Published: 11 March 2025
Reading time: Three minutes
Investors have had to look hard for positive news in commercial property over recent times, but there is evidence that is changing. UK Chief Economist James Sproule examines what’s happening in the commercial property market this year.
It’s been a while since there’s been some positive news for commercial property investors, but there is evidence property yields are approaching the point where prices are going to be driven by broader macro-economic considerations, rather than responding to movements in the gilt market.
Handelsbanken’s basic premise is that property always needs to deliver a premium over a gilt yield because there is naturally much more risk with property investing. Returns on gilts are almost guaranteed: you need to do nothing to receive your money.
But with property there are risks, including:
All of this is pretty straightforward, the challenge came in late 2022 when interest rates started to rapidly rise from what were always unsustainably ultra-low levels of sub-1%. With these interest rate rises we saw gilt yields also move up very quickly from sub-1% to far more sustainable levels around 4.5%.
But gilts are traded far more frequently than property and so yields adjusted a good deal more quickly than property prices. The rapid adjustment in gilt yields left the premium delivered by commercial property falling to about 1%, nothing like enough to justify the risks inherent in owning property.
Two things needed to happen: capital valuations had to fall, and or rental yields needed to rise. We have been seeing both, and these adjustments are taking place alongside a host of other factors which affect the main commercial property sectors: offices, retail and logistics.
For offices across the UK, yields are now back to the sorts of premiums over gilts that have prevailed over the last couple of decades. Apart from anything else, this points to yield differentials — which have been such a driving force in office valuations over the past two years — being less important than other issues moving forward. What is also notable is that there are two other key considerations.
Firstly the grade of office is critical. Offices with a high EPC rating are attracting premium clients, this almost certainly goes beyond merely being more efficient to run from an energy cost point of view.
Top flight clients demand top flight offices, and with the supply of “grade A” offices remaining somewhat constrained, rental prices at the top of the market have naturally risen.
Secondly, there remain significant differences depending on location. Even just within London total returns since the onset of the pandemic are overall down by 13.6%, but within that data the West End has only declined by 4.2%, while the City is down 16.6%.
How we shop, and where retailers can deliver value, has seen a lot of change over the past few years. Consumers in the UK have long been enthusiastic about online shopping — before the pandemic, about 20% of UK retail sales were online. Lockdowns naturally curtailed high street shopping and online transactions rose to about 35% of all retail sales. Since lockdowns have ceased, people have come back to the high street, but online sales now account for about 26% of retail sales, this is the sort of level that the pre-pandemic trend suggests we would have reached by now in any case. The question is at what point does enthusiasm for online shopping reach saturation?
Certainly it looks very unlikely that we're going to see an ever increasing share of people's spending shifting to online, shopping is too much of a leisure activity to point to that outcome.
At the moment, many investors continue to expect ever increasing degrees of online shopping to diminish returns from retail property; but we are likely to soon be at the point where this calculation has to be re-examined and the value of high street shopping and high street property will start to recover.
Geography also matters in retail, as in all forms of property. Looking at the returns generated by two towns which might be thought to be broadly similar, Guildford and Reading. The difference is that Reading has enjoyed a real boost from the Elizabeth Line, while Guildford’s transport links have not been upgraded.
The result is Reading has become something of a shopping hub, with retail property valuations up by 10% since December 2019, while Guildford’s have fallen by 30% over the same time period.
Just as was the case with retail, during the pandemic the sudden shift to purchasing goods online resulted in huge challenges for logistics. The difference is the immediate demand for logistics space needed to accommodate online shopping drove up property prices, which shot returns up by between 40% and 80%, depending on location.
This bubble lasted some two-and-a-half years before we saw a significant correction and falls to logistics property prices took returns down by 20%. Since this correction in December 2022, a disparate range of cities have done well, including Edinburgh, Leicester, Chester and Bristol. From a yield perspective it looks like there is a bit more adjustment to come and as a result we expect a bit more volatility in this part of the market.
