Extreme inflation, rising interest rates, and a stubbornly high consumer price index. What does all this mean for commercial real estate in London and the wider United Kingdom? Real estate investment professional Nick Millican says it might not mean what you think.
For real estate investors — professional or otherwise — it can be challenging to make sense of the constant flow of data, economic indicators, and business news that comes across their desks. At the moment, it’s hard to miss the tales of doom and gloom that seem to be spreading over the real estate sector from all angles.
In late July, Reuters predicted that commercial real estate investors were at risk of painful losses in the post-COVID world. The news agency conducted a poll of analysts, academics, and investors to highlight what it saw as the most significant risks to the market.
At the top was the threat that inner-city buildings full of offices and shopping malls would see tenancy plummet as people stayed home and shopped online. The next big problem was global lenders calling in their chits on a sector woefully in debt.
What smart commercial investors do in times of crisis
And it’s true, says Nick Millican, CEO of real estate concern Greycoat, that low occupation and debt recalls are risks for all commercial real estate providers and investors.
Says Millican, “Virtually everything is worth less than it was. An office-specific issue is the legacy of working from home., Tand that coincides impacting with increasing regulatory pressure to ensure that buildings consume less energy — which leads to increasing capital expenditure costsis pretty expensive to retrofit and— or to construct new buildings … on that basis. So you’ve seen … a huge increase in construction costs, both because of inflation and changing specifications.”
But the key point is that not all market participants will react in the same way to these challenges. Real estate companies have seen tough times before and there’s rarely ever a mass fire sale on assets across the board. Times of crisis tend to lead to an explosion in innovation, and Nick Millican — who has spent decades at the top of the industry — sees the current climate as no different.
Average UK commercial property values may have fallen by around 20% from the market’s peak, but this hasn’t triggered many major loan impairments. And policymakers are watching market values closely, determined to ensure British commercial real estate remains buoyant and resilient over the long haul.
“I don’t think we get back to exactly the way things were in 2019,” muses Millican. “CommercialPro real estate goes through cycles, right? But for a long time, ait was seen as, there are always exceptions. A lot of mainstream corporates viewed it as a cost centre where their real estate team’s job was to lower the cost per desk and drive efficiency out of it. What we are seeing now is that, ironically as part of the drive to increase workspace attendance, corporates are more focussed on having a home which appeals to their workforce, so high quality physical produce with a much higher level of amenity than would previously have been common.”
Back in April, Bloomberg was posing the bull case for UK commercial property, says Nick Millican. Four months ago — and even now — the market was pricing in bad news for the sector. Commercial property buyers currently need a higher rental yield to make purchases more attractive than other assets, and higher interest rates are making carrying debt expensive.
Real estate investment trusts have been hammered all year, continuing to price record lows. In May, the FTSE All Share REIT index slumped below 1,800 after a high of over 3,000 in November 2021.
Yet where others see gloom, Nick Millican sees opportunity.
Nick Millican: Reasons for confidence
For many people, all indicators point to a long-term bear market for commercial real estate in the UK. But Nick Millican, while not overly optimistic and deeply aware of the risks, says there are reasons for confidence. For one, the economy isn’t growing in leaps and bounds, but it is growing — especially if you look at the three-year curve from 2020.
“In fact, it’s stronger than analysts expected,” says Millican. “That implies businesses will still need office space and continue to pay rent.”
It’s also worth noting, Millican believes, that what growth there’s been in the British economy has actually come in large part from the construction sector.
After a Q2 banking crisis in the U.S. led to further repricing of global markets and the hint of recession, there are now plenty of conceivable opportunities for commercial real estate buyers and operators.
And as for the recent trend of remote work, Nick Millican notes that even if employees are required to come into work two or three days a week, they still need an office space to come in to. True, companies are rethinking the way they use their commercial space. But this also means that smart operators will be able to change with the times and offer premises that fit the new normal and changing corporate demands.
Industry data is telling a tale of turnaround
An improvement in market sentiment was registered in the Q1 2023 Royal Institution of Chartered Surveyors’ UK Commercial Property Survey. Around half of respondents to the survey saw the market as being in the downturn phase of the cycle, but this percentage was well below the 83% reported in Q4 2022. Additionally, 25% of respondents in Q1 felt the market had reached its floor and 21% saw the market turning up.
An aggregate net balance of minus 3% for tenant demand in Q1 2023 was a significant improvement over the minus 20% in Q4 2022, backing the sentiment that late last year saw the low point of the cycle. Meanwhile, the net positive balance for occupier demand for the industrial sector rose from 6% in Q4 to 16% in Q1.
Nick Millican notes that respondents to the Q1 2023 RICS sentiment survey are expecting rents to rise for both prime and secondary industrials (with net positive balances of 58% and 23%) and prime offices at 29%.
Critically, UK commercial real estate analysts are seeing that in the office space market, prime rental levels are proving to be highly resilient — a situation that seems to reflect the focus of tenant demand on top-quality space. Market observers are yet to see falls in prime rental levels in vital city centre markets. In fact, in the UK, many major city centres are actually experiencing increases in prime rents exceeding pre-pandemic levels.
“The big point for me is that a lot of damage has already been priced into the market,” says Nick Millican. “How investors will react now will largely be a product of whether or not they are convinced that this pricing is accurate. Which for me means a lot of opportunities.”