Commercial Real Estate Hits Crossroads

As the commercial real estate sector stands at a critical juncture, investors, developers, and lenders are bracing for what may be a turning point in this traditionally cyclical industry. After a decade of growth, the sector is now grappling with the impact of rising interest rates, lower transaction volumes, and changing market dynamics post-pandemic. The decline in commercial real estate transactions and valuation challenges, however, are accompanied by glimmers of hope in other areas, including industrial properties and debt management. The question for many remains: has the market hit bottom, or is there more pain to come?

Interest Rate Increases and Transaction Volume Plunge

Since interest rates began rising in March 2022, the commercial property market has witnessed a marked downturn, with transaction volumes hitting a 10-year low. The recent chart (see Figure 1) illustrates the fall in transaction activity from over $500 billion annually in 2022 to just under $200 billion by mid-2024. The sector had enjoyed a boom during the period of low interest rates, which saw record volumes of transactions and skyrocketing property values, particularly in the industrial and office sectors.

However, the sudden surge in interest rates has substantially cooled the market, making financing more expensive for potential buyers. As a result, deal-making has become more cautious, with only the most opportunistic transactions proceeding. Financing costs are squeezing investors’ margins, while inflationary pressures have made many businesses rethink expansion plans, further lowering demand for commercial space.

The sharp drop-off in transaction volumes is not just a reflection of investor caution but also an indicator of broader macroeconomic trends. Higher borrowing costs and stricter lending standards have created a bottleneck in deal flows, leaving the market in limbo as buyers and sellers struggle to align on valuations.

Debt Levels: A Mixed Bag for UK Real Estate

One of the more reassuring signs for investors has been the steady nature of debt levels in the UK’s commercial real estate market. As illustrated in the second chart (see Figure 2), debt levels in UK commercial real estate have remained relatively stable over the past decade, with a large majority of loans still in healthy ranges of less than 85% loan-to-value (LTV). Only a minor portion of outstanding loans exceed 100% LTV, indicating that most property loans are not significantly underwater.

This stability is crucial, as it means that while property values may have declined by around 20% since 2022, the risk of mass defaults or a sudden debt crisis remains low. In past downturns, particularly the 2008 financial crisis, over-leveraging was a significant factor in exacerbating market instability. Today, however, conservative lending practices and regulatory reforms since the global financial crisis have helped to contain this risk, keeping commercial property debt manageable despite the broader downturn in transactions and valuations.

Valuation Challenges Amid a Market Slowdown

Despite some stability in the debt market, the broader challenge lies in accurately valuing commercial properties. The fall in transaction volumes has left investors and valuers in the dark about where true pricing lies. Large office properties, particularly in cities like London, remain a question mark. Take CityPoint, for example, a landmark London office tower that has been a bellwether for commercial property valuations. Independent valuations have seen significant declines—from £670 million to £431 million in just a few months.

These valuation adjustments are not isolated incidents but part of a larger pattern of recalibration in commercial real estate values. With few transactions occurring, valuers are forced to rely on historical data or incomplete market signals, making it difficult to provide accurate assessments of the worth of commercial properties.

This uncertainty in valuations has spurred some investors to be cautious, leading to a wait-and-see approach, especially for large-scale investments. Until transaction volumes pick up again, the true extent of commercial real estate's repricing remains an open question.

Sector Breakdown: Diverging Realities

Not all parts of the commercial real estate market are equally affected by the current downturn. While the office and retail sectors are under particular pressure, other segments like industrial real estate and logistics properties remain bright spots.

Office Space: A Sector Under Pressure

The office market has faced significant challenges, driven largely by the continued adoption of hybrid work models and remote working arrangements. Vacancy rates have soared globally, and while some stabilisation in leasing activity has occurred, the outlook for the sector remains uncertain. Many companies have downsized their office space or renegotiated leases to reflect the reduced need for large, centrally located offices. According to JLL, the global office vacancy rate hit 15.8% in Q2 2023—the highest level since 2004.

The recovery in the office space market will largely depend on whether companies decide to fully return to in-person working, continue with hybrid models, or permanently downsize their physical footprints. With many large tenants still evaluating their long-term office needs, further stress could be seen in this sector.

Retail Sector: A Surprising Resilience

Despite being one of the hardest-hit sectors during the pandemic, retail real estate has shown surprising resilience. With consumers returning to brick-and-mortar shopping and prime retail locations maintaining foot traffic, some high-street properties have even seen rental growth for the first time since the start of the pandemic. However, this resilience is not uniform. Secondary retail locations, particularly those reliant on offices for footfall, continue to struggle.

The divergence in the retail sector underscores the importance of location and the growing demand for experiential retail—stores that offer more than just products, providing experiences that cannot be replicated online.

Industrial and Logistics: The Star Performer

Industrial and logistics real estate, bolstered by the e-commerce boom and the need for efficient supply chains, remains the strongest performer within the commercial real estate sector. Occupancy rates in this category have remained consistently high, with figures reported around 97.7% in Q2 2023. This sustained demand has been driven by the need for companies to increase their warehousing capacities to keep up with consumer demand and logistics efficiency.

Industrial properties, particularly those located close to urban centres or major transport hubs, are expected to continue seeing strong demand, making this sector the most robust segment in an otherwise challenged market.

A Market in Flux, but Opportunities Remain

The commercial real estate market is currently facing a critical moment. Interest rates appear to have peaked, but the full extent of the economic challenges resulting from these hikes may not yet have been fully realised. Transaction volumes are at a decade-low, and valuers are struggling to provide accurate assessments in the absence of meaningful market data.

However, there are areas of hope, particularly in the industrial and logistics sectors, where demand remains strong. Moreover, debt levels in the UK remain relatively low, which provides a buffer against broader market instability. As lenders and investors recalibrate their expectations, there may be opportunities for strategic investments, particularly for those willing to take on short-term risks in the hope of long-term gains.

The coming months and years will be decisive for the commercial real estate sector. While some areas of the market may continue to struggle, others are poised for growth, offering opportunities for savvy investors who can navigate this period of uncertainty.