Here Charu Lahiri, Investment Manager at Heartwood Investment Management, discusses the current challenges at the heart of online retailing and the overall effect click to click has had on commercial property markets.
Online retailing is an evolving landscape that is leading to structural shifts in the commercial property market across the globe. Here in the UK, internet sales now make up 16% of total retail sales compared to less than 4% a decade ago, according to the Office of National Statistics. This trend is expected to grow further; indeed, the average weekly value of internet sales totalled more than £1 billion in September, a 14% increase year-on-year. In fact, the UK leads the rest of Europe in total online sales volume.
Inevitably as retail purchasing trends are changing, demand for traditional bricks-and-mortar retail is falling. Mid-market UK based retailers in the fashion industry are reported to be reducing the number of stores that they plan to open, as well as considering closures at lease expiry. Furniture retailers’ expansion plans have also been curtailed in the last couple of years, with High Street names such as John Lewis and Next having ceased their activity in acquiring stores in the pure homewares market.
Instead, retailers are adapting by restructuring supply chains and, in turn, requiring warehouse and logistics facilities for multi-level purposes. These include e-fulfilment warehouses to prepare and ship orders; picking and sorting; returns; and last mile delivery centres. According to Prologis, every €1 billion spent online requires an additional 775,000 square feet of warehouse space.
Supply constraints and pent-up demand
Supply constraints mean that the warehouse/logistics sector is struggling to keep up with demand, which reached a new peak at the start of 2017 [Source: JLL]. For example, between 2012 and 2016, when e-commerce was expanding, just 13.65m square feet of warehouses was delivered to the market, compared to 40.47m square feet between 2005 and 2009 [Source: Kevin Mofid, Savills].
Constrained supply has been attributed to the lack of developable land, given that the UK market is noted for having high barriers to entry. This has resulted in a shortage of ‘grade A’ prime property: in the fourth quarter of 2016, grade A available supply fell 23% and a further 3.3% during the first quarter of 2017. In addition, speculative completions during 2017 are expected to be lower than historical levels. In part, this decline is due to limited development finance post the Brexit vote, but importantly some occupiers are shifting to purpose-built facilities as much of the existing stock is considered insufficient for e-commerce needs.
Pressure on prime rents
These trends are resulting in high occupancy rates, low vacancy rates and rising pressure on prime rents. According to researchers Cushman & Wakefield, annual prime rental growth ranged from 3.1% in the West Midlands to 13% in Yorkshire in the first quarter of 2017. The South East, East and Yorkshire are seeing the strongest increase in e-commerce demand and rental growth in those areas is above 10% per annum. These supportive conditions offer stable and long-term income opportunities for investors, notwithstanding that the risk premium versus UK gilt yields is compressing.
Overall, the outlook remains constructive for rental growth prospects in the logistics and warehouse sector, due to the underpinnings of strong supply and demand dynamics. Total returns in the industrial and logistics sector should outperform those for office and retail over the next few years. That being said, the UK property cycle is maturing and investors may have to expect lower returns compared with recent history, despite strong fundamentals.
We have for some time advocated an investment approach that is targeted to sectoral trends, but also one that can seek income and return from specific regions. Over recent months we have chosen to invest in UK regions and cities outside of the South East and London, where capital values and yields potentially offer more attractive value. We believe that there are opportunities to be exploited in UK commercial property, but they are now appearing in more specific areas of the market which are undergoing structural change.
New research among 2,000 UK adults commissioned by virtual letting agency LetBritain has revealed a mass consumer exodus from offline businesses, finding:
- Half of consumers (51%) rely on online solutions for the vast majority of their products and services;
- 45% of UK adults – 23.10 million people – favour online services over ones that require them to go to physical premises, with 29% refusing to use a business if there is no online service;
- Londoners are the most technologically demanding, with 62% opting for online solutions and a majority(51%) consciously avoid businesses that do not offer online services;
- Looking to the future, 57% of UK adults – 29.26 million people – believe businesses with no online presence will be replaced by online or app-based competitors by 2027;
- When it comes to the rental market, Generation Rent are frustrated by the archaic processes still used by high-street estate agents;
- 31% of adults (15.92 million people) think using high-street letting agents to rent out a property is outdated and burdened by reams of paperwork;
- 25% prefer to use online-only services such as Gumtree or Spareroom.com to source and secure a rental property, with 32% not having the time to use services that require them to visit a physical premise within working hours.
UK adults are turning en masse to online platforms, frustrated by the archaic and out-dated processes used by offline businesses, new research by LetBritain reveals.
An independent, nationally-representative survey of 2,000 UK adults commissioned by virtual letting agency LetBritain has revealed mass consumer discontent with businesses failing to embrace digital disruption, with over half (51%) regularly going online to buy the vast majority of products and services they use. What’s more, 45% favour online services over ones that require them to go into a physical premise, and 29% actively avoid those businesses that do not offer an online service. People in the capital are the most technologically demanding, with 62% of Londoners opting for online solutions and half (51%) consciously avoiding businesses that do not offer online services.
Across UK industries, the rise of digital solutions is enhancing the accessibility, transparency and quality of services available to consumers. In response, the majority of UK society (57%) believes that businesses without an online presence or that require a significant amount of offline communication will be replaced by online-only or app-based alternatives within the next 10 years – equating to nearly 30 million UK adults. This number rises to three in four in the capital.
In light of this, LetBritain’s research found consumer dissatisfaction was particularly prevalent in the letting market, with both renters and landlords voicing their strong discontent at the lack of quick, accessible and easy online services available to those seeking to rent a property. With the annual rate of rental growth recently doubling in the UK, 31% of adults think that using high-street letting agents to rent out a property is outdated and overly-burdened by reams of paperwork.
In response to these widespread frustrations, one in four (25%) UK adults prefer to use online-only services such as Gumtree or Spareroom.com to source and secure a property, with 32% not having the time to use services or undertake transactions that require them to visit physical premises. This trend was particularly pertinent for Londoners – half of people (50%) in the capital rely on online services only when looking for a room or property to rent, with 55% not having the time to physically visit a property or office to undertake or complete a transaction.
Fareed Nabir, CEO of LetBritain, commented on the findings: “Over the past decade, online solutions have drastically transformed the way we conduct business. Today’s research clearly shows that consumers not only expect but now demand that companies provide their services online. And on that point, the rental market is clearly falling short, with too many high-street real estate agents failing to embrace digital solutions, relying on cumbersome offline processes. For businesses in the rental market, the choice is simple – integrate and embrace online solutions or run the risk of being outpaced by changing consumer demand.”
(Source: LetBritain)
There are mixed thoughts across the UK on the current state of the property market and the prospects to come. In some regions economists believe it’s the best it’s been in the last ten years, while others are confident in the current slump, particularly in London. Here Paresh Raja, CEO of Market Financial Solutions (MFS), talks Finance Monthly through his thoughts on the future of the UK property market.
The UK has developed something of an obsession with homeownership. While our European neighbours are content with long-term leasing contracts, homeownership in the UK is as much of a personal milestone as it is a popular financial investment – a report by YouGov found that 80% of British adults are aspiring to buy a property within the next 10 years. As an investment, property is a resilient asset able to withstand periods of market volatility. At the same time, price appreciation as a consequence of demand positively contributes to home equity, increasing its resale value and potential to deliver long-term returns.
The allure of residential real estate has remained consistently high in the UK, and the Brexit announcement has done little to dampen investor appetite for property. The average house price has risen by an average of 0.37% per month since the referendum vote in June 2016. Should this trend continue, house prices could rise by as much as 50% over the next decade. While an impressive feat, the same YouGov report stated that 85% of respondents believes that owning a home is very difficult in today’s economic climate.
To ensure homeownership remains an attainable goal, the Government has pledged to increase the housing stock by promoting the construction of new homes across the UK. A housing white paper released earlier in the year has also set out the Government’s plan to reform the housing market and contribute to housing supply, though little has been done since then to demonstrate the Government’s commitment to supporting property investment. While this is a welcome measure, such a pledge needs to be informed by a long-term strategy that lays down the foundations for the ongoing support of the property market against any future economic and political shifts.
Of course, there are variety of different avenues for aspiring homeowners to jump on the property ladder should they struggle to acquire finance from traditional lenders. The Bank of Mum and Dad (BOMAD) has fast become a leading source of finance for millennials struggling to acquire a mortgage or buy a house in a desirable location. Parents are predicted to lend over £6.5 billion in 2017 to support the property aspirations of their children – a 30% increase on the amount loaned in 2016.
Considering the amount of property wealth that has been amassed by UK retirees and the Baby Boomer generation, the transfer of such wealth through inheritance constitutes a significant proportion of property transactions – a study by Royal London anticipated that over the coming decade, £400 billion worth of real estate would be passed on from older generations to those aged between 25 and 44. This transition will have profound impact on the wider property market.
Recent research commissioned by MFS found that that 36% of people across the country will be inheriting a property – equivalent to 18.64 million people. Interestingly, the research found that over half of people due to inherit a property will be looking to sell it as soon as possible so they can re-invest the money in a different asset or property of their choosing. A third would also look to take advantage of the long-term returns on offer by undertaking some form of refurbishment so that the house is in a better condition to sell or place on the rental market.
The challenge remains for the property sector to provide clear guidance around the options that exist for those seeking to maximise the potential gains of their real estate inheritance, while at the same time bringing new properties onto the market in improved conditions. Taking into account the full range of trends underpinning the property market, homeownership does not have to be an attainable goal for the few. The market is at a critical juncture, and with demand for property consistently high, there are likely to be significant opportunities arising over the coming year.
By Paul Aylott, Partner and Head of the Valuation & Lease Advisory Division at Glenny LLP
The property investment landscape is changing. According to studies, the number of buy-to-let landlords turning towards commercial property investment has grown by 200% over the last three years, with investors moving away from residential property and looking to commercial and mixed-use investments as an alternative.
The residential buy-to-let investor has had to face a series of recent challenges, including a 3% Stamp Duty Land Tax (SDLT) increase on residential investments and a phased reduction in tax relief on mortgage interest repayments, which has encouraged many landlords to either move portfolios across to limited companies, or to transition into the commercial property market.
Changes to the way investors vet and verify tenants, which includes conducting residency checks and taking out Tenancy Deposit Protection (TDP) schemes, are also creating a barrier to investment. Other landlord obligations – fundamentally designed to protect the tenant population – include providing the tenant with an Energy Performance Certificate, a Gas Safety Certificate and a copy of the Government’s latest copy of the guide “How to Rent” when they move in.
The benefits of commercial investment
With obligations such as these, the initial benefits of making this move from residential to commercial investment seem obvious. Firstly, the Stamp Duty Land Tax liability is lower and the 3% increase does not apply to commercial properties, including mixed-use premises that offer retail on the ground floor and residential above. Over the last 12 months, we’ve seen an increased number of borrowers looking to profit from the mixed-use nature of such investments.
With a commercial lease normally lasting considerably longer than a 12-month Assured Shorthold Tenancy (AST), investors are notionally guaranteed income for a longer period, an attractive proposition for an investor looking to borrow against a secure income stream. In this asset class, often upward-only rent reviews are built in – something excluded from a residential AST – with the rent compared to the open market or inflation hedged against RPI increases.
Often, residential property is bought with vacant possession, and only after a period of refurbishment is it let. But commercial property is typically bought with a tenant and lease already in place. The benefit to the investor is the immediate flow of income without losses during void periods. Added security comes with more stringent commercial tenant credit checks, undertaken with a higher level of due diligence than those typically completed by a residential landlord prior to a lease agreement. And, in times of financial stress, a commercial tenant is able to assign their lease to another tenant. This same option is excluded from a residential AST, with the property and the landlord subjected to a void period should a tenant default on their payment.
A commercial landlord’s repairing obligations are significantly less than those of residential landlords; commercial leases often impose full repairing and insuring (FRI) obligations, making it the tenant’s responsibility to carry out repairs within their premises. The insurance is reimbursed by the tenant and the landlord seeks what is known as a ‘clear lease’, where the landlord collects rent and the remainder of the obligations of the property are the responsibility of the tenant.
Understanding the asset class
However, although there is a current trend towards commercial property investment, it’s worth taking note of some of the potential pitfalls. Commercial property is a very different asset class from residential property, and investors should ensure they fully understand both before considering a change in the direction of their investment.
The litigation process, for example, is a long and detailed one; the drafting of a commercial lease takes considerably more time and incurs a much higher legal cost.
These complexities particularly around commercial lease clauses often result in the need to employ professionals to act on behalf of investors to advise on issues such as rent reviews, assignments, sub lettings, alterations, dilapidations and dealing with lease renewals in accordance with the relevant legislation, including the Landlord and Tenant Act 1954. The volume of case law involving commercial leases is perhaps one of the reasons for it, until now, being constrained to the professional investor who has some understanding of the commercial property market and a network of professional advisors to rely on.
Furthermore, the holding costs of a commercial property, should it become vacant, are often significantly higher than an equivalent buy-to-let investment.
The residential buy-to-let market is arguably far simpler to understand and affected by fewer legal intricacies to that of commercial. The financial return from commercial and mixed-use investments can often be more attractive than buy-to-let but this needs to be balanced against an investors’ knowledge of the commercial investment market and access to professional advisors.
Where the best opportunities lie
It’s important for investors to know what their objectives are prior to deciding where and when to invest. There is a trade-off that needs to be taken into consideration A single let commercial investment, leased to a strong covenant, would offer a secure rental return but is likely to be relatively low yielding.
For example, we recently valued and subsequently sold a warehouse in Hertfordshire, that had been let to Amazon with an unexpired lease term of four years. The rental yield was 5.5% and the investment would require limited landlord input during the term of the lease. By way of comparison, a mixed-use retail and residential investment in Tottenham, North London, offering a large shop and nine flats above, sold earlier this year at a rental yield of 8%. The Tottenham mixed-use investment produced a higher yield, but carried with it a greater liability in the way of landlord management input, a less secure income stream and a higher risk of voids.
Capital asset appreciation in respect of both scenarios is dependent on rental growth and demand in the investment market. Compare this to the typical single let residential buy-to-let investment, where the market can sometimes include owner-occupiers as well as buy-to-let investors, which can drive capital growth.
The verdict
Residential investment is by no means dead. There is still profit to be made from investing in this asset class, which is very different from its commercial counterpart. However, commercial investment is a growing trend, and provides an interesting investment opportunity as long as the risks, as well as the rewards, are fully considered, and the investor has the right professional team in place to make the most of the opportunities available.
About Glenny:
Glenny LLP is a multi-disciplinary property consultancy. Its Valuation & Lease Advisory division works closely with financial professionals to offer a range of services relating to residential and commercial property.
Commercial real estate industry leaders participating in The Real Estate Roundtable's Q2 2017 Economic Sentiment Index report that market conditions are stable and will maintain slow, but steady growth over the next several months – yet many respondents are also less optimistic about future conditions due to uncertainty in domestic policy and the geopolitical landscape.
"As the Trump Administration and Congress continue to consider ideas for tax reform, infrastructure investment and financial regulatory overhaul, The Roundtable's Q2 Sentiment Index is tempered by anticipation about what consequences the details of any eventual legislation could have on commercial real estate," said Roundtable CEO and President Jeffrey D. DeBoer. "We continue to remain engaged on the policy front to communicate the vital economic role that CRE provides to communities throughout the country and the industry's ability to create jobs."
A recurring concern among respondents to the Q2 Sentiment Index released today is uncertainty about the prospects for domestic policy and how volatile geopolitical situations may influence the economy.
The Roundtable's Q2 2017 Sentiment Index registered at 52 — three points down from the last quarter. [The Overall Index is scored on a scale of 1 to 100 by averaging Current and Future Indices; any score over 50 is viewed as positive.] This quarter's Current-Conditions Index of 53 decreased two points from the previous quarter, but rose two points compared to the Q2 2016 score of 51. However, this quarter's Future-Conditions Index of 50 dipped five points from the previous quarter – but is up two points compared to the same time one year ago, when it registered at 48.
The report's Topline Findings include:
- Many participants suggested they view market fundamentals as stable, despite potentially destabilizing factors, and predicted a continued period of slow but steady growth.
- With the new administration in Washington encountering challenges implementing their policies, there is not the same level of economic optimism as was expressed in the Q1 report. However, participants were nearly unanimous in their belief that the current real estate cycle has room left to run.
- In certain markets, asset pricing is at or near equilibrium. Retail stands out as the most challenging property type to price, followed by multifamily, which is seen to be near peak pricing.
- Capital is plentiful for the best deals. Equity and debt sources are employing greater levels of discipline for riskier investments. In what many feel is a healthy market environment, riskier deals are more expensive and may require multiple sources of capital.
Although 31% of survey participants report Q2 asset prices today are "somewhat higher" compared to this time last year, only 15% of respondents said they expect values to be somewhat higher one year from now — reflecting the view that the current market cycle is reaching a state of equilibrium. Additionally, 48% of Q2 survey respondents said they expect asset values in one year to be "about the same" as today. Many also noted a healthy availability of capital, predicting that inflows of private capital one year from now will be similar to today's healthy conditions in the equity and debt markets, dependent on the quality of the property.
(Source: Real Estate Roundtable)
As Parliament has now confirmed the implementation of Article 50 and the notification that the UK will commence negotiations to leave the EU tomorrow, the 29th March, FDR Law’s Commercial Partner John King, considers how commercial contracts could be affected by Brexit.
The Prime Minister has now announced the formal Brexit negotiation process will now be triggered Wednesday 29th March, following which the UK will then have two years to negotiate an exit deal. This commencement of the exit provisions has now been authorised by Parliament and it is expected that the Prime Minister will make a speech next Wednesday in the House of Commons to set out her aims, shortly after invoking Article 50. For the time being, EU law continues to apply until the exit negotiations are finalised and it has been suggested that the task of reviewing and, where appropriate, repealing or amending legislation could take up to 10 years.
Both in the run up to and following Brexit, Britain will clearly continue to do business with the rest of the world, so it is important to understand what ‘rules’ are likely to apply to commercial contracts which underpin their business relationships, particularly with EU companies. So to what extent will developments during the negotiation period affect some of the commercial and legal areas?
On the face of it, many commercial contracts would seem to be neutral as to whether the UK left or remained in the EU. They are generally less heavily regulated than many other areas of law, and, as the name suggests, tend to be based on the commercial bargain between the parties. But what if that commercial bargain is in itself significantly affected by Brexit? Now is a good time to start identifying any potential risk areas in your commercial contracts. These could include increased trade barriers, currency fluctuations, the territorial scope of your agreements, and changes in law.
Existing contracts
The UK leaving the EU may well affect the operation of existing contracts, possibly in a manner that the parties had not foreseen or planned for at the time of entering into the contract. For example, if the operation of the contract was wholly or largely dependent on the ongoing operation of some particular EU legislation it is possible that the contract could be frustrated (i.e. terminated) or the force majeure provisions could be triggered at the time of Brexit (or indeed possibly before when the terms of Brexit become clearer).
Short term contracts
Short term contracts are less likely to be affected by the UK leaving the EU due to the two year negotiating window that will start once Article 50 is invoked. This negotiating period should give both parties time to consider how the terms of Brexit might affect their longer term contractual arrangements and give rise to re-negotiation.
New contracts
Before entering into any new contracts with corporates in other EU Member States, careful consideration should be given to these areas if the contract is likely to continue post Brexit, and you should seek to provide provisions in the contract that might include:
- Either expressly including or excluding the UK leaving the EU in or from any force majeure provision
- Giving the parties termination rights when the UK leaves the EU
- Providing for/referring to an alternative mechanism which will apply once the UK leaves the EU
Overseas contracts
The greatest economic impact is being felt by businesses bringing in materials from abroad. Both the annual and monthly rate of producer price inflation increased in February 2017. Output prices rose 3.5% on the year to January 2017, which is the seventh consecutive period of annual price increases and the highest they have been since December 2011. Prices for materials and fuels paid by UK manufacturers for processing (input prices) rose 19.1% on the year, a slight decrease from the year to January 2017 but the second fastest rate of annual growth since September 2008*. The expectation is that in the event that Brexit means that the UK ends up trading with Europe under WTO (World Trade Organisation) rules, anticipated EU import tariffs would add approximately 10% to the price of UK goods sold to the EU. Any party to a contract that is no longer economically viable will need to review their contractual (and common law) termination rights to see how quickly they can bring the contract to an end or whether the contract offers opportunities to re-negotiation the commercial terms.
In these circumstances force majeure and material adverse change provisions are relevant. Whether they are triggered will depend on the exact drafting of the contract and the application of the rules of contract interpretation. Currently, the market consensus seems to be that it is relatively unlikely that force majeure clauses will be triggered in the absence of wording specifically contemplating Brexit. It may be easier to argue that financial consequences following on from Brexit constitutes a material adverse change but not every contract includes a material adverse change provision.
Next steps
If any of your key contracts are likely to be affected by Brexit, you could consider seeking to negotiate amendments to terms that are materially affected. It is also worth considering whether the contract contains any contractual remedies that could be triggered by Brexit.
Trade deals with the remaining EU states are highly likely to take several years longer than that. In the meantime, the ramifications of Brexit will hopefully become clearer so that businesses are able to confidently deal with any contractual issues that it may bring.
*ONS UK producer price inflation statistical bulletin: Feb 2017
