It has been a long winter for the UK’s commercial property sector, but at last it seems spring is in the air. Savills reports that the vacancy rate in the City and West End of London office property market has fallen from a peak of 9.5% in late 2023 to 7.4%, although it is still comfortably above the long-term average of 5.9%.
The rate of growth in online shopping has slowed to the mid-30s in percentage terms, including food, and shopping centres have learned to adapt. Customers see them as a destination. They want to browse in shops, visit cafes and restaurants, and go bowling. Retailers have learned that returns from online shoppers are expensive to handle, so shops are now not just sales outlets, but also showrooms for buying online.
In late 2024, Land Securities paid £490 million for the Liverpool One shopping centre, “one of the premier shopping centres in the UK”, it says. It expects to generate an income return of 7.5% and to grow that figure “meaningfully” over the next few years.
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A lot of capital has gone into “big-box” distribution hubs, so rental growth is likely to slow in that subsector, says Nick Montgomery, the manager of the Schroder Real Estate Investment Trust (LSE: SREI). But there is a supply shortage of estates with multi-let industrial and distribution units. Meanwhile, the market for the “alternative” property sector, including hotels, self-storage, residential and student accommodation, is mostly healthy.
“There have been plenty of false dawns since the market peaked in late 2022,” says his colleague Richard Gotla, “so it feels a bit like Groundhog Day.
Values have fallen 20%-25% since the peak – less than the 40%-45% [in 2009], but there has been less debt in the sector than then. In addition, rental values were flat then but have risen 10% since late 2022.”
London has returned to the office
Gotla says that “the big story is how little development there has been in recent years”, although it doesn’t seem that way in central London. The return to the office has been more advanced in London than in the regions, but the demands of occupiers have changed. Tenants want more facilities, better energy efficiency and cafes, rather than a small kitchen with a kettle, a microwave and a vending machine.
However, construction costs have gone up sharply, and buildings quickly become obsolete: “they start to depreciate when the builders leave”, says Gotla. With initial rent-free periods of up to three years, leases of up to ten and obsolescence thereafter, “it has become very difficult for developers to make the numbers work”. As a result, rents “are going nuts: £150 per square foot in the City, £250 in the West End”.
This is pulling up the secondary market. Refurbishing a quality building in a good location is much cheaper, allowing landlords to offer shorter leases (around five years) at far lower rents. Refurbishments comprise a large part of Derwent London’s (LSE: DLN) portfolio, and it reports strong demand from tenants. The shares trade on a discount to net asset value (NAV) of 40%.
The shares of Great Portland Estates (LSE: GPE) trade on a discount of 30%, the trust having diluted NAV with a £350 million rights issue at a discount in May 2024. Such issues are never popular with investors, but they reflect managements’ enthusiasm about the outlook. In April, Norway’s sovereign wealth fund paid £570 million for a 25% stake in Shaftesbury Capital’s Covent Garden estate, validating its NAV and reducing its debt. The shares have since risen over 20%, but still trade at a discount of 30% – despite reporting strong performance last year with rental income up 6% and earnings 20% from its West End estate, primarily retail and leisure properties.
Sector giant Land Securities (LSE: LAND), with £10 billion of assets and a 30% discount to NAV, has been adding to the retail segment of its portfolio. Rival British Land (LSE: BLND), with £8.7 billion of assets, has focused on “campuses” such as Broadgate and Canada Water. These encompass offices, but also retail and leisure outlets, and the public spaces in between. A quarter of its assets are in retail parks and 10% in shopping centres. Its shares are on a discount of 30%.
SREI is much smaller, with net assets of £300 million, so it is not going to own any trophy assets. But its smaller size enables it to look for value in areas the larger investors ignore. Its shares trade at a 20% discount, but the yield, close to 7% and fully covered by earnings, is attractive. Moreover, rental income of £30 million is well below “reversionary rent” of £40 million – the rent its properties would command if re-let now. Less than 10% of the portfolio is in London and over 40% in the North, while multi-let industrial accounts for half the portfolio, offices a quarter and retail warehouses half of the rest. Although its debt is significant, 75% of it is locked in for 11 years at a cost of just 2.5% a year, so it has been little affected by higher rates, but will benefit markedly from an improving market.
Schroders forecasts a total annual return of 8%- 10% for UK real estate over the next four years, which would ensure both higher dividends and capital appreciation. The group is keen to add value to the portfolio from repurposing units on its estate and redeveloping tired buildings. Montgomery also sees opportunities in affordable housing in the inflation-linked income from hotels, “but it is more interesting to be an owner and operator than just an owner”.
Sentiment in the property market is vulnerable to higher gilt yields and global factors, he warns, but with interest rates likely to trail lower, there should be a recovery. “With a shortage of supply, we don’t need a surge in demand to see decent returns.” Share prices in the sector have started to discount such a recovery, but there should be much more to go for.
This article was first published in MoneyWeek’s magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.
