Commercial Property Strategies in an Inflationary Market
This article was first published on Property Investor News, September 2022
I had a wry smile recently when I was looking back through commercial property journals from the beginning of 2022 which were predicting low interest rates for the next few years as part of the U.K.’s bounce back boom. How things have changed in a few short months! We now face a looming cost of living crisis this winter with rising energy costs, high inflation and increasing interest rates. But what tends to happen to commercial property in markets such as this?
Ordinarily, rents tend to rise with inflation in order to keep up with the cost of living and this can obviously be a huge benefit for commercial investors as capital values should also increase, meaning enhanced commercial returns, especially if you fixed your bank debt prior to interest rate rises.
Investors’ cash starts to erode in the banks and cash purchasers tend to pile into the market to hedge against inflation – this can also fuel capital value growth. At times like this commercial property tends to be perceived as a safe-haven in which to invest, as long as you choose the right product with long term growth potential.
However, these general trends may be tempered in 2022/23 by a looming recession. If this occurs, consumers will tend to restrict their “discretionary spend” meaning that tenants that operate businesses that fall in this category may start to see a reduction in sales and struggle to pay rents. Regrettably, I would expect to see some tenant failures should the cost-of-living crisis continue for too long. Clothing retailers are an example of ‘discretionary spend’ operators. When faced with a restricted ability to spend, often a consumer will choose to pay their bills, buy food or choose an ‘experience’ (such as a meal out) than buying new clothes, and it is often fashion retailers are affected by this first. Already, agents are reporting an unwillingness by some tenants to commit to long-term leases, operating a “wait and see” policy to see if the market is going to drop.
For those investors that need to use debt, however, the rising cost (and reduced availability) of finance will inevitably start to soften the investment market, despite cash investors’ desire to pile in.
However, I firmly believe that there will opportunities in the coming months as some of the more ‘punchy’ pricing that we’ve seen in the recent market starts to dampen as sentiment reduces. As Baron Rothschild famously said, “Buy when there’s blood in the streets, even if the blood is your own.”
There are obviously many profitable strategies you can pursue in commercial property in times such as this, but I’ve picked out seven, below, where I believe investors may be able to gain a competitive advantage in the current market:
1. Microniching
I believe that this is the absolute number one strategy to use in any market. Microniching is found at the ‘sweet spot’ of spotting national, local and international real estate trends; the strategies you employ; your investing location’s specific advantages and trends; and your available finance. With the premise being that there are strategies and locations that will outperform market conditions, it makes good business sense to pursue these to obtain a competitive advantage. Never has this been more important than in the current market!
A more detailed webinar on microniching can be found on my website (www.commercialpropertyacademy.co.uk)
2. Commercial to Residential & Permitted Development Rights
The trick in high inflationary conditions is to be able to add value to your investments. In the current market an additional necessity is to be able to refinance successfully after you have added value.
I’m expecting pricing to soften for opportunities where you can use class MA, class G and other permitted development rights in England. Conversion of Class E space to residential can be very profitable but make sure that you have accounted for enough build cost inflation in your numbers. In a looming recession it’s crucially important to follow these two principles:
- Let to recession proof tenants if keeping part or whole as commercial (service industries, health, food stores etc)
- Model multiple exits. For example, retaining as commercial rather than changing the use, and modelling both rental and sale models if you are converting to residential.
It may be that residential values remain robust as demand continues to outstrip supply, but sensitivities should be run on end values, in any event, to model the downside.
3. Commercial to Commercial
By employing microniching and looking to add value to your commercial assets you can look to “beat the market”. Every sector of the commercial market is responding differently to the current market conditions so choice of product and asset management strategy will be the key to success. There will be some sectors (such as logistics) where inflationary increases in rents will inevitably materialise – and those where tenant distress will mean that it is just not possible to pass rental increases through to tenants. Knowledge is king in this market!
Amongst others, opportunities may exist to add value to commercial property when:
– There is a short lease where you could have an early conversation with the tenant to extend their lease
or alternatively surrender their lease to facilitate a conversion to other, higher value, uses;
- There are lease clauses that can be changed – for example, by removing break clauses etc;
- There is the potential to implement current or past rent review/s;
- A tenant occupies the whole property but don’t use part – it may be possible to surrender, or part surrender, the lease to facilitate a conversion of the upper parts to a higher value use.
- You can pre-let / let a vacant property
4.Retail
My logic on this one is that a lot of retail is currently undervalued – even prime retail has been down-valued during Covid. Now may be the time to take advantage of this to purchase decent product in great locations as valuers may remain jittery about retail well into next year.
As above, make sure that you futureproof your tenant use, purchase the right properties in the right locations, model multiple exits and do thorough due diligence before you buy. Banks remain nervous about financing this sector so be prepared to purchase cash until they relax their lending criteria.
5. Distressed Landlords
Regrettably, with the increasing likelihood of some commercial tenants becoming distressed, coupled with rising interest rates on the back of the issues experienced during the pandemic, this will prove to be the final straw for some landlords. Vendors who may be distressed include owners of some secondary retail, highly leveraged investors, those that have suffered tenant insolvencies, and (in the future) those that are unprepared for the rising EPC standards.
6. Industrial
I don’t think there is any doubt that the logistics sector will continue to boom as demand far, far outstrips supply. However, there is currently also massive demand for smaller flex industrial space in many towns and cities across the UK.
A lot of socio-economic trends are ticked by industrial property where you can locate many types of businesses, as well as dark kitchens, trade counters, small logistics etc. This may be a sector where you can achieve inflationary growth, but make sure you do extensive due diligence on your investing location to be sure of supply and demand. The sector is oversubscribed so great relationships with commercial agents and some direct to vendor marketing will be essential.
Opportunities to look out for include buildings on large sites that can be developed or extended; large buildings that can be subdivided to provide more flex space: owner occupiers looking to do a sale and leaseback, downsize or sell, properties that fall within the old class B1(c) use class which are now class E and have the potential to be converted to residential, and larger retail that can be converted to industrial on the edge of town centres.
7. Sustainability
The big corporates have jumped on this, and I genuinely believe that this can also provide SME’s with a competitive advantage in the coming years.
It is currently forecast that EPC requirements will be at B or above by 2030 and that the current exemptions will be diluted significantly. I’m anticipating that there will be many distressed landlords faced with the cost of EPC works especially as, in the future, finance may well be conditional on properties meeting environmental standards. I genuinely believe that this could be an area of competitive advantage as blue-chip tenants become more choosy as to the product they occupy, and valuers are guided to penalise the capital values of those properties that do not meet standards.
In summary, in uncertain markets it’s always important not to overpay; niche your strategies; ensure you have multiple exits (and run sensitivities); do extensive due diligence; ideally de-risk before you buy (by pre-letting and purchasing creatively if you can); have several avenues of equity and debt available, check tenant covenant and tenant market sector and monitor market conditions carefully.
I genuinely believe that there will be many opportunities in the inflationary market of the next few months and now is the time to prepare to position yourselves to take advantage of that.
