Commercial Market Outlook

• UK economic growth has been somewhat erratic over the last 18 months, with a mild recession in the second half of 2023 followed by a strong rebound in the first half of 2024, and then little to no growth in the second half of the year. The latest quarterly data (Q3 2024) shows GDP growth of zero. The latest monthly figures estimate that output grew by 0.1% in November, following two months of -0.1% contraction, meaning the economy was flat over the three months to November.

• Survey evidence points to further weakness in the near term. The latest S&P Global UK Services PMI stands at 51.2, with construction at 53.3 (a reading above 50 indicates expansion). However, manufacturing remains in contraction territory at 48.2, and the GfK Consumer Confidence indicator for January 2025 fell sharply by five points to its lowest level since November 2023.

• There is increasing evidence that the employment market is softening, with the latest ONS release showing unemployment rising a little, and employment and job vacancies falling. A significant increase in employment costs will occur in April when rises in Employer National Insurance Contributions and the National Living Wage take effect. This will feed through to the broader economy in a mix of lower wage growth, lower employment, reduced profit margins and increased prices.

• The rate of CPI inflation slowed for the first time in three months in December, albeit only marginally, to 2.5% from 2.6% in November. Inflation is likely to accelerate modestly again during 2025, with the latest consensus forecast suggesting CPI of 2.7% in Q4 (but probably peaking somewhat higher than this during the year).

• There should be further reductions to Bank Rate during 2025, but there is considerable debate about the timing and extent. Given recent weak output growth and confidence indicators, plus December’s modest fall in inflation, a reduction of 25 basis points is widely expected at the MPC’s next meeting (due on 6th February). The MPC will need to maintain a careful balance between keeping CPI inflation on a path towards its target of 2%, whilst being supportive of economic growth.

• Growth is likely to remain weak during the first few months of 2025 as businesses adjust to the additional costs of employers’ national insurance contributions and the National Living Wage. On the positive side, falling interest rates will provide impetus, and wage growth should continue to outstrip inflation, benefitting consumers. The latest consensus is for growth of 1.2% for 2025 as a whole, above the expected outturn of 0.8% for 2024. 

Recent output trends and indicators

• UK GDP is estimated to have shown no growth in Q3 2024, revised down from the first estimate increase of 0.1%.

• On a monthly basis, GDP rose by 0.1% in November, following declines of 0.1% in both September and October. The clear overall picture is one of broadly flat economic output during the second half of 2024.

• Disaggregated, services were found to have grown by 0.1%, driven by accommodation and food services, while production output declined by -0.4%. The construction sector also grew, by a robust 0.4%, but this followed a fall of -0.3% (upwardly revised) in October.

• The S&P Global Flash UK Manufacturing PMI increased to 48.2 in January from a recent low of 47.0 in December. Although it remains in contraction territory (below 50), this suggests the slowest decline in output in three months. However, order books shrank for the fourth month running, staffing numbers continued to fall, and prices accelerated. 

• The UK Services sector PMI saw a marginal uptick in January, remaining in expansion territory for the 15th consecutive month at 51.2, up from 51.1 in December.  However, new orders declined for the first time in 15 months, employment continued to fall amid rising concerns over staff costs following the October Budget, and inflationary pressures intensified.

• The construction PMI declined in December, down to 53.3 from 55.2 the month before and marking its lowest level in six months. Weaker demand, higher borrowing costs and slowing consumer demand have impacted the sector. Commercial construction had the highest rate of growth followed by civil engineering work, with residential work contracting at its fastest rate since June 2024 and marking the third month of decline.

Labour market

• The latest labour market statistics show the employment rate falling slightly in November, to 74.8% from 74.9% in October but unchanged from one year ago. The unemployment figure moved up slightly to 4.4%, from 4.3% the month before.

• The number of pay-rolled employees fell by 32,000 between October and November. there is an estimated decline of 47,000 pay-rolled employees on the month, but this is likely to be revised and should be treated with caution.

• The number of job vacancies declined during the quarter between October and December for the 30th consecutive period, down by an estimated 24,000. Total vacancies are now 812,000, almost in line with pre-pandemic levels.

• Average annual earnings (excluding bonuses) rose again in the three months to November, increasing by 5.6% annually following 5.2% growth recorded in the previous three months. This is now the highest figure since May 2024. Wage growth accelerated in the private sector (6%) but slowed in the public sector (4.1%). Manufacturing, retailing, hotels, restaurants and finance and business services recorded the strongest growth, all at 6%.

Inflation

• December saw the rate of CPI inflation slow for the first time in three months, albeit only slightly, to 2.5% from 2.6% in November. Downward contributions came from restaurants and hotels, as well as recreation and communication. The largest upward contribution came from transport as prices for motor fuels and second-hand cars rose.

• Encouragingly, core CPI (excluding volatile elements such as energy and food) reduced from 3.5% in November to 3.2% in December 2024, and the CPI services annual rate fell from 5.0% to 4.4%.

• Most forecasters expect CPI to continue to be above the 2% target throughout 2025, and to accelerate a little. The latest consensus forecast is for CPI of 2.7% in Q4 (and it will probably peak a little higher than this during the year).

Interest rates

• The Bank of England’s Monetary Policy Committee (MPC) reduced the base rate by 25 basis points to 4.75% at its November 2024 meeting, marking the second reduction from a peak in the current cycle of 5.25%. This was followed by no change at the December meeting (with six members voting to maintain Bank Rate at 4.75% and three preferring a reduction 4.5%).

• It is widely expected by forecasters and financial markets that Bank Rate will see further reductions during 2025. There is considerable debate about the extent and timing, although a reduction of 25 basis points is widely expected at the MPC’s next meeting on 5th February.

• The uncertainty over the path of interest rates is understandable, as the MPC will need to maintain a careful balancing act between keeping CPI inflation on a path towards its target of 2%, whilst being supportive to the current anaemic rate of economic growth. The latest inflation data is encouraging, although the Bank will doubtless be concerned over the acceleration in wage growth, as well as a number of inflationary risks including the increase in Employer National Insurance Contributions and the National Living Wage due to take effect this April, as well as broader global risks.

Retail occupier market

• Retail sales volumes recorded a surprise fall in December, down by an estimated -0.3%, following a small rise of 0.1% the month before. Market forecasts were for a +0.4% rise during the month so this fall was highly unexpected. Non-food store sales saw a 1.1% rise, aided by clothing store sales which saw volumes rise 4.4%, but this was not enough to offset falls in food shops of -1.9%. For the whole of 2024, retail sales volumes rose by 0.7% year on year, down sharply from 2.9% in 2023 and 4.1% in 2022.

• The GfK Consumer Confidence indicator for January fell sharply by 5 points to -22, its lowest level since November 2023. All five components of the survey saw a decrease, driven by softening economic expectations.

• The Q3 2024 RICS UK Commercial Property Survey shows a net balance of -4% for retail occupier demand, similar to the -5% in Q2, but a noticeable improvement compared with -25% in Q3 2023. Respondents continued to cite an increase in overall vacant space.

• Average retail rental values have shown very modest growth since 2022, according to MSCI. The Monthly Index reports that average retail rental value growth in the 12 months to December 2024 was 1.3%, the fourth consecutive monthly increase, and its strongest pace 2008. However, average retail rental values remain 15.8% below their previous peak in 2018.

• The all-retail trend masks significant variation, depending on the type of property and location. Average rents for standard (high street) shops have been rising since May 2023, by a total of 2.4% to December 2024 (MSCI Monthly Index). Over the three months, the increase was 0.4%, the equivalent of 1.7% over one year. This is ahead of the current actual annual rate (1.0%).

• Average rental values in the retail warehouse subsector are continuing to rise, by 2.1% in the 12 months to December 2024, the highest rate of growth since 2007. On a quarterly basis, growth stands at 0.9% (three months to December 2024), the annual equivalent of 3.5% (MSCI Monthly Index).

• Average annual shopping centre rental values have been rising since March 2024 (by a total of 1.4%), although this is not yet reflected in the annual growth figure, which stands at -0.3% as at December 2024 (MSCI Monthly Index).

Office occupier market

• Most businesses have now passed the post-pandemic period of office floorspace downsizing, and some are actively adopting policies to encourage (or mandate) employees to return to the office. The provision of high-quality offices remains important to assist with recruitment, retention, and productivity strategies, as well as to enhance staff health & wellbeing. This is reflected in continued robust demand for prime space.

• Occupier demand is focused on buildings that are sustainable and energy-efficient, as occupiers try to meet increasingly ambitious ESG aspirations. This is being accelerated by the changes to MEES regulations which came into force in 2023, with the next round of tightening (requiring a minimum EPC rating of C) due to take effect from April 2027.

• In many key city centre markets, a constrained volume of office development since the pandemic relative to grade A demand means there is now a considerable shortage of prime supply. This is particularly true in central London districts such as Mayfair and St James’s, which have a long-standing undersupply due to their inbuilt physical and planning constraints. But even the core City of London, which is more able to accommodate large-scale high-rise schemes, is now running low on quality floor space.

• In addition to the shortfall of immediately available space, there are only limited options to lease buildings currently under construction. A high number of pre-lettings, in reaction to low immediately available stock, have taken much of the potentially available new supply out of the market. We have also seen an increasing number of developments geared towards the life sciences sector.

• We are seeing continued strong demand for serviced and co-working provision from established businesses that wish to lease short-term space, pending a move to longer-term conventional office space once the economic outlook becomes more certain.

• The Q3 2024 RICS UK Commercial Property Survey continues to show a positive net balance for office occupier demand at +4%, down a little from a recent high of +7 in Q2, and similar to the +6 recorded in Q1. Whilst this suggests a relatively modest level of demand, it does appear to have stabilised, and is in sharp contrast to the highly negative balances immediately post-pandemic. More broadly, demand remains heavily focused on prime stock, and in prime central London in particular. The RICS survey suggests that availability is continuing to rise, with the Q3 balance standing at +26 on this measure. Again, this will be reflecting the market as a whole rather than prime stock, which remains in very short supply in key markets.

• Prime rental levels have proved highly resilient, reflecting supply / demand imbalance for quality stock. Recent development schemes have set new benchmarks in several central London districts and regional city centre markets. The gap with rents for poorer quality grade B stock is likely to widen further.

• Average annual rental value growth for all UK offices was 2.1% per annum in December 2024, compared with a peak of 2.8% in March 2024 (MSCI Monthly Index). On a quarterly basis, the growth rate has slowed further to 0.4% between September and December. This is the equivalent of 1.6% over one year, suggesting we may see a further slowdown in the annual rate.

• Average rental growth in the West End / Midtown submarket remains strong, but decelerated to 5.4% in December 2024 compared with a peak of 6.7% in July 2024. The City of London continues to see a much lower rate of growth, at 1.2% per annum in December 2024 (MSCI Monthly Index).

• The rest of the south east recorded average annual rental growth of just 0.5% in December 2024, below a peak of 2.0% in January 2024. In contrast, average annual rental growth in the regional markets increased to 2.4% in December 2024, above a recent low of 1.3% in July 2024.

Industrial occupier market

• 2024 saw a positive occupier demand story in the UK industrial and logistics sector, with take-up rising from the recent low seen in 2023. Demand is being shaped by a variety of economic, political and technological drivers, including requirements for logistics and last mile distribution hubs, with the gradual shift online likely to continue and further rises in real household income boosting consumer demand. Supply chains will continue to evolve, and we expect to see more retailers outsource logistics functions to 3PLs, who can use their expertise to reduce costs and delivery times, and increase reliability and sustainability credentials.

• Logistics operators continue to face a shortage of labour in many parts of the UK. Labour costs are increasing, with wages rising in real terms and the National Living Wage and employers' National Insurance contributions due to increase significantly in April. The re-emergence of Amazon as an occupier taking large units will further compound the labour market pressures in certain areas.

• Occupier demand for larger distribution units has been somewhat subdued in recent quarters. However, demand for smaller size ranges has remained in line with longer term averages. Occupiers may now be looking ahead to lower interest rates, more sustained economic growth and an increase in consumer optimism. The Q3 2024 RICS UK Commercial Property Survey showed a net balance for industrial occupier demand of +14%, up from +10% in Q2 and a recent low of +3% in Q3 2023, although still well below the peak of +49% in Q2 2022.

• Vacancy rates have been rising over recent quarters, due to a combination of slowing demand and rising supply. However, vacancy at the national level now appears to be levelling off, and with a positive outlook for demand and relatively little speculative supply coming through, we think vacancy will peak this year and begin to decline. Demand remains focused on prime, energy-efficient space, particularly as many logistics operators are promoting their ability to maximise their clients’ sustainability credentials within the supply chain. Whilst new schemes are coming forward, the overall development pipeline remains restricted, and so the relative shortage of large high-quality units will continue.

• Competition amongst occupiers for existing and new build product has helped maintain upward pressure on rental values despite the overall lower demand levels. According to the MSCI Monthly Index, average annual industrial rental value growth peaked in August 2022 at 13.2% and has steadily decelerated from this unsustainably high rate, but remains strong at 5.5% in December 2024, still well above general inflation. Growth appears to be levelling off at around this rate, and indeed the rate measured over one quarter has accelerated modestly, from a low of 4.6% (annualised) in the three months to March 2024, standing at 6.0% in the three months to December 2024.

• The Q3 2024 RICS UK Commercial Property Survey reported a net balance of +48% expecting prime rents to rise over the next 12 months, a continued strong reading, albeit down from +59% in Q2. A net balance of +18% expected secondary rents to increase (also down a little on Q2).

Transaction volumes

• Investment in UK commercial property rebounded in Q4 2024 across all but one of the main sectors, with industrials seeing a notable contraction quarter-on-quarter. Overall, £12.3bn was traded in Q4 2024. This was 29% up quarter-on-quarter and 30% up year-on-year, but 6% below the five-year quarterly average. The rolling annual total exceeded £40bn for the first time since Q2 2023, but was 23% below the five-year average of £53.5bn.

• Similar to the previous quarter, approximately 33% of all investment (excluding multi-regional portfolio deals) occurred in the London market in Q4 2024, which is below the five-year average of 51%. Investors targeted offices but also operational real estate assets, such as hotels. Overseas capital continued to support volumes in London, accounting for 54% of the total.

• The alternative sectors accounted for the largest share of the Q4 total at 39%, while both the alternative and retail sectors recorded volumes above the five-year quarterly average. Offices accounted for the second-highest share of the volume traded in Q4 at 24% of the total, with industrials accounting for 16%.

• Overseas investment in UK commercial property totaled £5.5bn in Q4 2024, up 21% quarter-on-quarter and 17% above the five-year quarterly average. It accounted for 45% of total investment, below the 10-year average of 51.9%. US investors continued to account for the highest share of overseas investment in Q4 2024, totaling around £3.4bn, notably above the £2.1bn spent in the previous quarter. European investors had another strong quarter, with just under £1bn invested and above the £800m spent in Q3 2024.

Recent investment performance

• Following a sustained period of upward yield movement from mid-2022 to the end of 2023, commercial property yields were broadly flat during 2024, with the equivalent yield standing at circa 7.1% (MSCI Monthly Index). This contrasts sharply with 10-year gilt yields, which rose sharply during 2024 from 3.8% at the start of the year to 4.6% by the year end. This resulted in a narrowing of the gap between property and gilt yields from circa 350 basis points at the start of 2024 to 250 basis points by the year end. The initial weeks of 2025 saw gilt yields spike to 4.9% (due to market concerns around US interest rates and UK growth and inflation), but yields have now fallen back below 4.7% (as of 24th January). 

• All-property rental growth has been remarkably stable over the last two years, standing at 3.3% per annum (MSCI Monthly Index, December 2024).  Therefore, as property yields have stabilised, capital growth performance has improved rapidly, and year-on-year all-property capital value growth finally turned positive in December 2024 at 1.1%. This compares with -0.5% per annum in November, and a low of -21.2% in mid-2023. Indeed, this marks the first positive year-on-year growth since September 2022. Furthermore, the rate of growth is accelerating, with quarterly growth standing at 1.3% in the three months to December 2024 (an annual equivalent of 5.4%), up from 0.3% over the previous three-month period.

• Capital growth performance varies considerably across the main commercial property sectors. Industrial and retail are outperforming the all-property average, with annual growth in December 2024 standing at 3.9% and 3.0% respectively. In contrast, office capital values are continuing to fall on an annual basis, at -5.7% over the 12 months to December 2024. However, capital value performance is improving across all three main commercial sectors. Over the period September to December 2024, industrial capital values rose by 2.3%, retails increased by 1.7%, and the fall in the office sector was only  -0.3%. Indeed, office capital values have now broadly levelled off, posting a modest rise of +0.1% during December.

• The all-property annual total return peaked at 25.1% in May 2022, and then decelerated sharply, bottoming out at -16.9% per annum in the year to June 2023. Performance was in positive territory throughout 2024, accelerating to +7.0% pa by the year end (MSCI Monthly Index).

• The industrial annual total return is now +9.2%, compared with a low of -23.2% in June 2023. Retail annual returns turned positive in December 2023 and increased sharply to +10.4% in December 2024, compared with a low of -9.6% in July 2023. The total return for offices remains in negative territory (just) at -0.2% per annum in December 2024, well above the low of -18.9% in August 2023 (MSCI Monthly Index). Taking just the last three months, all three sectors are in positive territory (+3.6% for industrial, +3.5% for retail and +1.0% for offices).

Investment outlook

• Initial optimism following the festive break has been tempered by concerns about the risk of further stagnation in the economy, largely as a consequence of the fiscal changes introduced in the October Budget. However, sentiment around the prospects for interest rate cuts during 2025 has improved slightly since the release of the latest inflation and GDP figures, though it remains less optimistic than at the end of last year.

• The uptick in market activity during Q4 2024 is a positive signal, although transaction volumes remain below longer-term averages. Investor sentiment in UK real estate remains strong, and we expect a continued improvement in market conditions as the year progresses.

• The industrial and residential sectors remain the most favoured among investors, both domestic and international.

• Demand for regional offices is showing signs of increased activity, particularly in markets with strong occupier demand for assets that are well-located, possess robust ESG credentials, or are viable for conversion to alternative uses, especially residential.