Commercial Market Outlook

• Inflation is headed firmly back towards the Bank of England’s 2% target. CPI fell to 3.2% in March compared with 3.4% in February, 4.0% in January and a peak of 11.1% in 2022. The latest Treasury-compiled consensus forecast anticipates a further decline to 2.2% by Q4 2024, and indeed it may well dip below the target for a time during the middle part of this year.

• The Bank of England’s Monetary Policy Committee (MPC) has held the base rate at 5.25% since August last year. Although no MPC members voted for a rise at the latest meeting, only one member favoured a cut. Given that wage and services inflation are both running at 6.0% and core inflation is 4.2%, the MPC will remain cautious not to cut too rapidly. However, it will come under increasing pressure to reduce borrowing costs as inflation heads further downwards, in order to boost economic growth.

• Following a fall in output during the third and fourth quarters of last year (signifying a technical recession), UK economic growth has started positively in 2024 with a healthy rise of 0.3% in January, followed by 0.1% in February.

• The manufacturing, services and construction PMIs are all now in growth territory, and whilst consumer confidence remains weak, optimism about personal future finances has improved significantly. Together with the prospect of lower interest rates over the next few months, the UK economy should see further growth this year. However, this will continue to be rather weak. The latest HM Treasury-compiled consensus forecast suggests growth of 0.3% for 2024 as a whole (compared with 2023), with growth likely to reach just over 1% per annum by Q4 2024 (compared with Q4 2023).

Recent output trends and indicators

• GDP is estimated to have increased by 0.1% in February 2024, following (revised) growth of 0.3% in January. Services output grew by 0.1% while production output rose by a hefty 1.1% and was the largest upward contributor to growth during the month. Construction output on the other hand fell by -1.9%. Over the three months to February, GDP is estimated to have grown by 0.2% compared with the previous three months.

• The S&P Global UK Manufacturing PMI came in at 50.3 in March, up from 47.5 the month before and the first time the sector has been in expansion territory (above ‘50’) since July 2022. Output and new orders both increased, including factory production, which rose for the first time since February 2023. The overall contraction rates in employment and purchasing slowed sharply this month while business optimism about the year ahead hit an 11-month high.

• The Services PMI moved down slightly in March to 53.4 from 53.8 in February. This is the slowest rate of expansion for three months with the survey suggesting constraints on household incomes are partly to blame. However, output growth continued to rise sharply while employment growth remained unchanged. Rising wages and shipping costs led to input cost inflation increasing at the second-fastest rate in over eight months.

• Finally, the construction sector PMI rose to 50.2 in March, up from 49.7 in February, the highest figure for seven months and the first time it has been in expansion territory since August 2023. The month saw higher sales pipelines and increased new business enquiries. New orders also expanded at their fastest pace since May 2023, although employment numbers fell for the third consecutive month. Civil engineering projects were the best performing sub-sector while both housing and commercial building levels were unchanged.

Labour market

• Latest estimates show that unemployment rose in the three months to February, moving to 4.2% from 3.9% in the previous three months. Total employment decreased during the quarter to 74.5%. Recent data from the Labour Force Survey should be treated with caution due to low sample sizes achieved by the ONS over recent months.

• Total job vacancies declined for the 21st consecutive period, down by 13,000 to a total of 916,000 recorded vacancies. The number of payrolled employees also fell, down by 0.2% in March but up by 0.7% so far this year to reach a total of 30.3 million. 

• Average annual earnings growth (excluding bonuses) declined again slightly, to 6.0% year on year (December 2023 to February 2024). This figure is likely to rise again with the 10% increase in the National Living Wage from April. But most surveys suggest that overall wage growth will slow throughout the remainder of the year.

Inflation

• Annual CPI inflation fell to 3.2% in March 2024, down from 3.4% in February, marking the lowest rise since September 2021. The largest downward contribution came from food and non-alcoholic drinks, which hit a peak increase of 19.2% in March 2023 compared with 4.0% currently.

• Core CPI (excluding volatile elements such as energy and food) was 4.2% in the 12 months to March 2024, marking a deceleration from 4.5% in February, but still well above the headline rate.

• Ofgem’s energy price cap is falling by 12% in April, which will exert further downward pressure on inflation. A further rapid fall in headline CPI is therefore likely, with the rate expected to fall below the Bank of England’s 2% target over the summer (Experian forecasts suggest a rate of 1.6% in Q2 this year), before rising again modestly to a little over 2% by Q4, and remaining slightly above target during 2025 (but below 2.5%). 

• However, there is also upward pressure on inflation, including the rise in the National Living Wage. Clearly, there is much uncertainty surrounding the outlook, with wage growth and services inflation still well above CPI (both at 6%), and ongoing geopolitical risks around global trade flows and energy prices.

Interest rates

• The Bank of England’s Monetary Policy Committee (MPC) held the base rate at 5.25% in March, for the fifth consecutive meeting (following 14 successive rises to subdue inflation). Eight of the nine MPC members voted to hold rates, with one member preferring a decrease. This represented a further shift towards policy loosening since the previous meeting in February, when two members were still voting to increase Bank Rate.

• There was no meeting of the MPC in April, so interest rates remain at 5.25%, with the next announcement due on 9th May. Although the pace of inflation is now down significantly, the MPC will have to weigh continued strong wage growth against a slowing labour market.

• There are still considerable supply constraints in the economy, and given the relatively small output gap, the MPC will want to make sure that inflation does not reignite, especially with core CPI still above 4% and wage growth at 6%. The MPC will therefore take a cautious approach to interest rate reductions, the first of which is likely over the summer.

Retail occupier market

• Retail sales volumes were flat in March 2024, having increased by just 0.1% in February. Volumes increased by 1.9% in the three months to March 2024 compared with the previous three months, following low sales volumes over the Christmas period. Volumes rose 0.8% over the year to March 2024 while remaining 1.2% below their pre-pandemic level.

• The GfK Consumer Confidence Index rose a little to -19 in April from -21 in March, and a marked improvement from a recent low of -30 in October 2023. This remains a relatively weak reading, although consumers’ optimism about their own future finances is in positive territory.

• Many households are benefiting from the 2% reduction in National Insurance Contributions introduced from January 2024. From April, a further reduction of 2% comes into effect, and many lower income households will also benefit from a nearly 10% uplift in the National Living Wage (though this will adversely impact costs for many businesses in the retail and food & beverage sectors). In addition, wage growth is now above inflation, so wages are rising in real terms, and the lower energy price cap also comes into effect in April. This is all positive for household disposable income.

• The Q1 2024 RICS UK Commercial Property Survey shows a net balance of -10% for retail occupier demand, a noticeable improvement on the -18% in Q4 2023, and the -25% reported in Q3. Respondents continued to cite an increase in overall vacant space.

• Following three years of decline, average retail rental values have shown very modest growth since early 2022, according to MSCI. The Monthly Index reports that average retail rental value growth in the 12 months to March 2024 was 0.6%, and has been within a range of 0.5% to 0.8% over the last six months. Average retail rental values remain nearly 17% below their previous peak in 2018.

• The all-retail trend masks significant variation, depending on the type of property and location. The retail warehouse subsector has fared considerably better than most of the wider retail sector in recent years, with average rental values increasing by 1.1% in the 12 months to March 2024 (MSCI Monthly Index), a rate which has been broadly stable in recent months.

• Average shopping centre rental values fell by -2.0% over the 12 months to March 2024, compared with -2.4% in February 2024. However, the change over the last three months suggests that the rate of decline may accelerate again, with a fall of -1.7% from December 2023 to March 2024, the equivalent of -5.3% per annum.

• Average rents for standard (high street) shops were falling well before the pandemic. From May 2018 to May 2023, rental values fell almost continuously, by circa -29%, but some growth was recorded over the summer months of last year, with the result that annual growth is now in positive territory (+1.4% as at March 2024), and appears to be accelerating a little, with growth of +0.5% in the three months to March 2024.

Office occupier market

• High inflation has been creating cost pressures for corporates, further increasing their focus on productivity and cost reduction. This, together with the longer-term impacts of the working-from-home revolution, means that many businesses have been assessing their real estate footprint, although the level of downsizing is highly business-specific and appears to have been declining in recent months. Indeed, recent data suggests that office occupancy rates have broadly levelled off over the last year, and the three-day office week has emerged as the new normal. 

• Although corporate real estate is the second-highest cost after salaries for many businesses, the provision of high-quality space remains important to assist with recruitment, retention, and productivity strategies, as well as staff health & wellbeing issues. This is reflected in continued robust demand for high-quality space.

• There is also a much greater focus on buildings that are sustainable and energy-efficient, as occupiers try to meet increasingly ambitious ESG aspirations. This is being accelerated by the changes to MEES regulations which came into force in April 2023, with further tightening due in 2027.

• We are seeing continued strong demand for serviced and co-working space from established businesses that wish to lease short-term space, pending a move to longer-term conventional office space once the economic outlook becomes more certain.

• The Q1 2024 RICS UK Commercial Property Survey shows the first positive net balance for offices since 2022. At +6%, this was a considerable upturn on the -12% reported in Q4 2023, and the -19% in Q3. This upturn was entirely due to a marked improvement in central London, with little change reported in the regional markets. Respondents also continued to cite an increase in overall vacant space.

• A mixture of changing occupier requirements and regulation means a lower overall quantity of office space will be required going forward, with a focus on high-quality buildings that meet corporate and legal requirements.

• Prime rental levels have proved highly resilient, reflecting the focus of occupier demand towards top-quality space of which there is little available stock. Recent development schemes have set new benchmarks in cities such as Bristol, Birmingham, Leeds, and Manchester, whilst Oxford and Cambridge have seen strong rental growth due to limited prime stock and strong demand. The gap with rents for poorer quality grade B stock is likely to widen further.

• Average annual rental value growth for all offices was 2.8% as of March 2024, up from a post-pandemic low of 0.8% in January 2023. Annual growth to March 2024 was 2.0% in central London, 1.9% in the rest of the South East, and 2.1% in the rest of the UK (MSCI Monthly Index).

Industrial occupier market

• The UK logistics backdrop has been one of subdued consumer confidence and the near flatlining of household expenditure. However, this year should see an improvement, with wages rising in real terms and some consumers benefiting from lower energy bills and the rise in the National Living Wage. 

• Occupying buildings with the right specification will be ever more important, as occupiers adapt to new requirements. For example, the government recently introduced legislation to allow longer lorries, following a trial period. This permits semi-trailer combinations of up to 18.55 metres, 2.05 metres longer than the standard size. Whilst clearly beneficial in terms of HGV capacity, the size / shape of some warehouse yards is proving challenging, and this will be a greater consideration going forward.

• The Q1 2024 RICS UK Commercial Property Survey shows a net balance for industrial occupier demand of +14%, up from +6% in Q4 2023 and a recent low of +3% in Q3 2023, although still well below the recent peak of +49% in Q2 2022.

• The supply of new units is very limited across many key markets, and the development pipeline remains restricted. On the positive side for supply, more high-quality stock should come onto the market as subleases as occupiers release surplus space, a welcome boost to supply in key locations where vacancy is low.

• Competition amongst occupiers for existing and new build product has helped maintain upward pressure on rental values despite the subdued economic outlook. Average annual industrial rental value growth peaked in August 2022 at 13.2% according to the MSCI Monthly Index, decelerating to 7.0% by October 2023. Annual growth has since continued at broadly this rate, with the latest reading (March 2024) at 6.9%. However, on a quarterly basis, growth has been decelerating in recent months, from 2.2% in the three months to December 2023 to 1.1% in the three months to March 2024. This is now the lowest rate since March 2021 and the equivalent of 4.6% per annum, well below the annual rate.

• The Q1 2024 RICS UK Commercial Property Survey reports an increased expectation for rental growth in the industrial sector, with a net balance of +56% expecting prime rents to rise over the next 12 months, up from +48% in Q4 2023. A net balance of +22% expected secondary rents increase, up from +14% in Q4 2023.

• We believe that the often-overlooked open storage sector will continue to see huge demand amid a shortage of sites. This follows strong growth over the last two years, most notably for the highest quality ‘class 1’ sites which are available on leases of two years or more.

Transaction volumes

• £8.1bn was traded in Q1 2024. This was down 14% quarter-on-quarter, down 25% year-on-year and 40% below the five-year quarterly average. The rolling annual total also fell notably to £34bn, 37% below the five-year average of £55.3bn. The office and industrial sectors saw volumes continue to fall in Q1, whilst activity in the alternative sectors saw a notable uptick.

• Just over 45% of total investment (excluding multi-regional portfolio deals) occurred in the capital in Q1 2024, which is below the five-year average of 52%. Investors targeted assets in the living sectors, such as hotels and built-to-rent. 

• By sector, the ‘alternatives’ accounted for the largest share of the quarterly UK total at 51% and recorded volumes closer to the five-year quarterly average than any other sector. The office sector accounted for 20% of the total, whilst industrial amounted to just 16% and retail accounted for 12%.

• Overseas investment in UK commercial property totalled £3.6bn in Q1 2024, down 51% quarter-on-quarter and 31% below the five-year quarterly average. As a percentage of the total investment, it accounted for 45%, below the 10-year average of 51.8%. US investors had the highest share of overseas investment in Q1 2024, totalling around £3bn, a marginal increase of 3% quarter-on-quarter but 11% above the five-year quarterly average.

Recent investment performance

• All-property average equivalent yields have been shifting upwards since mid-2022 in reaction to rising interest rates and gilt yields, political uncertainty, and elevated occupier demand uncertainty. This rate of upward movement peaked in late 2022 but has continued at a more modest pace during 2023 and into 2024. The all-property equivalent yield reached 7.1% as at March 2024, a rise of 192 basis points since June 2022 (MSCI Monthly Index), and a rise of seven basis points over the last three months.

• Since June 2022, the office sector has seen the largest upward yield movement at 255 basis points, with industrial at 208 basis points and retail at 146 basis points. Offices continue to see the strongest rate of upward yield shift, at 20 basis points over the three months to March 2024, compared with just seven and four basis points for industrials and retail, respectively.

• 10-year gilt yields stood at 4.3% in late April 2024, compared with 4.1% at the end of February and a recent low of 3.4% at the end of 2023. The gap with the all-property equivalent yield is 310 basis points (as at the end of March 2024), compared with 350 basis points as at December 2023. This remains wider than the average for 2023 of 270 basis points, but is well below the average of more than 500 basis points in the decade to the end of 2020. 

• Yield movement has been the main driver of capital value change in the current cycle. All-property rental value growth was +3.9% in the 12 months to March 2024, but the sharp upward movement in yields seen during 2023 has resulted in a fall in all-property capital values of -5.3% over this period (MSCI Monthly Index). Although this rate is slightly below the -4.9% reported in February 2024, the fall is due to ‘base effects’, and the more recent trend remains upwards. Indeed, growth measured over three months has been improving since December 2023 (-2.6%), to stand at -0.8% in the three months to March 2024.

• Capital growth varies considerably across the main commercial property sectors. In the 12 months to March 2024, retail capital values fell by -5.6% (similar to the all-property rate), whilst office values fell by a significant -16.3%. In contrast, industrial capital value growth was in positive territory at +0.8%.

• The all-property annual total return peaked at 25.1% in May 2022, and then decelerated sharply, bottoming out at -16.9% per annum in the year to June 2023. Recent months have seen a rapid improvement in performance, with the all-property annual total return turning positive in January 2024 at +0.3%, rising to +0.7% in February. However, performance eased back to 0.3% per annum in March (MSCI Monthly Index).

• The industrial annual total return is now +5.9%, compared with a low of -23.2% in June 2023. Retail annual returns turned positive in December 2023 and stood at +1.1% in March 2024, compared with a low of -9.6% in July 2023. The total return for offices remains in firmly negative territory at -11.5% per annum in March 2024, but still an improvement on the recent low of -18.9% in August 2023 (MSCI Monthly Index).

Investment outlook

• We expect higher investment transaction volumes in 2024 relative to last year, but still below long-term averages. 

• The recent decline in inflation suggests a likely easing of interest rates by the Bank of England later this year. While the US Fed may cut rates less aggressively, lower interest rates in the UK, alongside currently reduced asset prices, could stimulate renewed investment activity.

• With a general election later this year, we believe that a change in government is unlikely to cause a significant market correction. Instead, we expect a slowdown in activity during the few months before and after the election as many investors hold off making material decisions. Previous changes in government have not shown a dramatic change in investor sentiment – unlike Brexit, the pandemic, and various geopolitical events that we have recently experienced.

• The low supply of offices considered prime in terms of both their location and the quality of the asset (including the correct green credentials) means they should benefit from rental growth in the short to medium term. Consequently, such properties should create interest from a growing range of investors, and we therefore expect a positive adjustment in pricing. However, this is more likely to be in the smaller lot size range as institutional investors, who typically target the larger deals, are still in ‘sell mode’ and are, therefore, unlikely to return to the office sector soon. Offices that are not prime and without the correct green credentials will likely continue to fall in value until a point is reached where it becomes economically viable to either refurbish them or change the use.

• As with the office sector, many industrial occupiers are seeking well-located buildings with the correct green credentials, where enhanced rental growth will likely continue. This, in turn, will attract institutional interest, and is where yield compression is more likely throughout 2024. Investor appetite for secondary assets remains healthy, albeit slightly subdued compared to previous years. Yields have moved out and offer more attractive returns than previously obtainable. Any further falls in interest rates will increase competition for assets of this nature as the buyer pool is expected to widen.

• Whilst households are still feeling the effects of the increased costs of living, the outward movement in retail yields (which in part is attributed to the associated occupational risk of tenant default) is at a level where it is once again looking attractive to experienced retail sector investors. Secondary neighbourhood parades let to local covenants continue to experience strong demand. We expect the retail sector's performance to be similar to 2023, but with potential for moderate growth when interest rates begin to fall.