly for retail, leisure and commercial space in urban centres. Urban centres need to be multi-purpose.
Real estate developers and owners need to be increasingly aware of the importance of environmental standards such as BREEAM ratings in order to secure ‘blue chip’ tenants. Demand for quality regional offices could increase.
Sector rating profile
The stress within the sector has gradually increased in recent years, as the steady transition to online shopping has created excess capacity. In 2020, COVID-19 has transformed the sector, with the very purpose of urban centres as commercial hubs coming under question.
To look at some of the challenges being posed in the sector by COVID-19 today, it’s worth looking back at some context from the previous financial crisis.
The commercial property market saw exceptional value growth in the period leading up to 2007, which was immediately followed by a significant price correction during and following the 2008 global financial crisis. Values remained relatively flat for a number of years thereafter, before recovering from 2013 onwards. Commercial property has traditionally been considered an attractive asset class as part of a diverse investment portfolio, providing relatively long secure income with potential for rental and value growth depending on asset management opportunities.
The three main commercial property sectors comprising retail, office and industrial have differing market dynamics and are often counter cyclical.
Retail. Prior to the COVID-19 pandemic many retailers were faced with challenging trading conditions due to reduced consumer confidence, rising occupational costs and an increased shift to online shopping resulting in a reduction in demand for physical retail stores. This led to an increasing number of retailer CVAs and insolvencies, leaving units either vacant or with tenants paying a lower rent, which led to landlords suffering a reduction in their net operating income and ultimately a deterioration in property values.
Commercial. The value of office buildings across the UK has generally remained stable. Supply in some major cities is low, which has helped to maintain rent levels, and occupiers were delaying their relocation plans pending resolution of the UK’s exit from the EU. There are pockets of distress where local industry has experienced change, e.g. in Aberdeen where demand for offices has declined significantly following the recent collapse of the oil price.
Industrial. The development of industrial property has been relatively unfashionable in recent years, yielding low returns relative to other property classes. However, the shift to online retail has increased the demand for both large logistic distribution centres and last mile delivery units. Increasing rents and lease terms have resulted in industrial estates and units becoming institutional grade investments.
2021 and beyond
The impact of the measures imposed by government in response to the COVID-19 pandemic are likely to be felt in the real estate sector for years to come. Occupiers will increasingly reflect on their operational needs whereas property owners will assess the impact on their business and how they can adapt to these changing times.
Retail. In 2019, 19% of all retail sales were online versus only 11% five years earlier. This suddenly jumped to 30% in April 2020 following the enforced closure of all non-essential retailers in the preceding month. Even prior to COVID-19 the retail sector was adapting to an increase in online shopping, and by some estimates there was already a 30% oversupply of retail premises.
As the economy emerges from lockdown, the oversupply of property is only likely to intensify. Whilst online shopping may not reach the lockdown highs, there has almost certainly been a pivotal shift in the demand for retail space. We’re likely to see a greater prevalence of turnover rents, reduced investment and creating a closer connection between yields and performance of the wider economy.
Property owners and other stakeholders may now consider alternative strategies, including repurposing assets for alternative uses where there is a significant obsolescence factor. Whilst prime and super-prime “destination” schemes are likely to be more resilient, the secondary and tertiary schemes, where there is an oversupply of comparison goods and fashion retailers, are likely to see the highest loss of income and value reduction.
Office Commercial. Before COVID-19 we anticipated an increased demand for office space from professional services as well as the creative and technology sectors. However, as the majority of office workers embraced working from home and the benefits of technology, many businesses will now re-assess what space they need and how this is used in the future.
Although the COVID-19 lockdown measures saw a number of services and flexible office providers lose income streams rapidly, there is a sense that flexible office space may be part of the solution post-lockdown as ‘hybrid working’ office requirements are mapped out. Landlords may therefore need to adapt to shorter leases and increase the amount of space that is used by flexible office operators.
Industrial. Industrial property values and rents have increased considerably over the past few years making development economically viable. Multi-let industrial schemes with asset management potential are likely to remain desirable investments particularly as we expect to see rental growth in the short term.
The demand for large distribution and logistics units is likely to continue, especially as supply chains seek greater resilience from post-Brexit border disruption. Some investors are now even turning away from the sector as they consider the pricing has become too keen.