What does 2023 hold for the UK’s commercial real estate market? Part 2

For most investors, the standard response to a weaker economic environment is to shift out of lower quality, higher risk assets into higher quality, lower risk options. We expect a similar ‘flight to quality’ theme to play out within commercial real estate. In this case, lower quality properties that fail to meet today’s (and more importantly, tomorrow’s) expectations for environmental standards will be increasingly punished, by commercial tenants as well as investors who all have their own de-carbonisation targets as their employees and shareholders demand to be in buildings that have a positive environmental impact. We also expect lenders will increasingly reject security on secondary and tertiary assets (even at modest loan-to-values) without a viable plan by the owner to bring these up to scratch.

Right now, parts of the UK, London included, have a structural problem where many office buildings are no longer fit for purpose. We think there are a number of owners of office buildings in London and elsewhere in the UK who are lacking the capital, skills and frankly, a local presence, to upgrade these buildings to achieve their full potential. The best offices will outperform, so from an investment perspective, if you can fix a good building at less than the cost of replacing it, you will be well placed to achieve outperformance.

Longer term, demographic trends for investors to consider
There are other pockets that offer optimism. The student accommodation sector should stay resilient through 2023 and beyond. In the UK, student numbers are at an all-time high, with demand for Purpose-Built Student Accommodation (PBSA) outpacing supply and we have seen multiple news articles where students are begging letting agents for flats and queuing overnight to secure accommodation. Again, those larger operators of student accommodation are going to be at an advantage over smaller companies but at the same time, developers and operators of smaller PBSA schemes are likely to find strong investment demand, especially as the larger players look to consolidate, exploit portfolio-wide efficiencies and become dominant brands in space.

The care home sector is another area that benefits from longer term demographic trends. It is well-known that the UK has an ageing population that needs higher levels of care and better-quality accommodation and often, this is income underpinned by the local authority. However, the question of whether investors should lease a building to a local authority or manage an operating business remains up for debate; the former provides a long-term, local government lease but with limited upside and the latter provides for likely higher income albeit, with complex (and often very public) management challenges under the auspices of the Care Quality Commission. An offshoot of this may be for investors and developers to consider partnering with NHS Trusts to convert former offices into “recuperation facilities” which can act as overflows for hospitals. These facilities are not fully-fledged hospitals, but could offer something in between being discharged too early versus unnecessarily taking up a critical hospital bed and helping to unblock the perennial bed-blocking problem faced by the NHS.

The third long-term commercial real estate trend for investors to consider is high-quality living for “senior” citizens. To help address the UK’s housing crisis, there’s an urgent need to build facilities of sufficient quality, that also offer better access to health and social care should they need it, and give seniors the incentive to move out of their multiple bedroom houses, which could then be freed up for younger families. In addition, this solution allows some to release equity which is trapped in their home and pass that on to their children and grandchildren who are struggling to buy homes of their own. However, this strategy is probably limited to pockets of the UK where housing wealth has appreciated to the point where one can downsize to live in a purpose-built facility and release equity.

Summary: an improving outlook towards the second half of the year
Tougher economic times don’t last forever. The signs are that the underlying drivers of inflation could be resolved slowly during 2023. Once inflation has been tamed and the Bank of England stops increasing interest rates, real estate prices should become more stable. This should have a positive (downward) effect on yields too, helping to create new longer-term opportunities for investors, particularly in those investment areas outlined above.