Prior to the pandemic, we were generally optimistic about UK commercial property. We were bulls of industrial property, anticipating with many others the growing demand for warehousing for the online shopping revolution and technology space for the fast-growing digital businesses.
We were fairly optimistic about office accommodation, seeing the slowdown in new developments and the possible emergence of a tighter market as a result. We were negative about retail, believing there to be too much shopping space and expecting the market share gains of online retail to continue at the pace established over recent years
As soon as the pandemic hit, we became more negative – with the continuing exception of industrials. The lockdowns accelerated the trend to online retail, intensifying demand for warehouse space to execute transactions and allowing still higher valuations of the properties. It also speeded up the movement away from in-store retail, adding to the falls in rents and the increase in unwanted space, which was beginning to emerge prior to the virus taking over our lives.
We also became worried about offices, pointing to the difficulty of knowing how much office space companies will need if we return to a hybrid form of working, with more work being done at home. Specialist areas such as hotels were hit for the duration of lockdown and travel restrictions, and leisure cashflows were disrupted by closures or social distancing.
Valuations still uncertain
As the UK works its way through a timetable to remove controls as vaccines are rolled out, the leading landlords and valuers are seeking to come to a view of what a realistic level of valuations looks like.
Last week, we saw the annual report of Land Securities, now the second-largest commercial property company. This one-time leader has been eclipsed in value by Segro, the industrial property specialist.
Land Securities has a substantial office portfolio, a smaller retail portfolio, and some assets in leisure and hotels. It reported a 38% fall in the value of regional shopping centres, a 26% fall in London shops, a 23% fall in leisure and 13% fall in hotels, along with a much more modest fall of 4% in offices. It is hopeful that the market in retail property is now somewhere near the bottom, and management says it will look for interesting retail property investment opportunities. it will need to be selective.
The shopping centres and high streets still have high void levels and the retail sector is living through a substantial number of bankruptcies. It may be that a fifth of the available space needs to be repurposed, as people look at schemes to convert retail to residential, office or services use or consider demolition and redevelopment.
To carry through such a large programme of change needs low valuations of the underlying shop properties. For a shop that cannot find a profitable tenant, the true value is alternative use value after allowing for conversion costs, which is often well below even today's shrunken valuations as a shop.
There are opportunities
Land Securities is doubtless right that some shopping centres and high streets will recover well and will perform based on the right offer of shopping, meals, drinks, services and experiences packaged together, with good active promotion of the centre, and with good access and parking. Many others will struggle whilst waiting to fill the voids and bring forward the conversions and redevelopments to tackle an underlying glut of retail space.
Offices remain difficult to judge as there is no clear pattern yet emerging of how much flexible- and homeworking there will be after the pandemic and what this will mean for how much space companies will continue renting. It seems likely there will be more flexible working and likely that, as leases fall for renewal, a significant number of companies will downsize.
Land Securities points to two offsetting trends. There will be demands for space from new and fast-growing companies, whilst the development pipeline has been cut back further given the circumstances. These will provide some underpinnings to rents and values. There will also be demand for more space that meets increasingly tough environmental targets, at the expense of older buildings that have not been extensively refitted with appropriate heating and cooling systems and proper insulation.
The bull case for property pre-pandemic included attractive yields compared to the income you could receive from a bond or the average share. Yields are now often higher relative to bonds than before the crisis. The average yield at 6% or so is more than 5 percentage points above the government 10-year bond yield.
Land Securities reports a rise in leisure and retail shop yields on its portfolio over the last year, despite the fall in general interest rates. It places leisure, retail park and regional shopping centre yields at 7.6%. They judge London retail and offices will hold fairly steady at 4.4%. These yields allow for some problems but have now to be looked at in the light of the new developments that distressed tenants may enter a voluntary agreement to walk away from rental agreements, and other tenants may go through a longish period without paying all or any of the rent.
Aviva has recently announced it is winding up its UK property funds on the grounds they are not liquid enough. The mood amongst professional investors and regulators is more hostile now to property funds after many closed themselves for fear of a run on the fund. They also reported difficulty in establishing fair valuations of the underlying properties during a period of excessive stress.
None of this is helpful to commercial property as a general asset class. Quoted real-estate investment trusts (REITs) in the right sectors and areas remain the best way of having some exposure which you can normally sell quickly if you wish. The long-term larger investor who can accept illiquidity may find individual properties to add to their investments at more attractive prices now. They will need to check out how the building will meet new environmental demands and how it will secure reliable tenants in this fast-changing property world.
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