Commercial property market update
Winter 2023

Economy: Have interest rates peaked?

The Bank of England’s decision to keep the base rate on hold at 5.25% for the second consecutive time in November has raised the prospect that interest rates are at their peak. This is still the highest rate in 15 years, and the clear signal from the Bank was that it would keep the rate at this level for however long was necessary to get inflation under control. A surprise inflation figure, with the headline CPI rate not falling in line with expectations in September muddied the waters slightly in the lead up to the latest rate decision. Since then, inflation dropped back to 4.6% in October as lower energy prices fed into the calculations. However, given the crisis in the Middle East, it cannot be ruled out that external inflationary pressures once again emerge if oil prices start to rise.

The immediate response to the Bank’s announcement however was a slight dip in gilts rates, with the markets pricing in the fact that the next move in rates may be down rather than up – even if that looks to be some way off. Capital Economics is forecasting that the first rate cut will be in November next year. The markets are pricing in a rate cut in the summer, and while Huw Pill, one of the Bank’s rate-setters indicated in a recent speech that expecting a rate cut in the middle of next year ‘doesn’t seem totally unreasonable, at least to me’, this was overruled by Andrew Bailey, the Bank Governor, who said it was too early to be discussing rate cuts.

Slightly weaker economic data, both in terms of GDP growth and employment levels, also indicate that the Bank’s moves over the last two years are having an impact. The IMF released new forecasts indicating that the UK economy would grow by just 0.6% next year, which attracted some criticism for being too gloomy. But the Treasury’s monitor of independent forecasts showed that UK economists expect 0.5% growth in 2024. The IMF also said interest rates would stay elevated at around 5% until 2028, but as examined above, UK economists predict a more rapid decline in rates in 2025.

Property market overview:

The spread between the average equivalent yields and 10 year bonds narrowed markedly during Q2, and remains tight in Q3, suggesting room for further softening in all-property yields this year.

The market also remains highly localised and sector dependent. All property capital values have fallen by -18.2% in the 12 months to the end of September, but on average Shopping Centres are down by   -10%, while offices in outer London are down on by -27% on average.

The picture looks a little brighter when examining trends in the last six months. All property capital values are down by just -1.9% between the start of April and the end of September this year. However, the sectors remain split in terms of performance, with shopping centres down -1.7% and outer London offices down -10.6%. Average capital values for industrial stock in the South East, rose by 2.4% over the same period.

As examined in more detail in our recent Commercial Property Examiner, we expect total all property returns to end this year at -6.0%, from -13.6% at the end of Q3 as rental growth in some sectors, coupled with a slowing in capital value declines result in a more modest downturn than 2022. We expect that total property returns will return to positive territory next year.

To find out more on the office, industrial and retail property markets by clicking the links below:

Offices: Flight to quality continues. There has never been such a distinct divergence between prime and secondary property, and this is still being driven by companies adjusting to changing working patterns as well as a desire to meet higher net-zero targets. This is a structural change in the sector which is still being absorbed, putting capital values under pressure for secondary offices where there is no change of use potential. Meanwhile the appetite for best-in-class office space remains strong. Read more.

Industrial: Slowing rental growth.  Robust occupational market conditions amid tight supply are helping to maintain a continued confidence after significant repricing in the sector. Fundamentals are more critical than ever taking account of location, quality, pricing and rents. There is continued investment appetite for mid-box assets, especially around towns and cities, driven by value-add. We expect rents will continue to rise but the pace of growth will slow further. Read more.

Retail: A slowing market. Prime high street assets are among the best performing within retail  – these assets have stabilised and there is opportunity for future rental growth where values have been rebased. However, this comes against a backdrop of the changing definition of prime retail, with a shrinking number of locations meeting the criteria. Values for shopping centres will continue to decline as a result of downward pressure on rents, but investors will be looking for opportunities where there is potential for redevelopment in city centre locations. Read more.

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