Is it wise to invest in the UK's commercial real estate market's recovery?

According to Terry Tanaka, the three-year decline in commercial real estate in the UK finally seems to be over

The commercial real estate market in the United Kingdom has had a long winter, but it appears that spring is finally here. While it is still comfortably above the long-term average of 5.9 percent, Savills reports that the vacancy rate in the City and West End of London office property market has decreased from a peak of 9.5 percent in late 2023 to 7.4 percent.

Shopping malls have learned to adjust as the growth rate of online shopping, including food, has slowed to the mid-30s in percentage terms. Consumers view them as a destination. They wish to go bowling, visit cafes and restaurants, and peruse stores. Since handling returns from online customers is costly, retailers have turned their stores into showrooms for online purchases in addition to being places for sales.

Land Securities purchased Liverpool One, "one of the premier shopping centers in the UK," for 490 million in late 2024. Over the coming years, it anticipates growing that amount "meaningfully" and producing an income return of 7.5 percent.

"Big-box" distribution hubs have seen significant investment, so rental growth in that subsector is probably going to slow down," says Nick Montgomery, manager of the Schroder Real Estate Investment Trust (LSE: SREI). However, the number of estates with multi-let industrial and distribution units is limited. In the meantime, the "alternative" real estate market, which includes lodging for students, residents, self-storage facilities, and hotels, is largely doing well.

It feels a little like Groundhog Day because, as his colleague Richard Gotla explains, "there have been plenty of false dawns since the market peaked in late 2022."

Values have decreased by 2025 percent since the peak, which was lower than the 4045 percent in 2009, but the sector has had less debt than then. Additionally, rental values have increased by 10% since late 2022, when they were flat.

The London office is back in operation.

Although it doesn't seem that way in central London, Gotla claims that "the big story is how little development there has been in recent years." London has made more progress in the return to the office than the other regions, but occupiers' demands have evolved. Instead of a tiny kitchen with a kettle, microwave, and vending machine, tenants prefer larger amenities, improved energy efficiency, and cafes.

However, Gotla notes that buildings rapidly become outdated and that "they start to depreciate when the builders leave" due to the sharp increase in construction costs. It has become extremely challenging for developers to make the numbers work because of initial rent-free periods of up to three years, leases of up to ten years, and obsolescence after that. Rents "are going nuts: 150 per square foot in the City, 250 in the West End" as a result.

The secondary market is rising as a result. The cost of renovating a high-quality building in a desirable area is significantly lower, which enables landlords to charge significantly lower rents for shorter leases (about five years). Tenant demand for renovations is high, and they make up a sizable portion of Derwent London's (LSE: DLN) portfolio. At a 40 percent discount to net asset value (NAV), the shares are traded.

In May 2024, the trust diluted NAV by issuing 350 million rights at a discount, which is why Great Portland Estates' (LSE: GPE) shares are trading at a 30 percent discount. Investors never like these kinds of issues, but they show how excited management is about the future. In order to validate its NAV and lower its debt, Norway's sovereign wealth fund paid 570 million in April for a 25 percent stake in Shaftesbury Capitals' Covent Garden estate. Even though the company reported strong performance last year with rental income up 6% and earnings from its West End estate, which primarily consists of retail and leisure properties, the shares have since increased by more than 20%, but they are still trading at a 30% discount.

With 10 billion assets and a 30% discount to NAV, industry titan Land Securities (LSE: LAND) has been expanding its retail holdings. Canada Water and Broadgate are two "campuses" that rival British Land (LSE: BLND), which has assets worth £8.7 billion, has targeted. These include public areas in between workplaces, as well as retail and recreational establishments. 10% of its assets are in shopping malls, and 25% are in retail parks. There is a thirty percent discount on its shares.

Since SREI is much smaller and has only £300 million in net assets, it will not own any trophy assets. However, because it is smaller, it can search for value in places that larger investors overlook. Although its shares are discounted by 20%, the yieldwhich is nearly 7% and entirely covered by earningsis alluring. Additionally, 30 million in rental income is far less than the 40 million in "reversionary rent" that the properties would fetch if they were re-let today. Just 10% of the portfolio is located in London, and more than 40% is in the North. The remaining 50% of the portfolio is made up of retail warehouses, offices, and multi-let industrial space. Even though it has a large amount of debt, 75% of it is locked in for 11 years at a cost of only 2.5 percent annually, so higher interest rates haven't had much of an impact on it. However, an improving market will help it greatly.

Over the next four years, Schroders projects a total annual return of 810% for UK real estate, which would guarantee both increased dividends and capital growth. Through the renovation of aging structures and the repurposing of units on its estate, the group is eager to add value to its portfolio. Montgomery believes that "it is more interesting to be an owner and operator than just an owner," but he also sees opportunities for affordable housing in the inflation-linked revenue from hotels.

He cautions that global factors and rising gilt yields could affect sentiment in the real estate market, but that there should be a recovery because interest rates are expected to decline. "A spike in demand is not necessary to achieve respectable returns when there is a shortage of supply. Such a recovery has begun to be discounted by the sector's share prices, but there should be much more to be gained.