The combination of home working, weak economic growth and rising interest rates created a tough environment for the UK commercial property sector, which has persisted in spite of an economic revival.
Companies do not need as much space, which has depressed rents and valuations, meanwhile money exited the sector, lured by the higher yields on offer in fixed income. However, there are tentative signs of a change in fortunes.
The Royal Institution of Chartered Surveyors commercial property monitor shows the UK market reviving in the first quarter of the year, led by some notable deals. For example, BT Group agreed the sale of the BT Tower for £275mn to MCR Hotels, who plan to preserve it as an iconic hotel.
Tenant demand rose 4 per cent, with the industrial sector particularly strong and office demand rising for the first time since 2022.
In the same week, Mark Allan, chief executive of Land Securities, said the market for higher quality UK commercial property was improving.
“Macroeconomic signals look more encouraging than they have for a while . . . absent any further macro shocks, we think the value of high-quality assets has largely bottomed out and will start to grow in the foreseeable future as rents rise,” Allan added.
That is not to say that there are not still problem areas. In February, some of the commercial property sector’s problems were laid bare with the disastrous sale of Canary Wharf office, Five Churchill Place. This was sold at a 60 per cent discount to its last sale price and became a bellwether for the difficulties in the market.
The biggest factor in the recent revival appears to be a stabilisation of interest rate expectations.
The spike in takeover activity this past year shows acquirers are rushing in to take advantage.
Marcus Phayre-Mudge, fund manager of TR Property Investment Trust, says that share price action is still being driven by base interest rate expectations to some extent, but as the path on interest rates becomes clearer, investors are beginning to differentiate between the less desirable elements of the sector and companies that own quality assets and have strong balance sheets.
Phayre-Mudge says: “These false dawns have led to many investors remaining on the sidelines, awaiting harder evidence of base rates falling. Our central case is that this point is drawing ever closer, but crucially, our positioning and optimism is not dependent on major reductions in interest rates. The companies we own have balance sheets which can withstand rates remaining at current levels.
“The spike in takeover activity this past year shows acquirers are rushing in to take advantage, where public markets have left quality assets languishing at significant discounts.”
This has been seen in some frenzied merger and acquisition activity among property investment trusts.
In the past couple of months alone, Abrdn European Logistics Income concluded its strategic review and said it would wind down, while Brookfield Asset Management said it was assessing a possible cash offer for Tritax EuroBox.
In January, Custodian Property Income Reit plc and Abrdn Property Income Trust Ltd agreed an all-share merger, and then in February, Tritax Big Box Reit plc said UK Commercial Property Reit Ltd had agreed to an all-share takeover.
In its report, Rics said that tenant demand also reflects this bifurcated market: “Tenant demand is becoming more split across location. In London, office demand significantly increased this quarter while elsewhere in the UK the picture is either flat or slightly negative.
“Retail demand is also showing stronger momentum in London than other parts of the UK. Industrial property demand remains steady, with most regions reporting positive demand sentiment.”
This is still a market where it is important to tread carefully. Where property companies have debt, they will need to refinance at considerably higher rates when that debt expires. ‘Problem’ debt is rising in the sector and this is another reason to stick firmly to the higher quality end of the market.
The TR Property Investment Trust has been relatively stable in a tough commercial property market. Its net asset value growth over the past year is 21.6 per cent and it remains at a 3.73 per cent discount to NAV. It also has some exposure to Europe, which has helped diversify its portfolio.
If investors are tempted to dip a toe back in UK commercial property, it may be worth balancing UK exposure with other types of commercial property exposure.
Time Commercial Long Income, for example, aims to provide a secure and stable investment return by buying commercial freehold ground rents and commercial freehold property (known as long income property), which benefit from long leases. It has shown its credentials as a diversifier.
Europe has already started on its rate-cutting cycle. As such, European exposure can be useful.
An end to central bank tightening tends to be followed by notable strength in listed real estate.
Cohen & Steers European Real Estate Securities invests in a portfolio of European-listed Reits. Its top holdings include German real estate group Vonovia and shopping mall group Klépierre.
Manager Leonard Geiger is optimistic: “An end to central bank tightening tends to be followed by notable strength in listed real estate. In addition, cash flows generally remain sound, and we anticipate healthy earnings growth in 2024.”
CT European Real Estate Securities is another option.
Infrastructure can be less cyclical than commercial property and First Sentier Global Listed Infrastructure would be our main pick there.
The sector is not out of the woods yet, but there are signs that it is starting to stabilise.
The commercial property sector should be a source of steady, inflation-adjusted income and stable capital growth, but it has been through an unusual period. Hopefully, this is about to come to an end.
Darius McDermott is managing director of Chelsea Financial Services and FundCalibre