As we start a new year, we caught up with one of our partners, James Routledge, to find out why he thinks 2024 will be a year of uncertainty and volatility as he takes a deep dive into the outlook for the economy and commercial property in 2024.
Backdrop
2023 has presented us with a new financial paradigm and continued longer-term structural change, which has delivered the toughest trading conditions for commercial property investment since the Global Financial Crisis. This is underpinned by geopolitical uncertainty, global and national economic fragility, a period of high energy costs and food security issues worldwide.
Looking ahead, megatrends and key influences likely to impact strategic planning in the property sector are:
- Global economy: in particular, higher normalised interest rates
- Geopolitics: a fracturing world and heightened political uncertainty
- Sustainability: the march towards net zero
- Technology: wider adoption of everything currently being deployed by early adopters
Some of the wider considerations for 2024 include:
- UK Inflation to fall gradually from the November CPI annual index of 3.9%.
- The latest CPI figures hide an 8%+ increase in food prices, which together with increased mortgage costs, emphasises a significant loss in domestic spending power.
- The Bank of England base rate has likely peaked at 5.25%, with a gradual fall anticipated as signalled by future 5-year SONIA swaps which are currently 3.4%.
- Limited prospects for GDP growth, with the UK economy shrinking slightly in the three months to the end of September by 0.1% and the threat of a technical recession in early 2024.
- Easing of supply chain issues and energy prices, subject to heightened political tensions not disrupting oil supplies and threats to global fuel security.
- Fluctuating bond yields (10-year UK gilts currently circa 3.6% versus circa 3.2% in November 2022 and around 1% at the start of 2022).
- A decline in real disposable income for UK households, and low consumer confidence.
- Tightening of credit terms, at a time when £35 bn of commercial property assets need to be refinanced, and challenges with the US financial system.
- Key elections in 2024 including the UK, US, India, Russia, and EU/European Parliament, accounting for nearly 60% of global GDP, with likely change of national priorities & strategies fuelling uncertainty.
- Stability of China’s economy and international relationships, at a time when China is playing a greater role in geopolitics.
- Growing importance of sustainability at the Board level as companies are being encouraged to disclose information about their impact on sustainability risks and opportunities in their annual reports (IFRS S1).
Structural changes in the UK are an overarching theme for 2024 and beyond. This is already driving extremes of fortunes within property asset classes, with a need to focus on the “right kind of asset”, considering demand-supply imbalances, hybrid working, demographics, the growth in online shopping during and after the pandemic, and the built environment’s significant role in a move to a low carbon economy.
Property Market Backdrop
Investor sentiment is showing signs of strengthening in the UK with commercial property repricing starting to re-align buyer and seller expectations, albeit significant challenges remain with regional and sector variations.
Industrial, living sectors and social infrastructure are top of many “buy lists” as traditionally constructed portfolios continue to preference away from offices and high street retail holdings. This is in the wider context of the UK economy possibly contracting in 2024 and owner-occupier house prices sliding further before stabilising.
This reshaping and therefore future proofing of investor portfolios also accounts for an uptick in purchaser sentiment towards core assets across markets, especially new high-quality assets with strong ESG credentials and low obsolescence risk that are significantly outperforming the rest of the market, as occupiers focus on upgrading space.
Farmland is also featured as a strategic play for carbon offsetting and biodiversity net gains. Incentives will result in more farmers opting for habitat creation and biodiversity net gain schemes to help developers and commercial and public sector organisations mitigate or compensate for the impact of their operations on the environment and as a demonstration of their commitment to their sustainability goals.
Opportunistic market players are however becoming relatively more active, taking advantage of subdued pricing and/or seeking assets which need to be repositioned.
The Outlook for Commercial Property in 2024
- Purchaser interest will be driven in part by a view that, following gilt yields, interest rates will edge down in the second half of 2024.
- Based on the November 2023 IPF consensus, a nominal increase in all-property (commercial) capital values are anticipated for 2024, of minus 0.1% (total return 5.1%), which compares to circa 5.0% projected decrease (total return minus 0.4%) in 2023 for institutionally held assets.
- Stronger consensus forecasts for 2025 and 2026 (8.4% and 8.2% total returns respectively) are a solid argument for 2024 as a year to re-enter the market.
- Income will be the main driver of investment performance.
- Increasing levels of obsolescence will provide opportunities for active managers with repositioning agenda.
- For owners facing debt refinancing, a double whammy of lower capital values and higher costs of borrowing, will lead to funding gaps and capital injection requirements. This will shake out some distressed sales.
- Whilst private UK investors have remained active in purchasing small assets throughout 2023, overseas investors are likely to be the mainstream buyers of 2024, as they see the UK as a relatively more attractive market than, say continental Europe.
- Specialist UK operating platforms and asset managers will compete to raise equity, whilst institutional-style managers of historically balanced portfolios will struggle to demonstrate the same level of skills to execute asset management initiatives.
- Net zero and de-carbonisation considerations will continue to grow in importance, with institutional investors focused on purchasing assets with EPC ratings of A or B amongst other sustainability criteria.
- The costs of the energy transition are not location or rent-level sensitive, therefore value recovery and retention will be stronger in higher value and economically vibrant towns and cities, affecting viability.
- Flexible working will be embedded as a business/employee strategy, with an ongoing impact on office and home workspace designs, as well as the provision of community and convenience facilities.
Sustainability is key
With the growing influence of net zero on both national and international corporate agendas, overriding themes will be ‘greening’, regeneration and re-positioning.
Developing low and no-carbon pathways will vary, depending on occupiers’ and/or owners’ strategies, however, the issue will impact most property-related considerations.
Broader climate and locational considerations (such as flooding) will impact the flexibility in building design, whilst local planning authorities will introduce more environmental-related conditions in planning consents.
Offices - Quality comes first
Within the office sector, and most notably highlighted in Central London, there is a growing occupational quality divide.
The flight to quality by occupiers should mean that well-located Grade A offices will attract growing interest from longer-term core and core plus investors, seeking buildings with strong environmental credentials and limited capital expenditure requirements. Whilst pricing for such assets should remain resilient, values will continue to fall in the short term for assets facing obsolescence risk and in need of refurbishment and repurposing.
Successful workplaces will be more people-centric, collaborative, authentic, sustainable, experiential, and above all, customised. The introduction of technology upgrades will be a further driver to achieve this, together with agile working and greater spatial awareness.
Trends that are likely to emerge from the above include:
- Lower office occupancy densities due to a focus on quality – ever more importance is placed on the quality and design of the workplace as it is proving to be a manifestation of a company’s brand and philosophy – critical to its talent acquisition and retention strategies.
- A potential resurgence in local market and suburban offices if close to local amenities, good infrastructure and access to talent pools, especially as satellites to HQs.
- The growing adoption of technology to manage buildings, on our journey to ‘smart buildings.
Industrial and Logistics - reposition overtakes development
After a turbulent twelve months, with a sharp correction of investment values, the industrial sector has largely settled, and will remain high on investor’s buy lists,
The occupier markets are experiencing a cooling of occupier demand across most parts of the sector, with take-up levels having now reverted to pre-pandemic levels. As leasing demand softens, the rate of rental growth will slow but is currently forecasted to stay positive.
However, constrained supply and competing uses, such as residential in urban environments, should ensure pockets of rental growth. Equally, the last mile is considered to include car showrooms and other service activities which will compete as future alternative uses.
A slowing speculative development pipeline has helped maintain a balance between supply and demand from a rental growth perspective. The relative lack of new build investment opportunities has directed investors to existing stock, however, sellers are broadly reluctant, and with large paper profits having evaporated, it is psychologically difficult to accept lower pricing. Private equity platforms are therefore raising equity to expand portfolios, which will serve to increase the weight of global capital targeting the UK industrial & logistics market, create competitive bidding situations and support pricing levels.
Owners are busily negotiating rent reviews, lease renewals and repositioning existing units to capture rental reversions. As such, repositioning rather than developing, is a key theme for specialist investor groups who see the recent sharp adjustment in investment yields as a buying opportunity.
Retail - structural change brings winning locations & players
- The UK retail market continues to undergo significant structural challenges, and occupier confidence is polarised, as shown by improving fortunes for Marks & Spencer versus the insolvency of Wilkos.
- The sector has been helped to some degree by business rates liabilities reducing to nearer current market rental levels, however, serious challenges remain with the increased costs of living hitting discretionary spending and an ongoing exodus of banking branches from the high street.
- The end of the high street continues to be exaggerated as ‘brick’ (store) networks will still play a critical role in enabling online offerings. Footfall returns in some locations to pre-pandemic levels are influenced by a myriad of issues, localism and WFH, versus centres relying on discretionary spending and which lack leisure and experiential facilities.
- Food and value retailers are clear drivers of footfall, as consumers target essentials over discretionary items. Retail parks, anchored by such retailers attracting the strongest footfall will continue to attract strong investment interest due to suitability for click-and-collect orders, customer returns, home deliveries (in effect last-mile fulfilment centres) and alternative use possibilities in urban areas.
- Whilst a sense of positivity is returning to the retail sector, following significant falls in rentals and capital values over recent years, the market is polarised. The definition of prime pitches has tightened, whilst tertiary locations are facing greater challenges with falling rents and higher levels of void.
- The switch to electric vehicles will continue to accelerate and help consolidate retail warehousing, as well as create EV charging hubs which incorporate food & beverage offerings, providing near-term challenges for traditional fuel stations.
Living Markets – price discovery is around the corner
Alongside industrials, multi-occupancy residential blocks and single-family homes will probably be the most active areas for investment equity raising, in the first half of 2024.
This continues to be driven by a worsening supply and demand imbalance, influenced primarily by private landlords selling/continuing to sell en masse.
The above is in the context of transaction numbers in the residential investment market have dwindled in the second half of 2023, with the market now in a phase of price discovery as selective buyers seek out distressed owners and gross income yields of 8% plus. Rental growth through demand imbalances has mitigated (and will continue to) the impact on pricing as yields have moved out.
UK Family offices, overseas groups with institutional backing such as from Israel, and other private equity groups are lining up to pick over opportunities in early 2024.
The adverse impact of high-interest rates and construction costs on the viability of development schemes has been compounded by fire safety and new building regulations coming into effect, forcing renegotiation of land prices. Perhaps a silver lining for 2024 will be falling construction costs at a time of reduced development activity, potentially improving the forward funding investment market.
Delivering the impact – social infrastructure
Social infrastructure assets are considered integral to the functioning of society and support the quality of life and well-being of communities, and managers of capital will need to demonstrate their own Social Impact credentials as part of attracting equity from institutional investors.
Social infrastructure sectors comprise Education (starting from nurseries to university facilities), Healthcare (ranging from care homes to specialist clinics), Sciences (including Life Sciences and Agri-tech), Roadside and Transport (such as EV charging hubs and motorway service stations), Storage (including open storage and energy (battery) storage), and Waste Management.
As with the living markets, assets within some social infrastructure sectors need to be reviewed as operational assets, especially given sectors such as the children's day nursery which is undergoing substantial consolidation, and explosive growth such as in the EV charging market, where a common theme is an ability to attain lengthy lease terms of 25 years and index-linked rental increases.
EV charging hubs are being rolled out by a range of operators, now including the major power group SSE and Applegreen (owners of Welcome Break service areas) alongside operators funded by substantial continental European operators. The main challenge is the UK’s National Grid, and the ability to access sufficient power, which is set to challenge the creation of future-proofed assets across all sectors.
More challenges ahead for development and planning
The challenges around project viability and mothballing of sites in all sectors are already well documented, and many argue that the “planning system is broken”. Further challenges are on the agenda in 2024:
- The need to comply with biodiversity net gain as well as nutrient neutrality regulations
- Planning bottlenecks are set to continue without reforms to the National Planning Policy Framework
- Delayed timing for the general election, which will likely push much decision-making into 2025
- Regulations stranglehold, such as the impact of ULEZ on SME builders and developers
