Commercial Market Outlook

• There was almost no growth in UK economic output during the second half of 2024, at 0% in Q3 and 0.1% in Q4 (despite the latest monthly figure for December coming in at a surprisingly strong 0.4%).

• The labour market is continuing to soften, with unemployment rising a little, and employment and job vacancies falling. A significant increase in employment costs will occur in April when rises in Employer National Insurance Contributions and the National Living Wage take effect. This will feed through to the broader economy via a mix of lower wage growth, lower employment, reduced profit margins and increased prices.

• Inflation is now accelerating again, with annual CPI rising to 3.0% in January, up from 2.5% in December. It is likely to rise further above its 2% target over the coming months with the Bank of England now expecting a peak of 3.7% in Q3.

• Following February’s 25 basis point Bank Rate reduction (to 4.5%), there should be further cuts during 2025. With inflation and pay growth accelerating, but the prospect of further subdued economic growth in the first half of the year, the Bank of England will need to perform a fine balancing act. This makes the speed and extent of further interest rate reductions particularly uncertain, with the latest consensus forecasts implying the most likely outcome is a base rate reduction of 50 to 75 basis points by Q4.

• Survey evidence points to continued weak economic growth in the near term. The latest S&P Global PMI for UK manufacturing (preliminary February figure) indicates contraction for the fourth consecutive month, showing its lowest reading since December 2023. The latest construction PMI (January) fell into contraction territory, having indicated expansion for much of 2024. However, the Services PMI is in positive territory and gained a little momentum in February, but remains below the long-term trend.

• Meanwhile, the GfK Consumer Confidence indicator rose by two points in February, but remains weak at -20. On the positive side for growth, falling interest rates (albeit gradually) will provide impetus, and earnings growth should continue to outstrip inflation (although the gap will narrow as wage growth slows and inflation rises).

• The latest consensus forecast (February) is for below-trend UK economic growth of 1.0% for 2025, revised down from 1.2% in January, although the Bank of England now expects growth of just 0.75%. This compares with an estimated 1.3% in 2024.

Recent output trends and indicators

• GDP increased by 0.4% in December, following growth of 0.1% recorded in November. Disaggregated, services output increased by 0.4% on the month, production grew by 0.5%, and construction fell by 0.2% in December.

• GDP is estimated to have grown by 0.1% during Q4 2024, following no growth over the previous quarter.

• The preliminary UK Manufacturing PMI for February fell to 46.4 from 48.3 in January, the fourth consecutive month of contraction (below 50), and the sharpest rate of decline since December 2023. Sales weakened in both domestic and overseas markets and employment levels fell significantly.

• The preliminary S&P Global Services PMI for February suggests continued expansion, rising to 51.1, from January's 50.8, but remains below the long-term survey average. The drop in new work was the fastest since November 2022, with respondents citing client budget cuts and weak business investment. Employment also continued to decline. However, expectations for activity in the year ahead edged up.

• The Construction PMI fell sharply into contraction in January to 48.1 from 53.3 the month before, ending a ten-month streak of expansion. Delayed decision making on major projects and wider economic uncertainty were cited by firms as the cause of the slowdown. Housebuilding remained in contraction for the fourth month in a row and declined at its fastest rate in a year. Civil engineering work also fell sharply while commercial construction slipped into contraction. New business orders fell for the first time in 12 months and employment levels fell for the first time in five months.

Labour market

• The UK unemployment rate was estimated at 4.4% in the three months to December 2024 (latest) marking no change over the previous month’s figure, according to the latest Labour Force estimates. There was a slight uptick in the employment rate which moved to 74.9% from 74.8% the month before.

• The early estimate of pay-rolled employee figures meanwhile showed an increase of 21,000 in January (month on month), equating to an annual rise of 49,000. The number of job vacancies decreased by 9,000 on a quarterly basis (November to January 2025), with the overall figure decreasing for the 31st consecutive period.

• Annual earnings (average, excluding bonuses) rose yet again in the latest three-monthly data, by 5.9%, up from 5.6% in the previous three-monthly reading. Average earnings in the private sector were found to have increased by 6.2%, while public sector increases were 4.7%. Sectors with the strongest growth rates were wholesaling, retailing, hotels and restaurants at 6.6%, followed by construction at 6.5%.

Inflation

• Annual inflation accelerated sharply in January to 3.0%, up from 2.5% in December, higher than consensus expectations and the highest rate since March last year. Rising prices from air fares and motor fuels together with food and non-alcoholic beverages placed the largest upward contribution to inflation while housing and household services placed the largest downward contribution.

• Core CPI (excluding volatile elements such as energy and food) rose by 3.7% in the 12 months to January, up from 3.2% in December 2024, and the CPI services annual rate rose from 4.4% to 5.0%.

• All-items CPI is likely to rise further this year, with the Bank of England now expecting a peak of 3.7% in Q3 this year. The latest consensus forecast (February) expects somewhat lower inflation, at 2.8% in Q4.

Interest rates

• At its meeting on 6th February the Bank of England’s Monetary Policy Committee cut the UK interest rate from 4.75% to 4.5%, the third quarter-point reduction since August 2024. Further cuts to the base rate are likely this year. However, with inflation and pay growth accelerating, together with the prospect of further subdued economic growth in the first half of the year, the Bank of England will need to perform a fine balancing act. This makes the speed and extent of further interest rates particularly uncertain, with the latest consensus forecasts implying the most likely outcome is a base rate reduction of 50 to 75 basis points by Q4.

• The Bank will doubtless be concerned not only by the latest uptick in inflation, but also by the acceleration in wage growth, as well as a number of inflationary risks including the increase in Employer National Insurance Contributions and the National Living Wage due to take effect this April, as well as rising household energy prices broader geopolitical risks.

Retail occupier market

• Retail sales volumes rose by more than expected in January at 1.7%, up from (a downwardly revised) -0.6% in December. Food store sales volumes rose by 5.6%, the strongest rise since March 2020, following four consecutive monthly falls. Non-food stores declined by 1.3% over the month, with clothing and footwear falling -2.7% and auto fuel down -1.2%. On an annual basis, retail sales grew 1.0%.

• Consumer confidence rose two points to -20 in February, according to GfK’s index. All five sub-measures increased, following a decline in January. The biggest improvement came from the Personal Financial Situation measure (over next 12 months) which increased four points to +2. The General Economic Situation metrics (both forward and backward looking) are still very much in negative territory at -31 and -44 respectively.

• The Q4 2024 RICS UK Commercial Property Survey shows a net balance of -12% for retail occupier demand, down from -4% in Q3, although still well up on negative balances of well below -20% seen for much of the period since 2020.

• Following a sharp declined from 2018-2021, average retail rental values have increased modestly since 2022, according to MSCI. The Monthly Index reports that average retail rental value growth accelerated to 1.7% per annum in January 2025 from 1.3% in December 2024, and the highest rate since 2008.

• The all-retail trend masks significant variation, depending on the type of property and location. Average rents for standard (high street) shops have been rising since May 2023, and rose at an annual rate of 1.3% in January 2025 (MSCI Monthly Index). Over the three months to January 2025 the increase was 0.5%, the equivalent of 1.8% over one year, a little ahead of the current actual annual rate.

• Average rental values in the retail warehouse subsector have continued to accelerate, reaching 2.4% in the 12 months to January 2025, up from a recent low of 0.6% per annum in June 2023, and highest rate of growth since 2007. On a quarterly basis, growth stands at 1.0% (three months to January 2025), the annual equivalent of 3.9% (MSCI Monthly Index).

• The annual rate of average rental growth for UK shopping centres finally turned positive in January 2025, leaping to +1.0% from -0.3% in December, as sharp falls in rental values a year ago have fallen out of the annual comparison. This is the first positive annual reading for this sector since early 2017.

Office occupier market

• Most businesses have now passed the post-pandemic period of office floorspace downsizing, and some are actively adopting policies to encourage (or mandate) employees to return to the office. The provision of high-quality offices 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 prime space.

• Occupier demand is focused on buildings that are sustainable and energy efficient, as occupiers try to meet their ESG aspirations. This is being accelerated by the next round of tightening to MEES regulations, with a minimum EPC rating of C due to take effect from April 2027.

• In many key city centre markets, a constrained volume of office development since the pandemic relative to grade A demand means there is now a considerable shortage of prime supply. This is particularly true in central London districts such as Mayfair and St James’s, which have a long-standing undersupply due to their inbuilt physical and planning constraints. But even the core City of London, which is more able to accommodate large-scale high-rise schemes, is now running low on quality floor space.

• In addition to the shortfall of immediately available space, there are only limited options to lease buildings currently under construction. A high number of pre-lettings, in reaction to low immediately available stock, have taken much of the potentially available new supply out of the market. We have also seen an increasing number of developments geared towards the life sciences sector.

• We are seeing continued strong demand for serviced and co-working provision 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.

• The Q4 2024 RICS UK Commercial Property Survey continues to show a positive net balance for office occupier demand at +3%, almost unchanged from the +4% in Q3, and slightly below the recent high of +7% in Q2. This suggests that demand has broadly stabilised at a robust level, and is in sharp contrast to the highly negative balances immediately post-pandemic. More broadly, demand remains heavily focused on prime stock, and on prime central London in particular.

• Prime rental levels have proved highly resilient, reflecting supply / demand imbalance for quality stock. Recent development schemes have set new benchmarks in several central London districts and regional city centre markets. 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 2.2% in January 2025, compared with a peak of 2.8% in March 2024. Annual growth has been relatively stable over the last six months, within a range from 2.1% to 2.4%. The quarterly growth rate accelerated a little from 0.4% in December 2024 to 0.5% in January 2025 (MSCI Monthly Index).

• Average annual rental growth in the West End / Midtown submarket has decelerated from a peak of 6.7% in July 2024, but remains strong at 5.8% in January 2025. The City of London continues to see a much lower rate of growth, at 1.3% per annum in January, although this marked the third month in a row where the growth rate has accelerated, from a low of 0.8% per annum in October 2024 (MSCI Monthly Index).

• The rest of the south east recorded average annual office rental growth of just 0.7% in January 2025, below a peak of 2.0% in January 2024, although up from a recent low of 0.5% in December 2024. Average annual rental growth in the regional markets is somewhat stronger at 2.3% in January 2025, compared with a recent low of 1.3% per annum in July 2024.

Industrial occupier market

• 2024 saw a positive occupier demand story in the UK industrial and logistics sector, with take-up rising from the recent low seen in 2023. Demand is being shaped by a variety of economic, political and technological drivers, including requirements for logistics and last mile distribution hubs, with the gradual shift online likely to continue and further rises in real household income boosting consumer demand. Supply chains will continue to evolve, and we expect to see more retailers outsource logistics functions to 3PLs, who can use their expertise to reduce costs and delivery times, and increase reliability and sustainability credentials.

• Logistics operators continue to face a shortage of labour in many parts of the UK. Labour costs are increasing, with wages rising in real terms and the National Living Wage and employers' National Insurance contributions due to increase significantly in April. The re-emergence of Amazon as an occupier taking large units will further compound the labour market pressures in certain areas.

• Occupier demand for larger distribution units has been somewhat subdued in recent quarters. However, demand for smaller size ranges has remained in line with longer term averages. Occupiers may now be looking ahead to lower interest rates, more sustained economic growth and an increase in consumer optimism. The Q4 2024 RICS UK Commercial Property Survey showed a net balance for industrial occupier demand of +7%, down from +14% in Q3. This is above the recent low of +3% in Q3 2023, although still well below the peak of +49% in Q2 2022.

• Vacancy rates have been rising over recent quarters, due to a combination of slowing demand and rising supply. However, vacancy at the national level now appears to be levelling off, and with a positive outlook for demand and relatively little speculative supply coming through, we think vacancy will peak this year and begin to decline. Demand remains focused on prime, energy-efficient space, particularly as many logistics operators are promoting their ability to maximise their clients’ sustainability credentials within the supply chain. Whilst new schemes are coming forward, the overall development pipeline remains restricted, and so the relative shortage of large high-quality units will continue.

• Competition amongst occupiers for existing and new build product has helped maintain upward pressure on rental values despite the overall lower demand levels. According to the MSCI Monthly Index, average annual industrial rental value growth peaked in August 2022 at 13.2% and has steadily decelerated from this unsustainably high rate, but remains strong at 5.4% in January 2025, still well above general inflation. Growth appears to be levelling off at around this rate, and indeed the rate measured over one quarter was 1.3% in the three months to January 2025, the equivalent of 5.3% per annum (almost identical to the actual annual rate).

• The Q4 2024 RICS UK Commercial Property Survey reported a net balance of +55% expecting prime rents to rise over the next 12 months, a continued strong reading, and up from +48% in Q3.

Transaction volumes

• Investment in UK commercial property rebounded in Q4 2024 across all but one of the main sectors, with industrials seeing a notable contraction quarter-on-quarter. Overall, £12.3bn was traded in Q4 2024. This was 29% up quarter-on-quarter and 30% up year-on-year, but 6% below the five-year quarterly average. The rolling annual total exceeded £40bn for the first time since Q2 2023, but was 23% below the five-year average of £53.5bn.

• Similar to the previous quarter, approximately 33% of all investment (excluding multi-regional portfolio deals) occurred in the London market in Q4 2024, which is below the five-year average of 51%. Investors targeted offices but also operational real estate assets, such as hotels. Overseas capital continued to support volumes in London, accounting for 54% of the total.

• The alternative sectors accounted for the largest share of the Q4 total at 39%, while both the alternative and retail sectors recorded volumes above the five-year quarterly average. Offices accounted for the second-highest share of the volume traded in Q4 at 24% of the total, with industrials accounting for 16%.

• Overseas investment in UK commercial property totalled £5.5bn in Q4 2024, up 21% quarter-on-quarter and 17% above the five-year quarterly average. It accounted for 45% of total investment, below the 10-year average of 51.9%. US investors continued to account for the highest share of overseas investment in Q4 2024, totalling around £3.4bn, notably above the £2.1bn spent in the previous quarter. European investors had another strong quarter, with just under £1bn invested and above the £800m spent in Q3 2024.

Recent investment performance

• Following a sustained period of upward yield movement from mid-2022 to the end of 2023, commercial property yields were broadly flat during 2024 at circa 7.1% (MSCI Monthly Index). The last three months have seen a modest downward movement to 7.0% as at January 2025. In contrast, 10-year gilt yields have been on a broadly rising trend since last September. However, there has been a recovery from the recent brief spike in gilt yields (caused by market concerns around US interest rates and UK growth and inflation) which hit 4.9% in mid-January, and currently stand at 4.5% as at 25th February. These trends have resulted in a narrowing of the gap between property and gilt yields from circa 350 basis points at the start of 2024 to circa 250 basis points currently.

• Average all-property rental values have increased consistently at a rate of over 3% per annum over the last two years. The rate of growth stood at 3.4% per annum in January 2025 (MSCI Monthly Index). With stable property yields during 2024, capital growth performance improved rapidly, and year-on-year all-property capital value growth finally turned positive in December 2024 at 1.1%. This compares with a low of -21.2% in mid-2023. Coupled with some recent modest downward yield movement, the annual rate of capital vale growth rose to 1.5% in January 2025, with growth over the three months to January standing at 1.2% (the annual equivalent of 4.9%). We should therefore see a further acceleration in the annual rate.

• Capital growth performance varies considerably across the main commercial property sectors. Industrial and retail are outperforming the all-property average, with annual growth in January 2025 standing at 4.3% and 3.5% respectively. In contrast, office capital values are continuing to fall on an annual basis, at -4.9% over the 12 months to January 2025. However, capital value performance is improving across all three main commercial sectors. Over the period October 2024 to January 2025, industrial capital values rose by 1.9%, retails increased by 1.4%, and the fall in the office sector was only -0.2%. Indeed, office capital values have now broadly levelled off, showing no net change during December and January (MSCI Monthly Index).

• The all-property annual total return was in positive territory throughout 2024, accelerating to +7.5% by January 2025 (MSCI Monthly Index). The industrial annual total return is now +9.6%, compared with a low of -23.2% in June 2023. Retail annual returns turned positive in December 2023 and increased sharply to +10.9% in January 2025, compared with a low of -9.6% in July 2023. The total return for offices turned positive in January 2025 at +0.5%, compared with a low of -18.9% in August 2023 (MSCI Monthly Index).

Investment outlook

• The uptick in market activity during Q4 2024 is a positive signal, although transaction volumes remain below longer-term averages. Investor sentiment in UK real estate remains strong, and we expect a continued improvement in market conditions as the year progresses, boosted by further interest rate reductions.

• That said, concerns remain around the risk of further stagnation in economic growth, largely as a consequence of the fiscal changes introduced in the October Budget, together with inflation rising further above target for a while.

• The industrial and residential sectors remain the most favoured among investors, both domestic and international.

• Demand for regional offices is showing signs of increased activity, particularly in markets with strong occupier demand for assets that are well-located, possess robust ESG credentials, or are viable for conversion to alternative uses, especially residential.