Could this be the time to invest in UK commercial property? Recent market shifts suggest that the sector, battered by rising interest rates and economic uncertainty, is starting to show signs of life.
The Long Road to Recovery
UK commercial property has been one of the hardest hit sectors over the last few years. In 2022, average property values dropped by a staggering 14.8%, and continued to fall in 2023 and 2024, dropping a further 3.9% in 2024 (source: FE fundinfo, AIC UK commercial property sector to 8 August 2024).
This slump has been driven by a perfect storm of factors, including:
- Higher Interest Rates: Increased borrowing costs have made it more expensive for property companies to finance their operations, putting pressure on valuations.
- Economic Uncertainty: The global economic environment remains fragile, with worries about a US recession casting a shadow over the market.
- Structural Shifts: The rise of remote working and e-commerce has impacted demand for traditional office space, further impacting the sector.
Signs of a Turnaround
Despite the challenges, there are encouraging signs that the tide is starting to turn:
- Falling Interest Rates: The Bank of England has begun to cut interest rates, offering some relief to property companies struggling with debt. Lower rates also benefit property valuations, as they make it more attractive for investors to buy.
- Improving Sentiment: In February, Hammerson, a major UK retail landlord, reported the first rise in rent expectations since 2017. In May, Land Securities, another major player, indicated that the market for high-quality commercial property was beginning to improve.
- Positive Industry Reports: The RICS Commercial Property Monitor for Q2 2024 showed that the sector is either at the bottom of the cycle or in the early stages of an upturn. The survey found that 34% of respondents believe the market is at the bottom of the cycle, while 41% see signs of recovery.
- Reit Performance: July saw a positive shift in the performance of UK real estate investment trusts (REITs), with the FTSE EPRA NAREIT UK Index returning 3.5%. CBRE reported that capital values across all UK commercial property were up 0.2% in June, marking the second consecutive month of growth.
Cautious Optimism
While the news is encouraging, it’s crucial to acknowledge that the recovery is still in its early stages. The average discount to net asset value (NAV) across the property investment trust sector remains high at 27%, suggesting that investor sentiment is still cautious.
Gilt Yields and the Future
The movement in UK gilt yields has been closely linked to the performance of property investment trusts. As yields have fallen, trust discounts have narrowed. This suggests that further rate cuts could drive valuations higher for UK commercial property.
Regional Variations
It’s important to note that the recovery is not uniform across all sectors. For example, Regional REIT, which focuses on offices in regional centers, saw a widening of its discount in July, reflecting the ongoing challenges faced by this segment.
The Challenges Ahead
Despite the positive developments, there are still significant challenges facing the UK commercial property sector:
- Environmental Standards: Many buildings require expensive upgrades to meet environmental regulations, which could impact valuations and profitability.
- Distressed Sales: The launch of a “Special Opportunities” REIT, aimed at acquiring distressed properties, was pulled in July due to lack of demand. This suggests that investors remain hesitant about the potential risks associated with distressed assets.
Looking Ahead
While the UK commercial property sector faces ongoing challenges, the recent positive developments offer a glimmer of hope. Falling interest rates, improving sentiment, and strong performance in certain segments suggest that the sector may be on the cusp of a turnaround.
However, investors should approach this market with caution and carefully consider the risks involved. It is crucial to conduct thorough due diligence before committing to any investment.