Commercial Market outlook: Response to the current Corona Virus situation

By Scott Harkness, Partner at Carter Jonas (UK)

The COVID-19 pandemic has created the biggest shock to the UK and global economies since the Second World War. This is an external shock, the severity of which has accelerated with immense speed. The social distancing measures and forced business shutdowns introduced by the Government are highly restrictive and unprecedented. The human consequences are clearly huge and are rightly the primary concern of policy makers. 

Unlike most previous downturns, it is occurring across virtually all major global economies both severely and simultaneously, with some parts of the UK economy coming to a juddering halt. It is also unusual, as it is impacting directly on both the demand and supply sides of the economy.

The impact on economic growth will be substantial, but the length and depth of the downturn is highly uncertain, as this will depend on many factors that are currently unknowable, including:

• the speed with which governments can bring the outbreak under control;
• the speed with which the bioscience sector can develop and mass-produce a vaccine and / or medication to assist recovery
• the success of interventions by fiscal and monetary policymakers. 
• the speed with which consumer confidence returns
• the ability of supply to recover in line with demand

If the outbreak can be contained quickly, then recovery could potentially be rapid, with the downturn followed by a strong upturn. However, the longer that major restrictions on consumers and businesses remain in place, the greater the potential for longer-term economic damage to be inflicted, as more output is permanently lost rather than postponed and the overall productive capacity of the economy is reduced. Given the unprecedented nature of the restrictions, the psychological effects on consumer and business confidence could be quite long-lasting.

However, we can say with near certainty that the fall in UK output in Q2 will be by far the largest recorded in modern economic history and that a severe recession will occur this year. Almost all sectors will be negatively impacted, although the extent will vary considerably.

The public sector will probably be considerably larger after the crisis, as some industries will not be able to survive and will have to be nationalised. We have already seen this, with the UK’s train operating companies now effectivity in public ownership, for example. Government borrowing will also rise significantly, and this will have long-term implications for future public spending.
The UK government has introduced a monumental package of fiscal measures, unprecedented in peacetime to “do whatever it takes”. Measures directed at households include a three-month mortgage holiday, additional welfare payments and funds for those unable to pay rent.

Measures for businesses include paying 80% of the salaries (up to £2,500 per month) for furloughed employees; the ability for businesses to defer VAT; a targeted business rates holiday; and cash grants. The UK’s corporates sector was in good health prior to the crisis, and these measures are designed to ensure that as many businesses as possible survive the crisis. However, the severity of the downturn is likely to hasten the demise of businesses that were already struggling (most notably in the retail sector).

The Government also announced £330bn of guarantees for bank loans to the corporate sector, which would be increased if needed. Although significant interventions, these measures will do little to alleviate the short-term impacts of the shutdown of large parts of the UK economy. Their main purpose is to ensure that the economy is able to restart when restrictions are lifted.
There has also been co-ordinated action between the central banks of the major advanced economies to lower interest rates boost the money supply. The Bank of England cut interest rates to an all-time low of 0.10% and injected another £200m of quantitative easing into the economy.

The labour market has been amazingly resilient in recent years, with employment at a record high and unemployment at a record low. It is encouraging that the labour market is starting from a strong position, and the Government has offered a substantial package of measures to help mitigate the adverse impacts of the crisis. A sharp rise in unemployment appears unavoidable however, although much will depend on how long the crisis lasts.

Perhaps of least concern is inflation, which is currently 1.7% (Feb 2020), close to the Bank of England’s target rate (2.0%). The impact of the crisis could well be relatively modest, as the supply impacts will create upward pressure, whilst the demand impacts will create downward pressure, but in the short term, inflation is likely to decelerate.

It is likely that there will be a host of other long-term implications, which are unknowable at this stage, although the following sections suggest some areas to consider across the commercial sectors.

Although Brexit is very much a secondary concern at present, this will return as an issue once the COVID-19 crisis is over. Although the government appears determined to adhere to its end-of-year deadline to complete trade negotiations, this appears increasingly unlikely.

RETAIL

Even before the COVID-19 crisis, the retail sector faced a challenging environment. Online sales have continued to increase their market share at pace, accounting for circa 21% of total retail sales in Q4 2019, a figure that has doubled in just seven years. This, combined with rising costs, has been reducing retailers’ profit margins, and there has been a continual drip-feed of established national operators going into administration, entering into CVAs or announcing store closure programmes.

The retail sector has been particularly badly affected by the COVID-19 crisis. The vast majority of outlets have been ordered to close, with the only exceptions being those providing vital goods and services, including supermarkets and other food shops; banks; hardware stores; petrol stations and garages; post offices; off-licenses; and dry cleaners. Cafes and restaurants have been allowed to offer takeaway services only. These draconian measures will clearly have a significant impact. 

However, the supermarket and foodstore sector has been trading exceptionally well since the start of the COVID-19 crisis, with strong sales due to panic-buying and demand diverted from cafes and restaurants. The national discounters were one of the few very active sectors prior to the crisis, taking advantage of larger vacant units, and they are likely to continue their expansion in the post-crisis period.

The Government’s fiscal intervention will mitigate retail closures and job losses to a certain extent. However, an acceleration of closures is inevitable. The Centre of Retail Research has predicted that more than 20,000 stores could permanently close across the UK this year, a significant increase on 2019. A number of retailers have already succumbed since the start of the crisis, including Laura Ashley and BrightHouse, and further weaker players are likely to go under. Other retailers will not re-open all their outlets once restrictions are lifted.

With the retrenchment of many national retailers in recent years, high street letting activity had become increasingly focused on local independent operators, favouring some secondary pitches with more affordable rental levels. A key question is therefore around the survival rate of these independent outlets that do not have access to the same resources or management experience as the national operators.

Overall, the UK retail market has an oversupply of units, although this varies widely both between and within markets, and average retail rental values were falling across the UK prior to the COVID-19 crisis. The latest figures from the MSCI Monthly Index (February 2020) show that average retail rental values fell by an annual rate of 4.8% as the re-basing of rents continued. This puts average rental values more than 17% below their all-time peak in 2008. There had been some tentative signs that the fall in rental values was beginning to decelerate, but this will now pick up again.

It is very possible that the inevitable hit to confidence will result in consumers adopting higher saving levels and reducing consumption for some considerable time after the COVID-19 crisis is over.It is likely that some of the increased use of online delivery during the crisis will be permanent, meaning a one-off acceleration, although the extent is unknowable at this stage. Whether growth will return to its previous trend remains to be seen.

Locations with a high tourist footfall have tended to be relatively successful in recent years. These centres are likely to face a quite lengthy period where overseas tourism is significantly reduced, even after most of the domestic restrictions are lifted.
The retail sector was already in a state of flux, and with oversupply and continued insolvencies and CVAs, there is considerable uncertainty around where rental levels may eventually find a floor. It is possible that the COVID-19 crisis could accelerate this process of change and adaptation. 

OFFICE

Prior to the COVID-19 crisis, the politics of Brexit had caused immense uncertainty for UK businesses over a three-year period, holding back corporate decision-making. Given the potential for the relocation of some office-based jobs to markets inside the EU, Brexit has in fact had a relatively small direct impact on the office sector to date. Some jobs have been lost overseas, but this appears to have been a trickle rather than a flood.

There is evidence that recent uncertainty has benefitted the labour market, as firms lacked the confidence to invest and instead hired workers. This has been supportive of occupier demand and take-up in most major city centres has been relatively strong in recent years. 

The COVID-19 crisis will have a significant impact on the corporate occupier sector in the short term, as businesses put relocation decisions on hold and assess impact on revenues and staff headcount. Tenants with lease expiries may decide to defer office moves and seek short-term lease extensions until economic conditions become more certain. A reduction in employment will mean some businesses reducing the space they occupy.

The flexible space market (or serviced office sector) has expanded rapidly in recent years, with demand moving up the size curve and rippling out from London to the regional markets, and it has underpinned demand in the office market. The COVID-19 crisis will be a major test for the sector, with its income levels clearly at risk as tenants fail to renew leases. Whilst office demand remained relatively strong prior to the COVID-19 crisis, the supply of quality space has been highly constrained. Construction activity has been subdued ever since the financial crisis a decade ago, and has been on a downward trend over the last two years. As a result, there is a shortage of grade A supply relative to robust demand in many markets, which will help to cushion rental falls at the prime end. 

The longer-term impact of the enforced and potentially lengthy period of working at home for many office employees is difficult to gauge. It is likely to accelerate the trend towards home working, but it could also bring into sharper focus the importance of office space as a place to communicate, share ideas, foster team spirit and corporate identity. Government measures to support businesses should considerably reduce the number of insolvencies that could have occurred. This will underpin the office market and help to contain any increase in vacancy rates. However, vacancy rates are likely to rise, both from landlords and through subletting by occupiers, although the extent will depend on the length and depth of the economic impact.

The importance of ESG (Environmental, Social and Governance) factors is unlikely to diminish post-crisis, and occupiers will demand buildings that have been sustainably constructed, are efficient to operate, are located close to public transport networks and amenities, and provide wellness features for staff such as good natural light and air quality. This means that the focus of demand will continue to be for high quality space. As we emerge from the crisis, some occupiers may decide to trade up into better quality space that had previously been outside their budget.

INDUSTRIAL

Industrial take-up has been buoyant in recent years as retailers and their third-party logistics partners adapt to growing online demand. The convergence of traditional supply distribution chains continues to fuel demand for both large distribution warehouses and smaller urban units for last-mile delivery. The distribution sector is relatively well insulated from the COVID-19 crisis, as occupier demand is being driven by this structural change in retailing. In addition, the logistics sector is providing an essential service during the crisis, ensuring that food and medical supplies are distributed and adapting supply chains.

The crisis may accelerate the rate of change in the sector if shoppers continue to order more goods online. It is also likely that companies will re-examine their supply chains, which have become increasingly long and complex as globalisation has increased. Indeed, the commercial and political impact of the crisis could halt the spread of globalisation, at least in the short term. 

Just-in-time manufacturing has reduced the need for storage and is reliant on these complex supply chains. We are now seeing the impact when they fail to operate properly, for example in the automotive sector. The lack of resilience in the manufacturing sector is likely to add to the argument for “reshoring”, leading to increased demand for storage space in the UK. There remains a severe shortage of well-located sites for distribution use, and also urban sites suitable for last mile delivery, waste recycling and open storage. Overall, it has been hugely challenging to satisfy occupier demand, creating strong upward pressure on values. 
Carter Jonas figures show that prime industrial headline rents increased by an average of 2.0% in 2019. This was above CPI inflation of 1.3%, but a lower rate than the 2.8% recorded in 2018 and 3.0% in 2017. 

Whilst the rate of prime industrial rental growth slowed in 2019, land value growth accelerated. The Carter Jonas index shows that land values increased by 12.5% across the UK in 2019, compared with 8.3% the previous year. This reflects the significant pressures on industrial land, with few sites available and strong competition from other uses.Supply shortages and structural change will combine to cushion the sector from the worst effects of the crisis, and rental performance should be the least impacted of the three main commercial sectors. 
 
INVESTMENT MARKET

Investor demand had been relatively strong over a sustained period prior to the COVID-19 crisis and there has been relatively little stock coming to the market. This has pushed office and industrial yields downwards, most notably in the industrial/distribution sector, which has taken centre stage in the retail revolution. Industrial yields are now the lowest of the three main sectors by some margin.

However, some UK and overseas buyers had been adopting a ‘wait and see’ approach to potential purchases, primarily due to the uncertainty surrounding Brexit. Some investors had also put a moratorium on retail purchases. Few investors have been under pressure to sell, and so transaction levels were relatively subdued prior to the crisis. The value of commercial transactions totaled £53 billion in 2019, well below the £63.5 billion transacted in 2018, and the lowest figure since the 2016 (with only £52 billion transacted due to disruption from the Brexit referendum). The first two months of 2020 saw £9 billion transacted, which compared favourably with £6.6 in 2019, but this was before the extent of COVID-19’s impact on the UK became apparent. 

As part of the suite of emergency government measures, commercial tenants unable to pay their rent will not face eviction for a minimum of three months (although landlords will subsequently be able to recover the lost rent). This will impact revenues due to landlords in the short term. In our view, this will impact all sectors, although the retail sector is the most exposed. Landlords are increasingly likely to offer short term leases rather than incur the potential loss of income and additional costs of vacant space. If void rates rise throughout the year, landlords will come under increasing financial pressure. 
We could see increased disposal activity through retail fund redemptions, and there will probably be ongoing disruption to overseas investment into the UK for some while.

Retail yields were already moving upwards prior to the crisis, reflecting the challenging conditions in the occupational market, whilst office and industrial yields have been broadly stable over the last year. The COVID-19 crisis will inevitably have a more negative impact on yields, and will have a broader impact across the sectors. In the medium term, property’s fundamental attractiveness will be unchanged by the COVID-19 crisis, although there will be specific impacts which will vary according to sectors, some of which we have highlighted above. 

The financial markets have reacted sharply to the crisis. The FTSE all-share index fell by more than 25% from mid-February to the end of March and will remain volatile until there is a clear path back to normality. 10-year gilt yields have been on a long-term downwards path, as the global economy has shifted to a lower interest rate environment. With investors flocking to safe assets and emergency interest rate cuts, the 10-year gilt yield has now fallen to just 0.4% at the time of writing. This compares with the all-property equivalent yield of 6.0%. This makes property look a relatively safe and stable asset, with a highly favourable yield against the risk free rate, and should encourage further flows of capital into the real estate sector. 

The impact of COVID-19 will not be spread evenly across the property market. Prime property should prove relatively well insulated due to the underlying supply shortage, which will continue to be a key feature of the market. Existing sectoral trends are likely to be accelerated, setting even more starkly the differences between sectors such as distribution, last mile delivery and office space on the one hand against secondary offices and retail on the other. 

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