EXECUTIVE SUMMARY

GLIMMER OF HOPE AS UK ECONOMY EXITS
RECESSION AND INFLATION DIPS

Investors in the UK had little to cheer about as they entered 2024. Anemic growth, high inflation, and elevated interest rates, coupled with a cost-of-living crisis and political turmoil, have made optimistic forecasts risky and often surprising.

However, as we move into the second half of the year, the outlook is beginning to brighten.

Politically, investors can expect more stability with the Labour Party in power. While the party has said it will revive the Renter’s Reform Bill and also deliver 1.5 million houses over the course of its term, the broad impact of Labour policies on real estate will be better determined in the Autumn Budget.

Data from the UK’s Office for National Statistics (ONS) shows that the economy emerged from a recession in the first quarter, growing by 0.6% and surpassing economists’ expectations of less than 0.5% growth. Although construction activity fell by nearly 1% during this period, it was a smaller drop compared to the previous quarter. Inflation continued to decline, reaching 2.3% in April on an annual basis, down from 3.2% the previous month. This marks the lowest inflation rate since July 2021.

While the Bank of England has decided to keep interest rates unchanged at 5.25%, the consistent reduction in inflation is giving investors hope for a rate cut in the latter half of the year. The central bank is expected to make a decision in August when it has access to its quarterly Monetary Policy Report.

The combination of higher GDP, declining inflation, and a potential easing of interest rates, along with currently lower asset prices, is likely to spark renewed investment activity in UK commercial real estate.

RESILIENCE AND RECOVERY IN THE UK OFFICE
REAL ESTATE MARKET

What does this mean for the UK office market?

Economic forecasts suggest a brighter picture for the second half of 2024. According to CBRE, property yields are expected to stabilize and compress after peaking in 2024, signaling a potential uptick in value across all sectors. The industrial and retail sectors are set to benefit from recovering consumer demand as real incomes grow. Prime office spaces, particularly in London, will likely see a boost from a relatively shallow peak in unemployment and job growth. Additionally, the anticipated shift from rate hikes to rate cuts will positively affect the cost of debt. CBRE projects that the full cost of debt for prime stabilized office assets is expected to decrease from 6.9% in Q3 2023 to 6.2% by the end of 2024.

The work-from-home trend has led many businesses to reassess their real estate needs, but the rate of downsizing has been declining. Data shows that office occupancy rates have stabilized over the past year, with the three-day office week emerging as the new norm. High-quality office space remains crucial for recruitment, retention, and productivity, as well as for enhancing staff health and well-being. This is reflected in the ongoing robust demand for premium spaces. According to UK property consultant Carter Jonas, there is strong demand for serviced and co-working spaces from businesses seeking short-term leases, pending a move to longer-term conventional office spaces once the economic outlook becomes clearer.

The Q1 2024 RICS UK Commercial Property Survey reveals the first positive net balance for office occupier demand since 2022, at +6%. This is a significant improvement from -12% in Q4 2023 and -19% in Q3. This upturn is largely due to a marked improvement in well-located and prime offices, with regional markets showing little change. Consulting firm Remit echoes this sentiment, noting that London office occupancy rates improved gradually throughout 2023, reaching over 50% by October.

The firm predicts that investment will return to London’s market as there is now some certainty regarding the direction, if not the exact timing, of interest rates.

INVESTMENT POTENTIAL:
RISING TIDE IN PRIME OFFICE RENTALS

The opportunity for investors in London’s office market hinges on two key factors: job growth and space supply. As these factors diverge, rents are set to rise. According to BNP Paribas, approximately 40% of all office properties under development in the City of London have already been pre-leased, with no new projects on the horizon that haven’t been claimed. This makes prime office spaces particularly valuable.

Today’s prime offices aren’t just about prestigious addresses. They also feature staff amenities and adhere to carbon footprint regulations. Oktra’s London Office Rent Report highlights a limited supply of top-tier spaces, driving up prime rents. Currently, West End rents have reached £135 per square foot, while rents in the City’s financial district stand at £77.50 per square foot. For Grade A office rentals in the City of London, this indicates a strong built-in demand for the future.

In this context, properties like Sidra Capital’s London Square show tremendous investment potential. Acquired in 2022, London Square is a 133,290 sq ft income-generating property. It offers Grade A office space across three buildings and 313 parking spaces in a prime location within walking distance of Guildford town center. Guildford, a wealthy town within London’s orbit, is Surrey’s major commercial hub and one of the UK’s leading tech centers outside London. The property boasts excellent road and rail links, with easy access to the motorway network, Gatwick and Heathrow airports, and Central London, which is just a 40-minute train ride away.

Since 2017, the property has undergone a £13 million upgrade, modernizing it to a high standard. Buildings 2 and 3 have achieved BREEAM Very Good ratings, while Building 1 has an EPC B rating. This well-established office campus is 80% leased to reputable tenants, including leading law firms Speechly’s and Clyde & Co, and service firms WSP, RSM, and Grenke.

Highlighting confidence in its prime UK office portfolio, Sidra Capital states, “The disconnect between negative investor sentiment and underlying asset performance for well located, specified and managed properties – where tenant demand and alternative use value remains strong – should present attractive opportunities for high yielding investors. However, stock selection remains key with an understanding of the ability of buildings to meet the demands of modern occupiers, particularly in relation to amenities and environmental considerations, and the associated capital expenditure being critical when analyzing opportunities.”

CONCLUSION: INVESTOR OPPORTUNITY AMID
ECONOMIC SHIFTS

According to Carter Jones, the office sector has experienced the most significant increase in yields, rising by 259 basis points since June 2022. Offices continue to lead in yield growth, with an additional 20 basis points over the three months leading up to April 2024, compared to 16 basis points for retail and just five basis points for industrials. However, the recent decline in inflation hints at a potential easing of interest rates later this year. Lower rates, coupled with reduced asset prices, should ideally boost investment activity. While investment transaction volumes are expected to remain below long-term averages, they are anticipated to increase this year compared to last year. Additionally, the limited supply of prime office spaces—those in top locations and of high quality—should benefit from rental growth in the short to medium term. As a result, these properties are likely to attract interest from a broader range of investors, leading to a positive adjustment in pricing.