The UK commercial property market, having faced considerable challenges in recent years, is showing signs of recovery, particularly in London’s City and West End office sectors. According to data from Savills, the vacancy rate for office spaces in these key areas has decreased from a peak of 9.5% in late 2023 to 7.4%, although it remains above the long-term average of 5.9%. This trend reflects a broader adaptation within the commercial real estate sector, where businesses are increasingly recalibrating their operational strategies.
While the surge in online shopping has cooled down to a growth rate in the mid-30s percentage range, which includes food commerce, shopping centers have pivoted to become experiential destinations. Consumers now seek more than just retail outlets; they desire a multifaceted experience that includes dining, leisure activities, and social spaces. Retailers have acknowledged the high costs associated with processing returns from online purchases, prompting them to transform physical stores into prime showrooms that facilitate online sales.
In late 2024, Land Securities made a notable investment, purchasing the Liverpool One shopping center for £490 million. The company hailed it as one of the premier shopping centers in the UK and projected an income return of 7.5%, with expectations of meaningful growth in the coming years. This confidence illustrates the belief among major players in the sector that robust investment can yield positive returns, even in the post-pandemic landscape.
The dynamics within the property sector, however, reveal contrasting trends. An influx of capital into “big-box” distribution centers suggests that rental growth in this segment may be plateauing, as noted by Nick Montgomery, manager of the Schroder Real Estate Investment Trust (LSE: SREI). Meanwhile, a notable supply shortage exists for estates featuring multi-let industrial and distribution units. The so-called “alternative” property sector, encompassing hotels, self-storage, residential, and student accommodations, continues to perform relatively well.
Industry observations indicate a sense of caution among investors, with Richard Gotla, a colleague of Montgomery, commenting on the relative stability of rental values amidst fluctuating market conditions. Since the peak of the market in late 2022, property values have decreased by approximately 20% to 25%, a less severe decline compared to the financial crisis of 2009, which saw values plummet by 40% to 45%. Notably, the current landscape has less debt exposure compared to that period, and rental values have increased by 10% since late 2022, a divergence from the flatlining seen during the prior economic downturn.
The shift back to physical office spaces has been more pronounced in London than in other regions, yet the expectations of tenants have notably evolved. Employers are now prioritizing spaces equipped with amenities that enhance worker comfort and productivity, such as improved energy efficiency and inviting communal areas, superseding the more basic facilities that characterized offices of the past. However, rising construction costs have posed significant challenges for developers, who are compelled to adapt their strategies amid the threat of obsolescence. Initial rent-free periods can extend up to three years, followed by leases of as long as ten years, complicating financial projections for property investments.
As rental prices escalate—reportedly reaching £150 per square foot in the City and £250 in the West End—secondary markets have begun to react. The refurbishing of older, high-quality buildings in desirable locations is becoming a more cost-effective strategy, allowing landlords to offer shorter leases, typically around five years, at more competitive rates. For instance, Derwent London (LSE: DLN), known for its refurbishment portfolio, has reported strong tenant demand, even as its share prices trade at a 40% discount to net asset value (NAV).
The wider investment landscape features key players like Great Portland Estates (LSE: GPE), whose shares are currently discounted by 30%. The company’s recent issuance of £350 million in rights at a discount in May 2024 has diluted NAV but signals management’s optimism about future prospects. Notably, in a strong endorsement of confidence, Norway’s sovereign wealth fund acquired a 25% stake in Shaftesbury Capital’s Covent Garden estate for £570 million, bolstering its NAV while simultaneously reducing debt.
Land Securities (LSE: LAND), a sector giant with assets totaling approximately £10 billion, is also strategically expanding its retail portfolio. Conversely, British Land (LSE: BLND), managing about £8.7 billion in assets, is focusing on integrated “campus” developments that combine office space with retail and leisure offerings, reflecting a modern approach to urban space utilization. Currently, approximately 25% of British Land’s assets are situated in retail parks, while 10% are allocated to shopping centers, mirroring the ongoing shift in consumer shopping habits.
On the other hand, the Schroder Real Estate Investment Trust, with more modest net assets of £300 million, is positioning itself to capitalize on opportunities often overlooked by larger investors. Notably, its shares are offered at a 20% discount, coupled with an attractive yield of approximately 7% that is fully supported by earnings. Furthermore, with over 40% of its portfolio located outside London and half attributed to multi-let industrial spaces, SREI is well-hedged against geographic market fluctuations. Although the company does hold significant debt, 75% of it is secured at a favorable fixed rate of 2.5% for 11 years, insulating it from the most dramatic effects of rising interest rates.
Looking ahead, Schroders anticipates a total annual return within the range of 8% to 10% for UK real estate over the next four years, a projection that bodes well for both dividends and capital appreciation. The group is actively focused on adding value through the repurposing of properties and the redevelopment of aging structures. Montgomery notes additional prospects in affordable housing, particularly concerning inflation-linked income streams associated with hotel operations, emphasizing the advantages of also being an operator rather than solely a property owner.
Despite various influences—including rising gilt yields and broader global economic factors—Montgomery expresses cautious optimism for recovery as interest rates are projected to decline in the future. The ongoing supply constraints within the market diminish the necessity for an explosive increase in demand to achieve favorable returns. Early signs indicate that share prices in the property sector are beginning to reflect expectations for this recovery, but analysts suggest that considerable potential remains for growth and value realization in the upcoming period.