The past two years has been a roller-coaster ride for investors in UK commercial real estate. From feeling the brakes slam on the economy in 2020, the subsequent acceleration in growth has been at break-neck speed.
Total returns from the sector climbed from -2% in 2020 to 17% in 20211. This is the best year since 2014 and well above the average achieved over the last 30 years, of around 8% per annum. Even allowing for last year’s acceleration in inflation, total returns were impressive at 11% in real terms, compared with a long-term average of 5% per annum.
Which areas of commercial real estate performed the best and why? Where do we expect to go from here?
We believe industrial is likely to be the best performing sector in the short-term, but some parts of retail and office could surprise investors further down the track. Crucially, we believe investors will benefit most by maintaining a diversified real estate portfolio.
The outlook; bright with scattered cloud
When non-essential shops, hotels and leisure facilities closed during the first lockdown, many tenants stopped paying rent. Major retailers such as Debenhams and Top Shop closed their doors forever. In addition, the sudden adoption of remote working raised doubts about the long-term future of the office. Lettings halved compared with 2019 and many investment deals stalled as investors withdrew from the market. Real estate yields rose on average by 0.25% in 2020, depressing capital values and total returns.
By contrast, the rollout of Covid-19 vaccines led to a strong rebound in investor confidence. The rent received by landlords returned to 2019 levels and prime yields fell again. As liquidity returned to the market, capital values and total returns received a boost.
Note forecasts should be regarded as illustrative of trends. Actual figures will differ from forecasts.
The star performer was industrial. Online jumped from 19% of total sales in 2019 to 29% in 2021. Demand for warehouses from internet retailers, conventional retailers and parcel couriers soared. But there was also a partial recovery in retail and office markets.
In the retail sector, investors focused on food stores and out-of-town retail parks. While they stayed open through lockdowns, their real strengths are that rents and service charges are affordable, and food and bulky goods (for example, DIY, furniture) are less vulnerable to competition from online retailers.
In the office market, rents on older, secondary buildings continued to fall in 2021. However, prime office rents - in Bristol, Cambridge, Edinburgh, Leeds, London and Manchester – rose. Here, occupiers gravitated towards better quality buildings and office development remained at low levels.
The strong outlook for the UK economy over the next few years augurs well for real estate returns, as in the past, the two have been quite closely correlated.
Schroders forecasts that gross domestic product (GDP) in the UK will grow by 5% in 2022 and by 2% to 3% through 2023-2024. Inflation is expected to slow in the second half of 2022 and then stay within the Bank of England’s (BoE) target range of 1% to 3%. The BoE is forecast to gradually raise the base rate to 1.75% by the end of 2023 and then leave it on hold.
Given this view, we expect ungeared real estate returns, across all sectors, to average 5% to 7% per annum between the end of 2021 and the end of 2024.
The main upside risk is that higher investment boosts productivity, which would lead to stronger economic growth without igniting inflation. That would support faster rental growth and higher returns.
The main downside risk is that the recent acceleration in inflation triggers a wage-price spiral, and the BoE is forced to instigate sharp increase in interest rates.
Although real estate yields are not mechanically tied to bond yields, they are influenced by them. We think real estate yields would start to increase if 10-year bond yields rose to 2% to 2.5%, or higher. That would dent capital values and total returns in the short-term. Thereafter, once real estate yields had settled at a new, higher level, the income return and total return on real estate would be higher in nominal terms.
Where to invest?
In the short-term, we expect that industrial will continue to be the best performing sector. Online shopping is likely to continue to gain market share and the industrial sector is also likely to benefit from the recent disruption of supply chains, as retailers and manufacturers dial down just-in-time deliveries and hold more stock of key products and components.
We expect industrial rental growth to run at 4% to 5% per year. through 2022-2023.
However, looking further ahead to 2024-2025 we think that the industrial sector could be overtaken by retail parks and grade A offices. This reflects two trends.
Firstly, we think that the decline in yields which has turbo-charged industrial returns over the past five years is now largely over. The average industrial net initial yield now stands at 3.6%, compared with the average office and retail net initial yield of 4.1% and 6.2%, respectively.
The days when industrial was the highest yielding sector are gone. The gap between prime and secondary yields in the industrial sector has also narrowed significantly. It is now almost back to the levels seen in 2006-2007 levels, just before the global financial crisis. That raises the possibility that some investors have over-paid for secondary industrial assets.
The second reason why we think that industrial could be over-taken by retail parks and grade A offices is that we expect industrial rental growth to slow from 2024 onwards. The last 18 months have seen a big increase in the development of large distribution warehouses and the revaluation of business rates in 2023 will shift more of the burden on to warehouses, adding to tenants’ costs.
As a result, we forecast that rental growth on distribution warehouses and London industrials, where rents have increased by 50% over the last five years, will slow to 2% to 3% per year in 2024-2025. Multi-let industrial estates in Birmingham, Leeds and Manchester - where rental growth has lagged London - could buck the trend.
At the same time, we forecast that rental growth on grade A offices in London and the big regional cities will accelerate to 3% to 4% per year. Office demand is likely to remain tepid in 2022-2023 as companies adapt to hybrid working. We estimate that office take-up this year and next will be around 15% below pre-pandemic levels. However, the continued growth in employment in professional services, technology and media means that take-up is then likely to grow, and we expect occupiers to focus on grade A offices. These are the offices that boast state-of-the-art air conditioning, excellent broadband, plenty of non-desk collaboration space and good energy efficiency.
This reflects the desire by companies to attract staff back into the office, but the other key driver is sustainability. The UK government has pledged to cut carbon emissions in 2030 by 68% compared with 1990 levels and the recent spike in oil and gas prices has provided a further reason to cut energy consumption.
There are already signs that occupiers are prepared to pay a higher rent for so-called “green” offices. In 2021, 70% of the take-up in the City of London and half of the take-up in Glasgow and Manchester was in offices with either a BREEAM2 rating of very good, or excellent. Demand for older, secondary offices is likely to remain weak and the increase in construction costs means that some offices in peripheral locations will become stranded assets (those assets that have suffered from an unanticipated write down or devaluation), because it is no longer viable to refurbish them.
Although we also anticipate a recovery in retail park rents from 2023 onwards as discount retailers expand out-of-town, rental growth is likely to be modest at 1% to 2% per year. Instead, the real attraction of retail parks is their high initial yield of 6.2%.
By contrast, the outlook for town centre retail is bleak. While bars and restaurants have enjoyed a strong recovery as Covid-19 restrictions have been lifted, demand for shop and shopping centre units remains weak. Banks, bookmakers and fashion retailers have been closing stores and moving more of their operations online. Furthermore, the large number of empty shops can deter shoppers, creating a vicious circle. We expect shop and shopping centre rents to fall by a further 5% to 10% over the next two years and then stagnate.
The real opportunity in town centres is to re-develop retail into other uses, particularly housing where there is an acute shortage. In theory this is a neat solution, given high residential prices and that people living in town and city centres have lower carbon emissions than people living in the suburbs. In practive, such schemes can take many years to deliver, given multiple landowners in most town centres and the need to win over the local authority and community.
Real estate has traditionally performed strongly in the early stages of recovery after a recession, and we expect that pattern to be repeated over the next few years. Although industrial is likely to be the best performing sector in the short-term, we think it could be overtaken by retail parks and grade A offices in 1 to 2 years time.
Investors should not assume that UK real estate is a one-horse race. The high transaction costs involved in switching sectors means that a well diversified portfolio is an appropriate way to invest in the market.
- MSCI / IPD UK Quarterly Property Index.
- Building Research Establishment’s Environment Assessment Method.