Is a real estate crisis looming in the commercial property market?
Rises in interest rates usually precede a fall in real estate prices and the rise in interest rates in the UK in 2022-2023 has seen this predictable pattern followed with a fall in house prices.
However, while the chatter has been and will continue to be about falling house prices, it is the commercial real estate market that will see much more damage. Here are the reasons.
Interest rates can rise either because real yields rise or because expected inflation rates rise. It is clear that this time an increase in expected inflation has pushed rates up. That means that investors need to earn higher returns, and the obvious way for that to happen is to buy for a lower price. But inflation can push rents up, and in the residential market this can happen very quickly, and every year. In the office market the inflation/rent link is much less clear as rents are often fixed for 3 or 5 year periods.
We are currently in the middle of an amazing demographic change that is pushing up the average age. This has a largely hidden but huge impact on the demand for housing. If we live for an extra 5 years, that soaks up around 10% of the housing stock which would otherwise go on the market. But the retirement age has not increased, so the demand for commercial space has not been boosted in the same way.
Increasing the supply of housing is notoriously difficult, and we have an accumulated shortage of 3-4 million homes in England and Wales. No such shortage exists in the office market.
What makes a healthy environment? The Covid crisis has pushed this issue up the agenda, resulting in a lot of discussion about office design and the negatives around commuting on public transport.
We have to reduce waste, carbon and energy use in both the residential and commercial property sectors. Governments will have to find ways to incentivise homeowners to insulate their homes and to get rid of gas boilers. No such help will be offered to office investors, who will instead be faced with a problem of managing so-called stranded assets.
Digital technology innovation has attacked the retail property sector as 30% of all UK sales are now online, boosting the demand for logistics space but hammering shopping centre values. The office market is next in line, as the move to 3 or 4 days in the office has reduced demand by 20-25%. This is because service sector employees can work from homes, for which demand has increased by a similar amount.
On top of this, we can observe the 'hotelisation' of the office market, meaning the growth of customer choice and the shortening of lease or licence agreements. Commercial real estate management has become more operational, as owners of space are encouraged to offer more services - like hotels do - in order to attract occupiers.
Hotelisation means that customers will increasingly express their opinions, driving office operators to provide more services or to cut rents. Hence the demand for shorter leases, smaller spaces and enhanced collaboration has driven the occupier markets closer towards the operational customer-centric model found in hospitality, where a positive or negative user experience is capable of being publicised by platforms such as Trip Advisor.
With shorter contractual obligations comes increasing choice. The end user of the space is now able to leave without penalty if that space does not meet their expectations or requirements. Accordingly, managers of flexible space have begun to compete by offering more amenities, often including a host of unnecessary luxuries as a part of their service offering.
Operational property returns are more directly dependent on the operation of the business carried out within the building. The heightened operational risk means that specialist skills are required to manage these real estate assets.
In accounting, the higher the degree of operating leverage in a business, the greater the potential danger that a relatively small error in forecasting sales can be magnified into large errors in cash flow projections. This concept has not typically been used in real estate, but recent market developments mean that it needs to be.
Core real estate is a low risk asset because there is no operational leverage, especially if the lease is triple net/FRI (full repairing and insuring, meaning that the tenant is responsible for these costs). There is operational leverage if the landlord has external repair, management or common parts expenses. Some shopping centres have a lot of operational leverage where low occupancy and falling rents leave the landlord with a heavy and irrecoverable cost burden. Net operating income (NOI) is then much more volatile. Where the landlord is responsible for all operating costs, including staff, raw materials and so on, operational leverage levels (and risk) go shooting up. This applies particularly to managed hotels, senior housing, and student accommodation. In such cases it should be possible to measure operational leverage and quantify risk.
Operators will develop a deep understanding of building and customer requirements in a specific property type and the best will operates at scale. They will develop modern buildings with the latest building technology, creating high quality, energy efficient environments for living, working and/or playing. They will use platforms — customer-centric systems for operating buildings with a high service/amenity component, and a centralised customer relationship management (CRM) and in-house leasing team with deep relationships with major customers.
The best operators will be highly sought after by investors as managers of risk and deliverers of return; for those who miss this trend, higher risk will not be compensated by higher returns. The Proptech wave means more customer power, more operational leverage and more risk for investors. Rises in interest rates are the least of their problems.
Andrew Baum is Programme Director for the Oxford Real Estate Investment Programme, a one-week open executive education programme. In 2017 he established the Oxford Future of Real Estate Initiative, an industry-supported research programme focused on the 2025-2030 impact of innovation and technology on the global real estate industry.
He is the author of a number of books on real estate including the fully written new edition of Real Estate Investment: A Strategic Approach.