Ten increases in Bank Rate in the space of just over a year have confirmed that the era of ultra-low interest rates is definitely over.
Changes in working patterns and the rise of working from home (WFH) during Covid, much of which has been maintained in the post-pandemic period, has raised doubts about the demands for office space. Even demand for warehouses, the most solid of bets during the pandemic, is not as secure as it was.
A number of high profile retail failures, meanwhile, are displaying a familiar pattern, in which the brand and intellectual property of the failed firm is acquired from administrators, but not the stores, leaving gaps in Britain’s high streets and shopping malls. This has been the pattern already this year for Paperchase, acquired by Tesco, and M & Co. Landlords used to be able to rely on hospitality moving into vacant store space but that sector has its challenges. Even Tim Martin, the bullish head of Wetherspoons, the pub chain, is selling or closing some pubs.
While everybody was fretting last year about what might happen to house prices in the context of rising interest rates, commercial property prices were falling. According to CBRE, the commercial real estate agent, capital values fell by 13.3% last year, and the fall accelerated towards the end of the year, with a 3% drop in December alone, the biggest in industrial properties, down 4.4%, followed by offices, which recorded a 3% fall, and retail, down 2.5%.
The latest commercial property monitor from the Royal Institution of Chartered Surveyors, published in late January, revealed a gloomy picture. Investors it said, were losing interest in commercial property as occupier demand falls. More than four-fifths, 83%, of respondents believed that the market was in a downturn. The net balance for tenant demand fell to -20% at the end of 2022, its lowest since late 2020, when the country was still in the grip of the pandemic. The balance of investor enquiries was a very low -30%.
Though prospects for rental growth in 2023 are marginally positive, according to the survey, expectations are that capital values will fall again, under the impact of higher interest rates.
“The investment side of the UK commercial real estate market has been significantly affected by tighter monetary policy of late, with higher borrowing costs weighing on investor demand and prompting an adjustment in valuation levels,” says Tarrant Parsons, an economist with RICS. “Indeed, linked to the rise in government bond yields over the past six months, capital values have pulled back noticeably of late, while expectations point to this downward trend continuing over the near term.”
What is the outlook? Matthew Pointon, a property economist at Capital Economics, predicts a 20% peak-to-trough fall in capital values, but that total returns, after falling by 9.1% last year, will be broadly flat this year, before recovering by 7.7% next year and 8.5% in 2025.
Perhaps surprisingly, the weakness of commercial property, and its potential impact on the financial sector, has not yet featured as a significant concern at the Bank of England. In the latest record of its financial policy committee (FPC), the trials and tribulations of the Chinese property market get more attention than anything happening in the UK.
The Bank’s own regional agents have noticed that, to quote their most recently summary, “higher borrowing costs, financial market volatility and high construction costs had weighed on investor demand for commercial property in recent months. As a result, values had fallen for all types of commercial property.” And, they added: Tenant demand for office space continued to fall, though demand for prime office space remained high. Occupancy rates for retail property held steady and demand for industrial property continued to outstrip supply.”
Commercial property funds were caught up in the fallout from the liability driven investment (LDI) blowout in the gilt market in late September early October of last year, the Bank’s FPC noted, when “UK pension funds had sold a large amount of investment-grade corporate bonds to rebuild their liquidity buffers. In addition, there had been evidence of pension funds seeking to liquidate less liquid investments, such as private assets and investment in commercial real estate funds”.
Its accompanying financial stability report noted that UK commercial real estate investment trusts are trading at a 25% discount to net asset value, compared with a recent average of 5%. It also pointed out that its annual cyclical scenario, its stress test, factored in a 45% fall in commercial property values, so there is some room for manoeuvre.
The European Banking Authority, which recent commented on an increase in commercial property lending by German and Austrian banks, also has a big fall in commercial property prices in its stress test scenarios, of around 30%, with some of the biggest falls in those countries.
The hope is that those scenarios will be some way away from reality, particularly now that mild recessions appear to be in prospect for both the UK and the EU. Otherwise, the authorities may have to sit up and take more notice.
