The UK commercial property market is unquestionably feeling the pinch from higher interest rates.
As monetary policy tightened significantly over the second half of last year, it coincided with a steep decline in buyer activity alongside sizeable downward adjustments in valuations.
According to CBRE figures, all-property capital values have fallen by 20% since July 2022, with investors modifying allocations in response to the sharp rise in bond yields.
What's more, all mainstream commercial property sectors have seen a substantial decline in values over the past seven months, with the previously booming industrial market posting a near 30% drop during that timeframe.
The re-pricing of other financial assets has led investors to reconsider the relative value of commercial property and, following an extraordinary 56% rise between the start of the pandemic and last July, the industrial and logistics sector in particular appeared to have become too heated in the face of the tougher lending environment.
Capital values set to keep falling
On a somewhat brighter note, the sheer speed of the correction over the second half of 2022 could mean that the worst is now behind us. In keeping with this idea, the month-on-month pace of decline in capital values has already slowed markedly, with February 2023 bringing a 0.5% fall compared to a near 7% drop seen in October alone.
Nevertheless, capital values are still forecast to end 2023 below where they started, while the outlook for interest rates will be critical in determining how pricing trends evolve beyond that. On that front, all eyes will be on consumer price inflation to see whether recent policy action proves sufficient to bring price growth down sustainably towards the 2% target set by the Bank of England.
The latest budget measures are unlikely to drive inflation lower, although the extension of the energy price cap for three months could prevent a possible reacceleration at that point.
On current forecasts, however, headline inflation is expected to remain above this level throughout 2023, leaving little prospect of easing the more restrictive policy until 2024 at the earliest – even under a more benign scenario.
Given the absence of a more accommodating lending environment, property values seem likely to remain under pressure over the next 12 months. The risks of further rate hikes beyond current expectations cannot be ruled out either.
Industrial market shows positive signs
On the occupier side, meanwhile, trends have so far proven more resilient than those seen across the investment market. Whereas investor demand from both domestic and overseas buyers reportedly fell across all traditional commercial real-estate sectors during the fourth quarter of 2022, demand from tenants continued to rise in the industrial market.
Similarly, 12-month rental growth expectations taken from the RICS UK Commercial Property Market Survey remain positive for both prime and secondary industrial space, while prime office rents are also seen edging higher over the year ahead. This goes to show that the recent retreat in industrial values has been caused by higher interest rates, and is not a reflection of a shift in occupier requirements across the sector. The broader economic outlook will be a key factor in determining rental market conditions.
Unfortunately, the UK economy is expected to stagnate at best during the next 12 months, as consumers grapple with still intense inflationary pressures and tighter credit conditions. Inflation is still seen remaining well above target for most of this year (averaging 6.1% in 2023 according to the Office for Budget Responsibility forecasts).
That said, some recent data has come in stronger than expected, with the widely watched Purchasing Manager Indices signalling a rebound in momentum after contraction during the second half of 2022.
Whether or not the economy can maintain this newfound impetus remains questionable, as the impact of previous interest rate hikes will take time to be felt; for instance, many mortgage holders on fixed rates will have been insulated from such hikes until now. Over the coming months, increasing numbers will face a substantial rise in repayment costs, thereby exerting further pressure on aggregate disposable incomes.
Commercial demand could weaken in downturn
The still-solid employment picture across the UK in part explains why tenant demand has held up better than investor demand until now. However, unemployment is forecast to rise, even if projections point to a relatively modest increase from 3.7% currently to slightly above 5% over the next three years.
If or when this happens, it would likely be accompanied by weakening demand from businesses looking to occupy commercial premises, which in turn could lead to a rise in vacancy rates. Indeed, the picture for occupancy markets is likely to lag behind the broader economic downturn, as reduced spending across the UK will, given time, lead businesses to cut back on output and thus shed jobs.
It is therefore probable that 2024 will prove more challenging for landlord's rental income than 2023, although much will depend on how macroeconomic conditions unfold. Away from more traditional commercial real estate, however, respondents to the RICS survey still see strong upside for rents across alternative sectors such as data centres, aged care facilities, student housing and multifamily residential.
Given the strength of demand and limited supply, each of these sectors may provide better growth opportunities during a recession than many portions of the mainstream market, especially considering the ongoing structural challenges across the office and retail sectors.