Why commercial property is flailing and thriving at the same time

Commercial real estate is in flux, with institutional investment sinking to its lowest level on record as office and retail asset values continue to drop due to high interest rates and question marks over both asset classes’ future. At the same time, analysts forecast strong warehouse and residential asset value growth thanks to resilient tenant demand.

According to Q3 data from MSCI, European commercial property transaction volumes sank for the sixth consecutive quarter to their lowest level in 13 years. Based on the current dearth of ‘pending deals’ – as in, the commercial property transactions that are either under offer or in advanced discussions – MSCI anticipates even less deal activity for the final quarter of this year.

The UK has performed slightly better than the rest of Europe but still poorly. For the year to date, UK deals are down 49 per cent on last year compared with 54 per cent across the whole continent.

‘Twin attack’

Part of the problem is a lack of willingness from sellers to accept buyers’ lowball offers, particularly for London offices where MSCI said buyers are looking to pay 28 per cent less on average than what sellers are asking. It added that the London office pricing mismatch is “far worse than during 2009 at the height of the global financial crisis”.

MSCI said this because of “the twin attack of cyclical tightening and heightened risk of functional and technical obsolescence”. Put another way, high interest rates coupled with the worry for long-term demand for offices in the post-Covid hybrid working world. MSCI said office asset values would need to fall another 13 to 15 per cent “to bring market liquidity back to its long-run average”.

For UK retail assets, the price mismatch is around 23 per cent. While this is not as bad as for London offices, it shows how buyers are still bearish about the asset class despite over a decade of devaluation due to the rise of online shopping.

Earlier this month, analysts were at odds over the prospects of the real estate investment trusts (Reits) dependent on the London office and retail assets. Jefferies downgraded Landsec (LAND) and British Land (BLND) because of their exposure to both and downgraded Derwent (DLN) and Great Portland Estates (GPE) because of their exposure to London offices. However, that same week Shore Capital upgraded its ratings for Landsec and British Land, arguing that their current discount to net asset value was unjustified.

Beds and sheds

While pessimism around offices and retail assets abounds, analysts are much more bullish about warehouses – known in the industry as sheds – and residential assets. The role of the former in online shopping has long excited investors, and the pandemic boost to internet retail only made them more keen on the asset class.

Sheds crashed in value after this boom ended last year. However, resilient occupier leasing activity, which has returned to the pre-Covid average after a spike during the pandemic, has brought some investors back to the sector – no doubt attracted by sheds’ much lower prices. 

Meanwhile, agency Savills (SVS) is reporting double-digit annual rental growth in Scotland and the southeast and north of England, a fact reflected in the net rental income increases recorded by many shed-focused Reits, such as Urban Logistics (SHED), Segro (SGRO), LondonMetric (LMP), and Tritax Big Box (BBOX).

“The UK industrial market is one of the few segments where deal volume is above a pre-Covid average and, after a rapid repricing and revaluation, both transaction prices and values appear to have stabilised,” MSCI said. Data from CBRE shows that, following said repricing, warehouse values have grown for seven consecutive months.

The build-to-rent (BTR) market is also booming despite the continued slump in house prices. While would-be home buyers continue to be put off by high interest rates, institutional investors are pouring money into BTR in response to record increases in rent. Though investment volumes have fallen after last year’s record high, they remain above the long-term average for the year to date, and agency Knight Frank said the sector “could almost double in total value over the next five years”, from £71bn in 2023 to £128bn by 2028. This comes after the sector doubled in value from 2019 to this year. 

If Knight Frank‘s bullish predictions prove correct, it'll be good news for Grainger (GRI), the largest listed BTR landlord. And if investor excitement around both BTR and warehouses continues, it’ll be good news for the whole commercial property sector after a very tough year.