Commercial Market Outlook

• Recent market indicators suggest the UK economy is showing continued resilience as GDP returned to growth in August, retail sales rose, and business confidence indicators for services and construction remained in positive territory. Although the labour market displayed some encouraging signs, it continued to soften overall, a trend that has been ongoing since the start of the year.

• The Budget contained a significant increase in the overall tax burden, raising an additional £36 billion per annum, presented as a one-off rise. Together with additional borrowing of £32 billion per annum, this means a sustained increase in government spending, rising by almost £70 billion per annum over the next five years (a little over 2% of GDP). As a result, the size of the state is forecast to settle at a record 44% of GDP by the end of the decade, almost 5 percentage points higher than before the pandemic.

• A key measure announced in the Budget was to increase National Insurance (NI) employer contributions. This is likely to feed through in part to lower average wages (particularly for low paid workers), although the Chancellor also confirmed an increase in the National Living Wage to £12.21 per hour from April 2025. These measures together are likely to hold back employment growth and have a modest loosening impact on the labour market.

• Donald Trump’s decisive election victory plus a Republication-controlled Senate are positive for domestic US political stability. US economic policy will look very different however, with significant tax cuts funded through higher borrowing and the spectre of tariffs on imports into the US. These policies may result in slightly higher US inflation and interest rates than would have been the case under a Democrat administration.

• Following strong GDP growth in the first half of 2024 (0.7% in Q1 and 0.5% in Q2), the economy appears to have slowed a little in the first two months of Q3 (zero growth in July and 0.2% in August). The Office for Budget Responsibility (OBR) assesses that Budget policies will give a temporary short-term boost to growth, but will ‘crowd out’ some private sector activity in the medium term. A third of the additional revenue generated is destined for capital spending, which should be positive for growth over the longer term. In its assessment for the Budget statement, the OBR forecasts GDP growth of 2.0% in 2025, 1.8% in 2026, and then decelerating to around 1.5% per annum.

• Annual CPI inflation fell to 1.7% in September, down from 2.2% in August. This marks the lowest rate of inflation since April 2021. However, inflation is now likely to rise modestly, with the September consensus forecast expecting CPI of 2.5% in Q4 this year. The OBR expects CPI to remain close to the 2% target over the next five years, albeit with a temporary rise to 2.6% in 2025 (driven by higher energy prices, the net impact of Budget announcement, and broader supply side pressures). The OBR also cites significant uncertainties to the inflationary outlook.

• The Bank of England’s Monetary Policy Committee reduced the base rate by 25 basis points to 4.75% at its November meeting, marking the second reduction from a peak in the current cycle of 5.25%. A further base rate cut in December appears unlikely, with the Bank expecting the Budget to add to inflationary pressures (by just under half a percentage point on CPI at its peak). The Bank now expects CPI inflation to increase to around 2.75% by the second half of 2025 (broadly in line with the OBR).

Recent output trends and indicators

• Monthly GDP grew by an estimated 0.2% in August, following no growth recorded in both June and July. Disaggregated, services output rose by 0.1% while production output increased 0.5% and construction grew 0.4%. In the three months to August growth is estimated to have been 0.2% with services output being the main contributor, increasing by 0.1%.

• The S&P Global Flash UK Manufacturing PMI fell to 49.9 in October of 2024 from 51.5 in the previous month (just below the ‘50’ mark indicating expansion). New orders fell due to a wait-and-see approach before the Budget and overseas orders fell for the 33rd month. Employment increased for the third time in the last four months, albeit at a slower pace due to lower demand. Business optimism recovered slightly from a nine-month low in September.

• The UK Services PMI also fell in October to 51.8 from 52.4 in the previous month, but remains in positive territory. Firms continued to deplete backlogs of work to support output levels, and excess capacity, cost-cutting pressures, and broad concerns over the economic outlook resulted in job reductions. Looking forward, business confidence continued to soften.

• The UK Construction PMI meanwhile rose well past expectations increasing to 57.2 in September, up from 53.6 previously. This marks the highest rate of expansion in the sector since April 2022 and is the seventh consecutive month of expansion. New orders expanded at their fastest pace in over 2.5 years and overall activity rose to its strongest in nearly three years. Civil engineering projects increased the most on the month although both commercial and residential work also rose at strong rates.

Labour market

• According to the latest Labour Force Survey the UK employment rate edged up slightly in the three months to August, moving to 75.0% from 74.8% in the previous reading. The unemployment rate also moved down slightly to 4.0% from 4.1% previously.

• Job vacancies fell again for the 27th consecutive reporting period, down 34,000 during the quarter to 841,000 total vacancies.

• Finally, annual growth in employee wages showed a rise of 4.9% on average, down from 5.1% the previous month. This is the slowest rate of growth since June 2022 as wage growth eased in both the private and public sectors. Manufacturing posted the highest annual increase at 6% while finance and business services saw the lowest rate at 4.4%.

Inflation

• Annual CPI inflation declined to 1.7% in September, down from 2.2% in August. This marks the lowest rate since April 2021. The largest monthly downward contribution came from transport, particularly air fare and motor fuel prices. Prices also fell for housing, utilities and furniture and household equipment while costs rose at a lower rate in recreation and culture, restaurants and hotels.

• Services inflation fell from 5.6% to 4.9%, still well above general inflation. Core CPI (excluding volatile elements such as energy and food) also fell, from 3.6% to 3.2%.

• With last year’s declines in energy prices now falling out of the annual comparison, the consensus forecast is for CPI of 2.5% in Q4 this year before reducing modestly to 2.2% by Q4 2025. However, the OBR expects somewhat higher inflation of 2.6% for 2025, and the Bank of England now expects CPI inflation to increase to around 2.75% by the second half of 2025 (broadly in line with the OBR).

Interest rates

• The Bank of England’s Monetary Policy Committee (MPC) reduced the base rate by 25 basis points to 4.75% at its November meeting, marking the second reduction from a peak in the current cycle of 5.25%. The decision was decisive, with eight of the nine MPC members voting to cut.

• The Bank commented that the Budget has boosted economic growth but added to inflationary pressures (by just under half a percentage point on CPI at its peak). In addition, the downward path of interest rates in the US may now be slower following the election result. Given this, and broader uncertainties over the impact of the Budget, it appears unlikely that the base rate will be cut again at the MPC’s December meeting.

Retail occupier market

• Retail sales volumes rose by 0.3% in September, down from 1.0% in August. Computers and telecommunications sales grew strongly but this was offset by falls from supermarket sales. Overall, sales at non-food stores rose sharply by 2.5% while food store sales declined 2.4%, the largest fall of the year in this sector. Year on year sales volumes have risen by 3.9%, the largest annual increase since February 2022.

• The GfK Consumer Confidence indicator for October slipped another point to -21, down from -20 in September. This is the lowest level since March with the likely cause of the downbeat mood being the Budget. Of the sub-measures, consumers’ feelings about the general economy in the year ahead worsened while their feelings about their own personal finances improved slightly.

• The Q3 2024 RICS UK Commercial Property Survey shows a net balance of -4% for retail occupier demand, similar to the -5% in Q2, but a noticeable improvement compared with -25% this time last year. Respondents continued to cite an increase in overall vacant space.

• Average retail rental values have shown very modest growth since 2022, according to MSCI. The Monthly Index reports that average retail rental value growth in the 12 months to September 2024 was 0.9%, and has been within a range of 0.5% to 0.9% on this measure since October 2023. However, average retail rental values remain 16.3% below their previous peak in 2018.

• The all-retail trend masks significant variation, depending on the type of property and location. Average rents for standard (high street) shops fell almost continuously from May 2018 to May 2023, by circa -29%. However, growth has returned over the last year. Annual growth accelerated to 1.9% by May 2024, but has subsequently slowed to 0.5% over the year to September 2024 (MSCI Monthly Index). Performance is being driven by the London market.

• Average rental values in the retail warehouse subsector are continuing to rise, by 1.6% in the 12 months to September 2024, the highest rate of rental growth since 2007. On a quarterly basis, growth stands at 0.6% (three months to September 2024), the annual equivalent of 2.4%.

• Average rents for shopping centres have also returned to growth in recent months, rising by +0.8% in the three months to September 2024. This improvement is feeding through to the annual figure, although it is still in negative territory at -0.4%.

Office occupier market

• The longer-term impacts of the working-from-home revolution mean that many businesses have been assessing their real estate footprint, although the level of downsizing is highly business-specific and has now declined noticeably. Indeed, national occupancy rates have broadly levelled off, and the three-day office week has emerged as the new normal.

• Although corporate real estate is the second-highest cost after salaries for many businesses, the provision of high-quality space 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 high-quality space.

• There is also a much greater focus on buildings that are sustainable and energy-efficient, as occupiers try to meet increasingly ambitious ESG aspirations. This is being accelerated by the changes to MEES regulations which came into force in April 2023, with the next round of tightening due in 2027.

• 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 Q3 2024 RICS UK Commercial Property Survey continues to show a positive net balance for office occupier demand at +4%, down a little from a recent high of +7 in Q2, and similar to Q1’s +6. Whilst this suggests a relatively modest level of demand, it does appear to have stabilised, and is in sharp contrast to the highly negative balances immediately post-pandemic. More broadly, demand remains heavily focused on prime stock, and in prime central London in particular. The RICS survey suggests that availability is continuing to rise, with the Q3 balance standing at +26 on this measure. Again, this will be reflecting the market as a whole rather than prime stock, which remains in very short supply in key markets.

• Prime rental levels have proved highly resilient, reflecting the focus of occupier demand towards top-quality space of which there is little available 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 2.4% per annum in September 2024, unchanged from August. Indeed, annual growth has been within a range of 2.2% to 2.8% during 2024 so far, contrasting with the post-pandemic low of 0.8% recorded in January 2023 (MSCI Monthly Index).

• Average annual rental growth in the West End / Midtown submarket stood at 6.0% in September 2024 on the MSCI Monthly index, down slightly from a recent peak of 6.7% in July 2024. In contrast, the City of London saw annual growth of 1.2% in the year to September 2024, also representing a fall from a recent peak of 2.3% (in March of this year). The rest of the south east recorded average annual rental growth of 1.2% in September, below a recent peak of 2.0% in January. Average annual rental growth in the regional markets was 2.1% in September, above a recent low of 1.3% in July, but slightly below the peak of 2.4% recorded in January of this year.

Industrial occupier market

• Industrial and logistics take-up has reduced following the exceptionally strong demand experienced during 2020-2022, driven by pandemic-specific requirements as well as accelerated change in global supply chains. Longer-term structural change continues to generate occupier demand, most notably the influence of e-commerce, with ‘last mile’ units for urban delivery being a key area.

• Occupier demand for larger distribution units has been somewhat subdued in recent quarters, amid political uncertainty and elevated interest rates. 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 post Budget. The Q3 2024 RICS UK Commercial Property Survey showed a net balance for industrial occupier demand of +14%, up from +10% in Q2 and a 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 the supply of high quality, energy efficient new units remains very limited across many key markets. This is where demand is focused, 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. 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 6.2% in September 2024, still well above general inflation. Growth appears to be levelling off at around this rate, and indeed the rate measured over one quarter has been accelerating modestly, from a low of 4.6% (annualised) in the three months to March 2024 to 5.9% in the three months to September.

• The Q3 2024 RICS UK Commercial Property Survey reported a net balance of +48% expecting prime rents to rise over the next 12 months, a continued strong reading, albeit down from +59% in Q2. A net balance of +18% expected secondary rents to increase (also down a little on Q1).

Transaction volumes

• UK commercial property investment volumes have been broadly stable over the last few quarters. Total investment eased marginally in Q3 2024, with activity in the alternative sectors seeing a notable contraction quarter-on-quarter, while the office, retail and industrial sectors all recorded a marked uptick.

• £9.5bn was traded in Q3 2024. This was down 4% quarter-on-quarter, 29% below the five-year quarterly average, but 17% up year-on-year. The rolling annual total was marginally above the previous quarter but was 29% below the five-year average of £54bn.

• Approximately 33% of all investment (excluding multi-regional portfolio deals) occurred in the capital in Q3 2024, which is on par with the share recorded in the second quarter but below the five-year average of 51%. Investors targeted offices in prime locations as well as assets in the living sectors, such as hotels and built-to-rent. Overseas capital continued to support volumes in London, accounting for 56% of the total.

• Conversely, investment in the regional markets (UK excluding London) accounted for 67% of the total, in line with the share recorded in Q2 2024. The South East region recorded the highest level of investment outside the capital, with circa £820m purchased in Q3 2024, followed by the West Midlands with £650m.

• The alternative sectors accounted for the largest share of the quarterly UK total in Q3, at 32%. The industrial sector accounted for 28% of the total, with offices at 23% and retail at 17%. As a proportion of the total, the alternative, industrial and retail sectors were all slightly above the five-year average, whilst offices were well below the average.

• Overseas investment in UK commercial property totalled £4.6bn in Q3 2024, up 11% quarter-on-quarter but 22% below the five-year quarterly average. As a percentage of total investment, it accounted for 48%, marginally below the 10-year average of 51.9%. US investors had the highest share of overseas investment in Q3 2024, totalling around £2bn.

Recent investment performance

• Property yields have been relatively stable in recent months across all the main commercial sectors, and the all-property equivalent yield has remained at circa 7.1% since February 2024. This follows the sharp correction witnessed during the second half of 2022 (in reaction to rising interest rates and gilt yields, political uncertainty, and occupier demand uncertainty), and a more gradual upward shift in yields during 2023.

• 10-year gilt yields stood at 4.0% at the end of September 2024, compared with a recent low of 3.4% at the end of 2023, and a recent high of 4.4% in May 2024. As at the end of September 2024, the gap with the all-property equivalent yield was therefore 310 basis points, compared with 290 basis points in June 2024, 350 basis points in December 2023, an average of more than 500 basis points in the decade to the end of 2020.

• Gilt yields have subsequently seen some volatility as a result of the Budget, rising in the lead-up to and also following the Chancellor’s statement due to concerns over higher future debt levels, together with a higher market expectation for inflation and interest rates. The 10-year gilt yield is currently almost 4.5% (4th November).

• Although values have continued to fall year-on-year at the all-property level, capital value performance has improved significantly over the last year, standing at -2.8% per annum in September 2024, compared with -4.7% three months ago and -21.2% per annum at the bottom of the cycle in June 2023 (MSCI Monthly Index). However, with the stabilisation of yields, plus relatively healthy and consistent rental growth (currently +3.7% pa), capital values have started rising modestly in recent months. Indeed, all property capital values have increased by +0.6% over the six months since bottoming out in March 2024.

• Capital growth performance varies considerably across the main commercial property sectors. Industrial capital value growth was in positive territory in the 12 months to September 2024 at +0.8%, according to the MSCI Monthly Index, with positive rental growth more than offsetting upward yield movement. This contrasts with capital growth of -2.3% for retail property and -10.5% for offices. Taking just the last three months, where yields have been broadly flat, industrial capital value growth performance was stronger at +1.1%, the equivalent of +4.3% on an annual basis. Retail has seen significantly improved performance recently, with capital values rising by +0.5% over the three months to September (annual equivalent +1.9%) whilst office capital values fell by -1.0% (annual equivalent -3.9%).

• The all-property annual total return peaked at 25.1% in May 2022, and then decelerated sharply, bottoming out at -16.9% per annum in the year to June 2023. Performance has been in positive territory during 2024, reaching +2.9% pa in September.

• The industrial annual total return is now +5.9%, compared with a low of -23.2% in June 2023. Retail annual returns turned positive in December 2023 and increased sharply to +4.7% in September 2024, compared with a low of -9.6% in July 2023. The total return for offices remains in firmly negative territory at -5.3% per annum in September 2024, but performance has steadily improved in recent months, and is now well above the low of -18.9% in August 2023 (MSCI Monthly Index). However, taking just the last three months, all three sectors are in positive territory (+2.3% for industrial, +2.2% for retail and +0.4% for offices).

Investment outlook

• The Q3 2024 RICS UK Commercial Property Survey showed a net balance for investor enquiries of zero, compared with readings of -4% during the first half of this year. This therefore paints a picture of relatively flat but modestly improving demand. Industrial enquiries remained positive, rising slightly to +14% in Q3 from +10% in Q2. Office and retail remained in negative territory in Q3, at -7% and -10% respectively, although both improved modestly from their Q2 readings.

• Transaction volumes remain muted in a historical context, but following an understandably quieter-than-normal summer period, we have noticed a recent uptick in market activity, particularly in the industrial, retail warehousing, and living sectors, with sentiment now focused on when the market will start to improve.

• With consumer price inflation having been within 30 basis points of the Bank of England’s target for six consecutive months, investors are now more positive around continued base rate reductions albeit gradual. Together with more certainty post Budget, we can expect higher transactional volumes in the following quarter, with the potential for yields to sharpen as investor competition increases.

• With improved confidence and reducing debt costs, we anticipate an upward trend in pricing, albeit a gradual upturn. Many investors will now be readying themselves for increased opportunities and activity over the next 12 months. We are now seeing portfolios and larger lot sizes come to the market, which is a further sign of positivity returning to some sectors.

• The focus remains on core assets in strong locations with increasing demands for ESG-compliant buildings, and this is where yield compression may be witnessed.