The latest UK commercial property report from the CBRE showed, for the moment, that returns have stabilised for the troubled sector. While there remain pockets of weakness, overall capital values and rental income were flat.
While the sector has some way to go to reverse the weakness of the past 12 months, might it be stabilising?
The report showed overall rental growth of 0.2% and no growth in capital values. This is a notable improvement from Q4 2022, when capital values fell by -14.6%, hit by an unwelcome combination of Trussonomics, interest rate hikes and inflation, plus longer-term structural changes in the office and retail markets.
Nevertheless, the CBRE report showed meaningful differences between individual sectors. The retail market appears to be recovering after a lengthy period of weakness, particularly in the South East.
Despite fears over valuations, the industrial sector continued its strength, with capital values rising 0.5% and rental income also showing strong growth. However, office values continued to decline, dropping a further 0.8% through May. Central London offices continued their weakness.
While few would suggest a return to open-ended direct property funds, there do appear to be opportunities opening up in the investment trust sector. UK commercial property investment trusts have yet to reflect any potential stabilisation, with most of them remaining at significant discounts to their net asset value.
The Abrdn Property Income trust sits at a 37% discount, Schroder Real Estate investment trust is at 26%, while the UK Commercial Property Reit is on a 30% discount. There are also some attractive yields on offer – 6.85% for the Abrdn trust, 5.34% for UK Commercial Property and 6.1% for the Schroder trust. If the sector were about to turn, these valuations would look attractive.
Gavin Haynes, investment consultant at Fairview Investing, says: “There are clear signs of some stability in prices after an horrendous 2022. The move from a zero interest environment was a real shock for valuations, but that has now been repriced.” He says that if rates were to go substantially higher, or there was to be a hard landing for UK economy, the sector would still be vulnerable.
There are still some ongoing concerns about the future landscape of UK commercial property. Nevertheless, Winterfloods notes in a recent report that all 12 investment trusts have given NAV updates for the first quarter and adjustments to capital values have been muted. This is a notable contrast to the previous quarter when there were significant revaluations.
Its view is that there are unlikely to be “any further material declines in UK real estate valuations over the remainder of the year across most sub-sectors”. It added: “discounts on a number of UK property focused investment trusts remain extremely wide, which we think offers value for long-term investors.”
There was also better news on transaction volumes. Real estate data provider CoStar showed that the volume of M&A transactions has also been picking up in the UK commercial property sector. In the first quarter transactions picked up 24% against the final quarter of 2022 (though transactions had been hit by the fall-out from the mini-Budget in September). The value of deals hit £6bn for UK offices, retail and industrial property, though this is still half the 10-year average.
The notable exception to this relative optimism is the office sector. CoStar also pointed out that deals for central London offices, historically an important influence on investment volumes, were depressed. Winterfloods added: “Property fund managers generally expect offices, particularly secondary assets with poor ESG credentials, to continue to underperform as the market adjusts to hybrid working patterns and changing occupier demands.”
Recent data from property adviser Cushman & Wakefield showed a record number of office moves in 2022, but made it clear that companies were taking smaller premises, and had higher demands that prior to the pandemic. They wanted better-located, better equipped and more attractive offices to tempt employees back in person.
This isn’t necessarily a problem for UK commercial property trusts. Many have divested of their weaker office holdings. Abrdn, for example, sold the The Kirkgate in Epsom in December 2022 fearing ongoing problems in the regional office sector.
Winterfloods says that while the Balanced Commercial Property Trust, Schroder Real Estate Investment Trust and abrdn Property Income Trust all have reasonably high office weightings, the assets are generally high-quality, prime properties and not as vulnerable to the uncertainty surrounding the future of offices.
Haynes believes there are opportunities and the discounts to NAV across the sector look pessimistic. They also leave some margin for error should the environment weaken. “Yields look more attractive and some property trusts have inflation protection in place – they can raise rents in line with inflation.”
ESG is an important consideration. In particular, environmental factors are becoming more important, with tenants increasingly considering the carbon footprints of the buildings they occupy.
The Net Zero Carbon Buildings Commitment was created in 2018 and enhanced in 2021. The initiative aims to recognise and promote climate leadership action in decarbonising buildings and is a growing factor for decision-making by property buyers and investors. It encourages participants to target net zero building emissions in their portfolios by 2030 and a full net zero carbon built environment by 2050.
This means that property funds are increasingly having to look to their existing property portfolio and improve it, or divest quickly. The alternative is being left with assets that no-one wants to rent or buy.
Some funds have been quick off the mark. Abrdn’s commercial property team, for example, has released its pathway for net zero, which includes improving existing assets and divesting where necessary. An integral part of its plans has been a vast woodland and peatland restoration project in Scotland’s Cairngorms National Park. It is planting around 1.5m trees to help with carbon capture and to achieve net zero sooner.
While this environmental improvement impulse may act as a drag on certain parts of the UK commercial property sector, it may also improve demand – and therefore valuations – elsewhere. Equally, some stabilisation in the interest rate outlook could bring calm back to the sector. Ultimately, if supply is taken out of the sector, it will ultimately raise rental income, as has been seen in the buy-to-let market, but this may be some way off.
A final question is whether the vulnerabilities in the banking sector could weigh on commercial property. This appears to be a greater issue in the US, where a potential credit crunch in the regional banking sector could threaten the availability of financing for commercial property. No-one is – yet – predicting similar problems for the UK.
The rot may well have stopped for commercial property, though a revival doesn’t appear very likely either. Investors may have to content themselves with collecting the rental income and hoping that improving sentiment erodes the discounts a little.
