Upon his appointment as Prime Minister this week, Rishi Sunak declared that 'our country is facing a profound economic crisis'. At this time, it is interesting to ponder the implications for the commercial property sector. The Covid-19 pandemic fuelled an unexpected boom in the property industry – what will be the effect of the current crisis?
Real estate specialist Savills is bullish, at least with regard to retailers: the pandemic has left the ‘market more resilient, more robust and ultimately in a better place to tackle [this] next challenge’. However, quantitative data appears to undermine this conclusion for the commercial property market as a whole. According to Morgan Stanley’s Capital International (MSCI) World Index, UK commercial property values fell 2.6% in September alone; meanwhile, property company CBRE records that in the last quarter commercial real estate transactions have decreased by 16% year-on-year.
In hope of clarification, this article will first analyse the state of the commercial property sector during the pandemic; and second, evaluate the market reaction this time around.
The impact of the pandemic
During the Covid-19 pandemic, the property market unexpectedly prospered. For over a decade, the market had been recovering from the 2008 crash. For example, loans provided to first-time buyers only returned to pre-financial crisis levels in 2018. However, the growth witnessed during the pandemic (following an initial plunge – see charts below) was both unforeseen and unprecedented. Many attribute this to the stamp duty holiday, at least in the domestic context. In the commercial property market, however, there were problems beneath the surface. Where business models could not easily be adapted so as to become virtual, businesses had to temporarily, or sometimes permanently, close. MSCI data shows that rental value growth for office and retail remained between -0.2% and -6.2%, in comparison to 2018 levels of between +0.5% and -3% for retail, and +1.5% and below +2% for offices.
Accordingly, whilst it is easy to proclaim that the property market boomed during the pandemic, and demonstrated its elasticity, the true picture is more nuanced.
The impact of the cost-of-living crisis: how far can pandemic growth be extrapolated?
Michael Lockhart, a director in Savills’ In Town Retail team, has argued that having emerged from the pandemic stronger, ‘there are signs that the industry is robust enough to tackle these new headwinds'. Given ‘record fuel prices…[the] rise in the cost of commodities…[and] rising costs when it comes to construction and energy’, it would be easy to see the cost-of-living crisis as the final ‘nail in the coffin’ for the sector; however, this is not definitively the case. Many businesses restructured during the pandemic, especially through Company Voluntary Arrangements (CVAs), leaving them stronger, with better managed portfolios and more streamlined operations - and therefore more equipped to take on the cost-of-living crisis.
Nonetheless, there are two important caveats. Firstly, Lockhart’s article is directed at retailers, which is not illustrative of the larger picture for the commercial market. Secondly, the blog post was published three months ago. Earlier this week, the Financial Times warned that ‘rising interest rates could prompt [a] prolonged downturn’ and that commercial property valuations ‘are falling at their fastest pace since the Brexit vote'. It appears that the true state of the market is far worse than initially anticipated.
Indeed, in the words of Tom Leahy (head of real assets research for Europe, the Middle East and Asia at MSCI), recent data demonstrates the 'fairly gloomy outlook’ for commercial property. Analysts at Goldman Sachs have predicted that asset prices could fall by as much as 20% by the end of 2024, and further warned of how the UK commercial property market may be fast approaching a drastic price crash, with rising interest rates hurting homeowners attempting to acquire mortgages as much as businesses paying for offices, shops and warehouses.
The role of political uncertainty also cannot be ignored. Following the spike in borrowing costs after the government’s ‘mini’ budget, Goldman Sachs think billions of pounds of commercial property value could be wiped out. The disruption to the gilt market and the crisis for defined-benefit pension schemes has also had an impact, with funds needing to raise money quickly reportedly considering selling off property holdings. Nor is this just a knee-jerk reaction to the mini budget. Shell’s pension fund is selling its UK property portfolio ‘as part of our long-term plan to reduce…investment risk’. Then there is the economic uncertainty more generally, which has choked dealmaking. As stated above, in the last three months transaction levels were down 16% from the same period last year. The deals that are going through do so at a discount. For example, Landsec’s recently sold Deutsche Bank’s new City of London office for a price 20% less than an offer received last year.
But the big problem is clearly maturing debt. From 1% a year ago, the five-year swap rate enacted by commercial property borrowers has now surpassed 5%, with gross financing costs for listed companies covered by Goldman Sachs expected to increase by around 75% over the next five years, due to higher rates. The risk is that these rises force owners into selling when existing loans mature, given how expensive it will be for them to refinance. The uncertainty surrounding the impact of higher borrowing costs on valuations may also mean banks are more hesitant to lend.
Higher gilt yields have also decreased the attractiveness of property as an investment - in some sectors property yields are as low as 3%. Significant recovery in these returns will be necessary for investors to return.
Despite all this, some inflation reports offer hope. Scotia Bank and ING Group, amongst others, predict that the UK’s inflation rate will peak this year, and drop by around 3% each subsequent year, before stabilising in 2024. In this sense, whilst Goldman Sachs and the Financial Times may be correct that a ‘looming slump’ is incoming, it appears unlikely that this slump will transition into a long-term crash, at least for now.
Conclusion
In conclusion, though Savills’ positivity about the impact of the current economic crisis is tempting, the conclusiveness of the quantitative data cannot be ignored. The UK is clearly going through a ‘profound economic crisis’, the most tangible effect of which is higher borrowing costs, that is damaging practically every sector, including commercial real estate.
There is still hope in the ING Group’s UK inflation rate forecast for 2022; and in the fact that although inflation is expected to peak at 10.4% in the fourth quarter of 2022, it is forecast to gradually decrease to the Bank of England’s upper inflation target of 3% by the final quarter of 2023.
Accordingly, there is something to be said for Savills’ belief in the elasticity of the commercial property market. Especially if the economy, and particularly inflation, is predicted to recover with the brevity anticipated, there is cause for thinking that although the market will certainly not prosper as it did under the pandemic, it will certainly not collapse either.
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