Commercial Market Outlook

• There was mixed news on economic growth in June. Performance in Q1 2024 was revised upwards to a strong +0.7%, its highest rate since Q2 2021 (at the tail end of the post-pandemic recovery period). This marked the end of a short and shallow technical recession in Q3 and Q4 2023. However, the latest monthly data has reported no growth during April.

• All the latest PMI survey readings (services, manufacturing, and construction) are in positive territory, and consumer confidence has now improved for three consecutive months to its highest rate since the immediate post-pandemic period. We therefore expect continued quarter-on-quarter growth this year, albeit at lower rates than seen in Q1.

• CPI inflation has continued its downward trend, falling to the Bank of England’s target of 2% in May, down from 2.3% in April, and the lowest rate since July 2021. CPI is forecast at 2.2% by Q4 this year, although it may well dip below target in the coming months.

• The voting pattern of the Bank of England’s Monetary Policy Committee (MPC) saw no change at its June meeting, with two of its nine members voting to cut Bank Rate, and the other seven preferring to hold. However, the Bank’s signalling has become more dovish, describing the decision as ‘finely balanced’. This signposts an initial 25 basis point cut, possibly as early as the next meeting at the start of August, when the MPC will be guided by the Bank’s latest Monetary Policy Report. Given that wage and services inflation remain stubbornly high, the MPC will move cautiously.

• Domestic politics has replaced inflation and geopolitics as the focus of attention in recent weeks, and an incoming Labour government with a large overall majority should provide a period of relative political certainty. The Labour manifesto acknowledges the importance of economic growth and contains several positive initiatives. These include an industrial strategy delivered through a new statutory Industrial Strategy Council, and a National Wealth Fund targeted with attracting three pounds of private investment for every one pound of public investment.

• Taken with policies to accelerate the upgrading of transport and utilities infrastructure, and to raise the rate of housebuilding, a Labour administration has the potential to impact positively. The Labour manifesto also proposes to replace business rates in England with a new system which would raise the same revenue as the currently. The objective is to ‘level the playing field between the high street and online giants’ and reduce vacancy rates, although the devil will be very much in the detail.

Recent output trends and indicators

• UK gross domestic product (GDP) is estimated to have increased by 0.7% in Quarter 1 (Jan to Mar) 2024, revised up from a first estimate increase of 0.6%. This represents a strong bounce-back from the mild recession at the end of 2023 (-0.1% in Q1 and -0.3% in Q4). Services grew by 0.8% on the quarter with widespread growth across the sector. Elsewhere, the production sector grew by 0.6% while the construction sector fell by -0.6%.

• Monthly GDP is estimated to have shown no growth in April, down from 0.4% in March. This was still above market expectations of -0.1% and should lead to a 0.4% quarterly rise during Q2. Disaggregated, the services sector grew by 0.2% in April, the fourth month of growth in a row, while production and construction declined by -0.9% and -1.4%, respectively. The unusually high amounts of prolonged rain during the month likely contributed to the construction sector fall.

• The UK Manufacturing PMI (S&P Global) rose to 51.2 in May, its highest reading since July 2022 and only the second time it has surpassed the ‘50’ mark (indicating growth) since then. This expansion reflects rising levels of new work orders, improved market conditions, and a boost in new business. However, new export orders continued their downward trend, marking the 28th consecutive month of decline. Despite this, manufacturers remain optimistic, with a near two-year high of 63% of companies expecting to expand over the coming year.

• The UK Services PMI however cooled in May, down from 55 in April to 52.9 currently. Despite this, it is the seventh month in a row of expansion in this sector. New order growth continued, fuelled by rising business and consumer confidence. Employment levels also saw a slight increase, although concerns about rising costs are delaying further hiring. On a positive note, input inflation has fallen to its lowest level in three years, and forecasts for future business activity remain high.

• Finally, the construction sector PMI rose again in May, moving to 54.7 from 53.0 in April and now the highest reading from this sector since May 2022. Activity, new business, purchasing, and employment all rose at the fastest rate in two years, while supply-chain issues continued to improve, contributing to input cost inflation slowing slightly.
  
  

Labour market

• There is further evidence that UK labour market constraints are easing as the unemployment rate rose again in the three months to April, to 4.4%, up from 4.3% last month. The employment figure declined, to 74.3%. Recent data from the Labour Force Survey should be treated with caution due to low sample sizes achieved, although it likely reflects the general direction of travel. 

• The total number of payrolled employees for May showed a decline of around 3,000 on the month although it rose by around 0.6% over the last year. The number of job vacancies also fell, down by 12,000 during the last three months to 904,000 and the 23rd consecutive period of falling vacancies.

• Average wages (excluding bonuses) rose by 6.0% year-on-year in the three months to April, unchanged from the previous three-month period. Average earnings growth in the public sector was slightly stronger at 6.4% while private sector growth averaged 5.8%.

Inflation

• Headline CPI inflation fell to 2.0% in the 12 months to May, the lowest rate since July 2021. The largest downward contribution to the headline figure came from food, with prices falling this year. However, services inflation remains elevated, down only slightly to 5.7% in May, with much of this coming from persistently rising airfares and accommodation prices. Core CPI (excluding volatile elements such as energy and food) remained well above the headline rate at 3.5% in the 12 months to May 2024, down from 3.9% in April. 

• The Treasury does not publish its consensus forecasts for the UK economy during the pre-election period, so its latest forecast remains the May update. This suggests that CPI inflation should be 2.2% by Q4 this year, with the same figure projected for Q4 2025. Given the impact of volatile elements such as energy prices, CPI could well undershoot the Bank of England’s 2% target in the coming months, before rising again modestly. 

• 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 (at 6% and 5.7% respectively), and ongoing geopolitical risks around global trade flows and energy prices.
  
   

Interest rates

• Bank Rate was held at 5.25% in June’s meeting of the Monetary Policy Committee (MPC). Seven members voted to hold with two preferring to cut the rate. However, the Bank’s signalling has become more dovish, describing the decision as ‘finely balanced’. This signposts an initial 25 basis point cut, possibly as early as the next meeting at the start of August, when the MPC will be guided by the Bank’s latest Monetary Policy Report. Given that wage and services inflation remain stubbornly high, the MPC will move cautiously.

Retail occupier market

• Retail sales volumes rose by 2.9% in May (month on month), above consensus forecasts and a marked improvement on the (upwardly revised) -1.8% fall in April. Strong sales volumes were driven by non-food shops which saw a rise of 3.5%, with clothing sales in particular seeing a strong boost of 5.4% month on month. Household goods sales increased by 3.5% while food sales posted a 1.2% monthly rise.

• The recent gradual rise in consumer confidence continued into June with the overall figure from GfK’s series moving to -14, up three points compared with May. Confidence in consumers’ personal financial situation declined by three points to +4 but this is not far off the long-run pre-pandemic average of +5. As real wage growth continues, we expect that confidence will continue to rise. Having said that, the Major Purchase Index is still firmly in negative territory at -23, although this too rose three points this month.

• Many households are benefiting from this year’s reductions in National Insurance Contributions, and many lower income households are also benefiting from the recent uplift in the National Living Wage of nearly 10% (though this is adversely impacting costs for many businesses, most notably the retail and food & beverage sectors). In addition, wage growth continues to be well above inflation, and the energy price cap continues to fall. 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 2022, according to MSCI. The Monthly Index reports that average retail rental value growth in the 12 months to May 2024 accelerated to 0.9%, up from 0.8% in April and the highest annual growth rate since 2016. 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. Average rents for standard (high street) shops fell almost continuously from May 2018 to May 2023, by circa -29%. However, this trend has reversed over the last year, and the annual rate of growth has accelerated month on month since November 2023, reaching +1.9% in May 2024 (MSCI Monthly Index).

• Average rental values in the retail warehouse subsector are also rising, increasing by 1.3% in the 12 months to May 2024, the same as the previous peak in annual growth seen in January 2023 (MSCI Monthly Index). On a quarterly basis, growth has been stable at 0.3-0.4% in recent months, broadly in line with the current annual rate.

• Average shopping centre rental values are still falling on an annual basis, by -1.5% over the 12 months to May 2024, compared with a recent low of -2.4% in February 2024. However, the quarterly rate has also improved significantly, with no change recorded over the three months to May 2024, compared with a recent low on this measure of -1.7% in the three months to March 2024.

Office occupier market

• The longer-term impacts of the working-from-home revolution mean that many businesses have been assessing their real estate footprint, although the level of downsizing is highly business-specific and has declined in recent months. Indeed, 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 to enhance staff health & wellbeing. 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.

• Total office take-up across the Carter Jonas ‘Commercial Edge’ cities (Bristol, Birmingham, Cambridge, Leeds, and Oxford) saw a modest increase in Q1 2024, reaching just over 1 million sq ft, 12% above the five-year quarterly average and the third consecutive quarter of rising take-up. This underscores the commitment from many businesses to physical office space.

• The Q1 2024 RICS UK Commercial Property Survey shows the first positive net balance for office occupier demand since 2022. At +6%, this was a considerable upturn on the -12% reported in Q4 2023, and the -19% in Q3. Notably, this upturn in sentiment 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.

• 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 UK offices was 2.5% as at May 2024, up from 2.3% in April 2024 and compared with a post-pandemic low of 0.8% in January 2023, although slightly below the recent high of 2.8% in March 2024. However, there is an increasing geographical divergence, with the central London market pulling ahead of the south east and regional markets, boosted by strong performance in the West End. Average central London rental values rose by 4.5% in the year to May 2024, with the West End / Midtown seeing growth of 6.0%, compared with 2.3% in the City of London. The rest of the south east recorded average rental growth of 1.4%, slightly below the 1.8% reported in the regional markets (MSCI Monthly Index).

Industrial occupier market

• Logistics demand has been holding up relatively well, buoyed by ongoing structural change and the influence of e-commerce, with ‘last mile’ units for urban delivery being a key area. However, take-up has returned to more ‘normal’ levels following the exceptionally strong demand experienced during 2020-2022, driven by pandemic-specific requirements as well as accelerated change in global supply chains.

• 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 become available 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% and has since decelerated from this very high rate, but remains strong at 6.3% as at May 2024, well above general inflation. Average industrial rental values increased by 1.3% during the three months to May 2023, the equivalent of 5.1% on an annual basis (MSCI Monthly Index).

• 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 shifted upwards from mid-2022 in reaction to rising interest rates and gilt yields, political uncertainty, and elevated occupier demand uncertainty. The rate of upward movement peaked in late 2022, continuing at a more modest pace during 2023. However, the all-property equivalent yield has broadly stabilised at 7.1% during the first half of 2024 and is currently 193 basis points above the most recent market peak in June 2022 (MSCI Monthly Index).

• Since June 2022, the office sector has seen the largest upward yield movement at 253 basis points, with industrial at 212 basis points and retail at 154 basis points. Offices and retail have continued to see some upward yield shift, at +13 and +10 basis points respectively over the three months to May 2024, whilst industrials were virtually stable, and other sectors (hotels and residential) within MSCI have seen some downward yield movement. 

• 10-year gilt yields stood at 4.2% at the end of June 2024, compared with a recent low of 3.4% at the end of 2023, and a recent high of 4.4% in May 2024. As at the end of May 2024, the gap with the all-property equivalent yield was 275 basis points, compared with 350 basis points as at December 2023, and 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 during the current cycle. Although values have continued to fall year-on-year at the all-property level, capital value performance has improved significantly over the last year, standing at -5.3% per annum as at May 2024, compared with -21.2% per annum at the bottom of the cycle in June 2023 (MSCI Monthly Index). However, with the stabilisation of yields, capital values are now levelling off. Indeed, all property capital values were virtually unchanged over the three months to the end of May 2024 (-0.1%).  

• Capital growth performance varies considerably across the main commercial property sectors. In the 12 months to May 2024, retail capital values fell by -5.6% (similar to the all-property rate), whilst office values fell by a significant -15.6%. In contrast, industrial capital value growth was in positive territory (just) at +0.2%.

• 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. Performance has been in positive territory during 2024, reaching +0.7% in February, although easing slightly to +0.3% in May.

• The industrial annual total return is now +5.3%, compared with a low of -23.2% in June 2023. Retail annual returns turned positive in December 2023 and stood at +1.2% in May 2024, compared with a low of -9.6% in July 2023. The total return for offices remains in firmly negative territory at -10.7% per annum in May 2024, but performance has steadily improved in recent months, and is now well above the recent low of -18.9% in August 2023 (MSCI Monthly Index).

Investment outlook

• We expect higher overall investment transaction volumes in 2024 relative to last year as lower interest rates in the UK, alongside currently reduced asset prices and increased post-election political certainty stimulate renewed confidence and market activity. However, volumes will remain below long-term averages. 

• 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 buyers, 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. 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. Falling 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.