Development Outlook Summer 2023: Commercial

We analyse development activity, occupier market trends and forecasts, and the movement of capital values to gain insights into the prospects for future industrial and office construction.

Development activity

Figure 7:

New construction orders, denoting the value of new contracts awarded in the construction industry, is an indicator of future construction activity. Despite an uptick in commercial sector new orders in the third quarter of 2022, they were down 13.3% overall in the 12 months to Q1 2023 (ONS). Of the commercial sub-sectors, office new orders saw the greatest drop in that period (-22.9%), followed by retail (-21.0%) and then industrial (-2.4%). Despite these decreases, new orders for office and retail were above their longer-term averages, whereas industrial new orders were lower.

The number of project starts and submitted applications also suggest a slowdown for commercial developments (new developments over 500sqm; Glenigan). New project starts in the first half of 2023 were 23.1% below the five-year average, and 36.3% below H1 2022. Likewise, the number of planning applications submitted has decelerated, suggesting that the pipeline for construction is shrinking. In H1 2023, application submissions for new commercial projects were 16.8% below the five-year average, and 20.2% below H1 2022.

Figure 8:

Sources; Glenigan; Carter Jonas

Figure 9:

Encouragingly, 2,761 commercial projects in the UK (new developments over 500 sqm) obtained planning consent in 2021 or 2022 where development has not yet commenced (at June 2023; Glenigan). This accounts for 59.1% of the total applications approved in those years. As the economic conditions and supply chain conditions normalise, developers may move forward and bring these opportunities to the market in the near future (for those of these that have not been abandoned).

Occupier market conditions 

Figure 10:

Activity in the commercial property market has fluctuated in recent years and varied vastly according to sector. Industrial occupier demand was propelled to historic highs during the pandemic and, although weaker business conditions have slowed take-up, the structural shift to e-commerce continues to benefit the sector.  

Meanwhile, office take-up in key UK cities was boosted by the removal of pandemic restrictions, but remains generally subdued due to the ongoing uncertainty about the long-term impact of remote working and technological advances such as AI, and is especially subdued in out-of-town locations. Expanding corporate and investor sustainability targets and legal requirements have increased the focus on (often newer) buildings with enhanced environmental credentials. Likewise, the provision of high-quality, amenity-rich space is important to assist with recruitment, retention, and productivity strategies, as well as staff health and wellbeing. 

Physical retail, too, has been recovering after a difficult pandemic, but high inflation and the cost-of-living crisis has dampened consumer confidence, adding to the impact of the structural shift online for the physical retailing sector.  

Across the board, the commercial property market remains characterised by a dearth of quality supply required by occupiers for key city centre offices, last mile delivery and distribution warehousing.  

A two-tier market is increasingly apparent between prime and secondary/tertiary space, with a supply/demand imbalance for prime office and industrial stock (and stock in selected high-demand sectors such as life science laboratories). These assets have typically seen high occupancy rates and faster rental growth. As such, developers with the resources to deliver prime office and industrial properties in the near- to medium- term will benefit from resilient occupier demand.

Figure 11:

Average all-property rental values fell throughout 2019 and 2020 (see figures 10 & 11; MSCI Annual Index) but returned to growth in 2022, ending 3.8% higher than the previous year. However, this masks a disparity between sectors; whilst the industrial sector saw 10.5% rental growth in 2022, office rental values grew by 1.1% and retail by 0.1%. For retail, this marks the first year of growth (albeit minor) after four consecutive years of falling rental values. 

Looking forward, our forecasts suggest that the industrial sector will continue to see the strongest rental growth, albeit slower than the last two years. The office market should see an acceleration in rental growth, although this will be highly dependent on quality, whilst the retail sector should see only a very modest increase in average rental values. 

Capital value trends 

All-property equivalent yields experienced a downward shift as the pandemic receded, but this trend reversed in the second half of 2022 as interest rates and gilt yields rose, and the economic outlook deteriorated. All-property equivalent yields have risen by almost 150 basis points (MSCI Monthly Index), although they have broadly stabilised since January this year.

The industrial sector saw a sharper correction in values than the commercial market as a whole, despite the positive occupier story and the resilience of rental values, with average equivalent yields seeing an upward shift of more than 180 basis points.

Rising yields, combined with limited rental growth, resulted in all-property capital values falling sharply. As at June 2023, all property capital values are 21.2% lower than in June 2022 (MSCI Monthly Index). Industrial capital values are 26.5% lower (albeit from a frothy peak), with offices falling by 21.1% and retail by 15.2%. The three months to June 2023 saw a fall of only 0.4% at the all-property level. This was helped by annual rental value growth of 3.6%, driven by the industrial sector at 7.6% (with offices seeing +1.9% and retail 0.1%).

For prime assets with strong ESG credentials in favourable locations, investor demand has remained robust and they will continue to outperform their lower quality counterparts. For these assets, we expect pricing to stabilise at a faster rate and offer more certainty for developers.  

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