Commercial property as an asset class is currently under the microscope, with the Covid-19 pandemic accelerating certain structural changes that were already putting pressure on parts of the market. Challenges include the rise of online retailers at the expense of bricks and mortar retailers and the demand for office space, which is under threat from a potential increase in the level of remote working moving forwards. These pressures are paired with the fact that commercial property is somewhat geared towards GDP growth, which might be challenged in the short-term. Consequently, our short-term outlook for commercial property has weakened when compared to our view twelve months ago. However, the values of many of the vehicles we use to access the UK commercial property market fell significantly over the first half of this year, discounting an extremely negative outlook for the sector. Whilst we do not dispute the structural challenges above, we would contend that some of these may be met with counterbalancing forces. In our latest investment bulletin, we explore the three traditional commercial property sectors (office, retail and industrial), providing a market outlook for each sector and what it means for client portfolios.
In the office sector, the government’s encouragement to work from home during lockdowns has negated the need for much office space in the short-term. The proportion of employed people working from home in the UK was well in excess of 40% during April (Figure 1), although the level of homeworking varied across industries, as workplace dynamics dictated.
Source: Office of National Statistics, April 2020
All else being equal, should this dynamic persist post-pandemic, it would likely place downward pressure on demand for office buildings and thus lower rents earnt by landlords. We feel it is reasonable to expect that there will be an increased level of homeworking in many traditionally office based professions when compared to prior levels. This may mean that companies budget for fewer employees in the office on a daily basis. However, we do not think this means the concept of the office as a place of work is now defunct.
Face-to-face interaction amongst colleagues not only carries important social benefits, but is also a key driver of innovation and creativity through collaborative working. We believe it would be a bold decision for companies to write-off the potential for this manner of communication completely, and those that do may risk falling behind their peers. Indeed, since April, as lockdowns have begun to ease, the number of employees working remotely has fallen to 28%.
In addition, for employees that do return to the office in the future, businesses may need to provide more space per individual. Although social distancing will not be required forever, this experience will likely force companies to consider the attractiveness of the working environment they provide for their employees. As a result, the Covid-19 pandemic might be the catalyst that reverses the decade-long trend we have seen of companies providing less office space per employee to minimise their rental burden.
Source: Cushman & Wakefield Research; Bureau of Labor Statistics; Moody’s, January 2020
What we can say with certainty is that there will be conflicting pressures on supply and demand in the future driven by the above, and other, dynamics. On the supply side, it is interesting to note that a number of prime regional centres including Oxford, Cambridge and Bristol have experienced rental growth in their office markets this year, driven by an undersupply of top-quality, ‘grade A’ office assets. Further, Savills estimate that 8 of the 10 key UK regional office markets are undersupplied with grade A office space at present.
Overall, we believe that the outlook for the office sector is both nuanced and unclear at this stage. In our opinion, office tenants will likely demand higher quality working space that conforms to high standards of hygiene and user comfort, provides for social distancing and scores well on environmental impact. Flexible office space might play a bigger role in some companies’ plans moving forwards, but this will not work for everyone. Companies may have fewer employees in the office at one time, but they will likely desire more floor space per employee. There will be winners and losers at a property level in this type of market, but this should provide opportunity for our fund managers in the space and, in our view, does not signal the end of the office market as some have foretold.
The retail sector has struggled considerably as a result of the coronavirus outbreak, with all non-essential retailers having to shut up shop for most of the second quarter of 2020. Changing consumer behaviour has weighed on the sector for some time, as demand for physical retail space has declined with the rise in online consumption. This has only been exacerbated by the pandemic. As restrictions have eased and the high street has opened up to consumers, some pressure has been lifted from the sector, but the imposition of further lockdown measures over November are a cause for concern. This is particularly true for smaller retailers that have less access to funding support through the capital markets and face the challenge of surviving another period in which they cannot generate much revenue.
However, the retail commercial property market is not a ‘one-size-fits-all’ market. Properties can vary from single retail units on the high street, to out of town retail parks (“retail warehouses”) through to shopping centres. The latter in particular have been struggling as consumer behaviour has changed. The move to increased online shopping, a trend strengthened temporarily at least during the pandemic (Figure 3), has put significant pressure on footfall in shopping centres across the UK.
Source: Refinitiv Datastream, October 2020
Reductions in footfall impair the ability of tenants to operate units within these centres profitably, as consumers continue to shop online. This has led to material reductions in the value ascribed to many shopping centres over 2020, which is a continuation of a trend seen over the last few years. The shopping centre owner Intu was a high-profile casualty of this dynamic earlier this year, going into administration in June.
Our allocations in the commercial property space have no exposure to this extremely challenged segment of the market.
Instead, the bulk of our exposure to the retail sector comes either from the high street, or in many cases, the retail warehouse sector. Whilst these sectors have not been immune to price falls, they have characteristics that make the outlook more balanced. For example, some of our high street units are let to supermarkets on long, inflation-linked lease agreements. These provide access to inflation-linked income payments from tenants that have traded very resiliently through the pandemic. Other units have clear alternative use cases, such as conversion to residential, which can underpin valuations to some extent.
The retail warehouse sector – where a large portion of our property allocation is invested – has traded more resiliently than the other retail sub-sectors through the pandemic. This has been driven by a number of dynamics, including the accessibility of their locations via car and the fact that a number of common tenants on these sites have been able to remain open during lockdowns (e.g. DIY stores and budget supermarkets). Consequently, footfall in the sector has remained more robust than other areas of the retail market (Figure 4).
These sites also often have compelling alternative use potential, helping to underpin valuations. They are typically close to major urban conurbations, making them attractive locations for last mile delivery logistics centres, which are in strong demand at present.
Source: Office of National Statistics, November 2020
Much like the office sector, we believe there will be winners and losers in the retail sector on a property-specific level, but we have not lost belief that accessing the right parts of the market can deliver positive investment returns.
The third key traditional commercial property sector is the industrial sector, typically comprised of warehouse sites used for logistics or storage. For this sector, Covid-19 has accelerated and strengthened structural trends that were positive for the sector. In particular, the rise of online shopping mentioned above provides structural positive support for valuations in this sector, as there is more demand for last mile delivery storage hubs, for example.
Indeed, despite the unprecedented nature of the year to date in terms of economic disruption and uncertainty, the industrial sector has generated record levels of leasing activity over 2020. The agreement of new leases on logistics units to the end of the third quarter of the year has already exceeded that of any year in the last decade, with a quarter’s worth of activity still to come (Figure 5).
Source: CBRE, at 30 September 2020; showing take-up of Second-hand, Built to Suit (i.e. built to tenants’ specification) and speculatively developed logistics units in the year to date.
Significantly, 37% of the logistics unit take-up this year3 has been by online retailers requiring additional warehousing space, driven by the increase in online retail transactions as noted above. This highlights clearly that this sector has been a direct beneficiary of the structural pressures which have been a headwind for the bricks and mortar retail sector, and especially so in the year to date.
Whilst the pressures on brick-and-mortar retailers has placed some downward pressure on rental growth achievable from retail units, we have seen the reverse in this sector. Rents achievable from assets in the industrial sector have continued to rise and have reached record levels this year as a result of the strong demand for space (Figure 6).
Source: CBRE Big Box Logistics Rents
These trends should be supportive of industrial valuations moving forwards and highlight that exposure to this sector provides a clear counterbalance to the pressures facing the retail and office sectors. This should provide a stable base in a portfolio of diversified commercial real estate, such as the ones into which we invest.
Indeed, many of the investment managers we use in the property sector have noted the positive trends benefiting the logistics sector over recent years and have pivoted their portfolios towards the sector as a result. The result of this is that the average exposure to industrial assets within our recommended commercial property investment trusts is 40%. This is despite the fact that there are four sectors across which they can invest (retail, office, industrial & ‘alternatives’ – comprising assets such as hotels, pubs, leisure facilities).
As we said at the start of this bulletin, our view on the commercial property sector as a whole is less positive than it was 12 months ago and we accept there are structural pressures on parts of the market.
However, property remains an income-generating asset class, as the majority of the return for an investor comes from rental payments by an asset’s tenants. Through time the capital values of properties tend to fluctuate but balance out (assuming an investor remains invested), with the income generated from the underlying leases making up the majority of the total investor return.
In the short-term, Covid-19 has disrupted payments of income, as some tenants were given rental holidays and some have refused to pay rent through the year. However, rent collection within our recommended property investment trusts has been surprisingly strong given the environment, with many having reinstated or increased dividends that were suspended or cut in the immediate aftermath of the lockdown in March.
In our view, the fact that property is income-generative should be supportive of the asset class in the medium-term, particularly in the current environment of extremely low bond yields. Fund managers’ underlying property selection will be increasingly important moving forwards, as there will be winners and losers from the structural trends noted above. These have become prominent points of discussion in our regular interactions with managers in this space.
Overall, we still feel a modest allocation to the sector can play a diversifying role in portfolios and as such, we do not feel that reducing client allocations at this stage (potentially locking in a loss for clients) is prudent, when current valuations still imply a significantly negative outlook for the entire sector. The sharp increase in property investment trust share prices following the news in early November of a successful Covid-19 vaccine trial is an indication that valuations of the vehicles we use to access the sector can recover rapidly when sentiment improves.
With all of the above said, we are investigating ways to diversify our clients’ future allocations into a wider selection of commercial property sub-sectors, with alternative return drivers on the right side of structural changes. These cover many sub-sectors from commercial property used in the provision of healthcare services to self-storage, for example. We expect to be able to provide a further update on this in the new year.
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