New year, new start?

Anyone with an interest in commercial property these past few years has needed nerves as strong as the steel holding up Britain’s skyscrapers. After the economic collapse in 2007 the sector slumped and building work came to a halt overnight. A better start to 2010 brought some rest bite, but demand for commercial property – particularly office space – has since fallen back. It seems for every step forward there’s a step or two back.

So what does 2011 hold? A decidedly mixed picture, according to the experts. If you’re hoping for sustained growth in demand and rental values, look away now. But there are bright spots amid the gloom. Simon Rubinsohn, chief economist at the Royal Institution of Chartered Surveyors (RICS), says this year has panned out largely as forecast.

“The recovery we saw for the latter part of last year certainly has been sustained fairly firmly into much of this year. That is something we felt was likely,” he said. “We were however, sceptical as to whether the recovery would continue to power ahead with the pace we had seen at the early part of this year.”

Those fears were borne out by the RICS UK Commercial Market Survey which found occupier demand falling for the second consecutive quarter in Q3 2010, with demand for office space showing the greatest decline. Kelvin Davidson, property economist for Capital Economics, is another whose predictions proved to be spot on. “We’re seeing rental values reach what looks like some sort of trough and yields seem to have come down as far as they’re going to – which is broadly what people were expecting going back 12 months,” he said. “It looks like capital values have reached some sort of plateau. The big question is what happens next year.”

It’s a very big question. There’s much to factor in, not least the government’s big spending cuts, a potential above-increase rise in business rates, overseas investment and regional differences. To turn first to the coalition government’s cutbacks, as outlined in October’s Comprehensive Spending Review – will they have an impact on the commercial property sector? Yes says Lester Wagman, partner at King Sturge, one of the largest international property consultancies in the UK.

“There are concerns, particularly in places where the public sector has a very important function in propping up the provincial office market,’ he said. “That’s especially true in more secondary locations where there’ll be a lot more vacant space coming onto the market.”

The cuts, he said, are: “going to have a significant impact on the market’ but the size of that impact will vary across the country. In some locations, where there’s an existing and established commercial market – cities like Leeds and Manchester – I think they’ll be fine. In the smaller towns there may well be a substantial local authority office or a central government outpost which might be affected badly. I don’t think one can generally say it will completely slump, but there is already a feeling of waning confidence”.

“There are certainly different prospects ahead for different kinds of property,” says Kelvin Davidson. “There are a lot of concerns about the tenants who occupy so-called non-prime properties, whether they’ll stay in business and whether the rental incomes occurring to landlords from those properties will remain. If they don’t then prices and rents could fall on those properties. On the other side of the coin, the better quality stuff looks like it will be flat at worst and may take up a small rent rise with investment demand staying pretty buoyant. Averaging all that out our view is that things will be pretty stable, maybe slightly down. We’re not talking about a reversal of the recent gloom; it’s more like a flat patch”.

Simon Rubinsohn shares those concerns about non-prime properties. “Those very definite secondary-type properties that are struggling to find occupiers are going nowhere fast. I think that differential between the desirable and what’s left is something that will continue through 2011”.  Regionally, London looks set to be a winner again. Francis Salway, the chief executive of the UK’s largest commercial property company Land Securities, said recently that London offices are through their low period in the economic cycle, with City rents increasing from around £45 to £50-plus per sq ft in 2010.

Much of the increase in Middle East investment in UK commercial property has also gone to the capital, with trophy assets including Chelsea Barracks and the Shard London Bridge skyscraper going to the gas-rich nation of Qatar alone. “Central London’s going to keep going ahead, even though it looks like the prospects have become a little weaker than our expectations a few months back”, said Kelvin Davidson. “Rents will still rise in the City and West End next year, whereas regional office markets look like they’re going to be hit pretty hard by the public sector job cuts – especially areas like the North of England and Wales. It’s very much a two-tier market”.

Lester points out the contrast between the heart of the city and its outskirts. “There’s a lot of overseas investment coming into the West End. And the City’s doing quite well because the financial markets are currently faring OK. “Where we’re already starting to see markets fray at the edges are at some of the suburban locations around the periphery of London where it’s becoming increasingly difficult to attract tenants to office space”. Because there’s already been a ‘big move’ in demand for commercial property in London, Simon did not talk up the sector’s prospects in 2011. “In terms of smart money and London I’m not sure – there is value there but it’s by no means as compelling as it was. I think it’s steady money. “Regionally you might find some opportunities – there again they carry a much greater risk. I don’t think there is easy money to be made in property”.

Certain areas of commercial property will fare better than others next year, says Wagman. While offices are struggling to attract tenants, retail looks to be in better shape. “A lot of people were concerned that the internet and online shopping would have a huge impact on the retail market. That seems not to have happened because there’s a great social and leisure experience attached to people going shopping. So good quality attractive shopping centres in town and out of town seem to be holding up quite well, vacancy rates are down I understand from only a few months ago”.
In November Capital Shopping Centres reported that a decrease in high-quality retail properties has been ‘increasingly apparent’ in the UK. It said occupancy at its nationwide sites were approaching 100 percent. But there is a relationship between the office and retail property sectors. Shops in UK towns rely on the spending of office workers – if offices close, shops will come under pressure.

Lester also sees a distinction between the industrial and distribution markets. “Distribution appears to be holding up really well, with a trend towards larger units and rents holding up,” he said. “But the traditional manufacturing sector has been suffering a long-standing decline and that’s continuing. It’s becoming increasingly difficult to let anything other than a modern warehouse with high eaves height and good loading access”.

Capital Economics’ Kelvin Davidson sees little to choose between sectors when deciding where to put your money. “Industrial has a very high income return but perhaps not much scope for capital gains, whereas offices have a lower income return but perhaps more scope for capital gains driven by rental growth. Balancing all that out, our view is most sectors will be pretty much in line with each other. There don’t seem to be any screaming areas which are cheap”.

The continuing credit squeeze will have an impact through 2011, says Simon. “In the short term the real issue as far as the UK market is concerned is a lack of mortgage finance. It’s not exactly a case of lenders falling over themselves to lend”. As well as cutting spending, the coalition government has promised measures to stimulate private enterprise and create jobs to replace those going from the public sector.

One idea announced by Deputy Prime Minister Nick Clegg was empowering local authorities to raise development funds from Tax Increment Financing (TIF). This would allow a council to borrow against future additional property tax revenues (ie, business rates) from new developments to support the initial costs of a facilitating potential projects, such as a new transport scheme.

But our experts were dismissive of the government’s ability to boost commercial property.

“History tells us that even if measures are taken now they may have some short-term effects but I don’t think in the long run you ever get rid of the cycles. Bikes are here to stay”, said Simon. Kelvin went further: “The last Labour government almost seemed indifferent about commercial property. You’d have a strong lobby for reinstating empty rates relief for example, which just basically got ignored. In terms of government priorities commercial property is pretty low so it will just be left to its own devices”.

Wagman believes environmental factors will have an increasing impact on demand for property in 2011. “The landscape is changing quite significantly in terms of the property market in the UK. The other influence we’re seeing come to bear, in the office sector in particular, is the sustainability factor. Companies are having to justify to their shareholders that the premises they occupy are as energy efficient as they can be. We’re seeing this clearly with companies deciding either to locate or not to locate to certain buildings because of how well they perform in terms of their carbon footprint and  overall sustainability”.

“Also, journey times and carbon emissions are affecting journey to work times. Office and technology parks aren’t faring quite as well now, in terms of the occupational markets, as more in-town locations with better public transport links. That is going to become more and more acute. More office tenants are going to want to relocate in towns, and probably in the larger cities – Birmingham, Leeds, Manchester, London, and Bristol – where the transport connections are good”.

So commercial property is the proverbial curate’s egg in 2011: good in parts. But sensible property investment has never been about a quick buck: so how is the long term picture next year?

According to a report this year by BNP Paribas Real Estate, the UK’s commercial property sector will not regain the value lost during the crash for more than 15 years. We will have to wait till 2025 at the earliest before values reach similar pricing to 2006 and 2007 when the market peaked.

RICS UK’s Simon Rubinsohn concurs. “Many will say they’ll take advantage of the withdrawal of the state from lots of sectors of the economy, but even so it’s going to be a fairly long haul to get the economy back to where it was in terms of lost output. If you were looking at a growth rate trend from 2007 on we’re still about ten percent down on where we would have been in other circumstances, and that is a loss of demand for properties”.

His advice? Don’t panic. “The outlook for property going forward will probably be fairly stable – I don’t think we’re looking at a double dip recession. Maybe prices will slip a bit, or go up a bit; this is what tends to happen in markets. I wouldn’t read too much into value going down for the odd month or two. The economy is going to be facing some pretty difficult challenges. That will be reflected in the uncertainty around which property investors and occupiers behave”.

The London 2012 Olympics will help ‘prop things up’ in the capital for the next 12 months says Lester. But the market could suffer a hangover when the “post-Olympic euphoria may have evaporated”. Kelvin also has his eyes on the far horizon. “Our forecast is that GDP growth will slow next year which is another reason to think that the commercial property market will be a bit subdued. Further out GDP will eventually return to trend growth, when the returns will go up. You have got to take a longer term view”.