RICS economic analysis of commercial property sector

The Commercial Property sector, worth around £1.6tr to UK Plc and employing over one million people and supporting a million more, is a key part of the economy and society. By providing a home for everything from retail to hospitality to office space, it shapes our everyday environment and impacts on how we work, live and play. The impact of COVID-19 has been stark, with a fault line appearing in the relations between landlords and tenants over the payment of rent and service charges. As we hit the June quarter day, our Chief Economist, Simon Rubinsohn, looks at the economics of the sector, before our Global Property Director Paul Bagust considers what next for commercial property and the role RICS can play in a post COVID-19 world.

Economic analysis

By Simon Rubinsohn, Chief Economist

The economy is now slowly beginning to emerge from the depths of the lockdown but the legacy of COVID-19 will be lasting scars both on the macro economy in general and the commercial property market more specifically, whether or not there is a ‘second wave’ to the pandemic. A big part of the challenge for government will be to ensure the tentative signs of a recovery in economic activity can be placed on a sustainable footing while, at the same time, managing the overhang of ballooning public sector indebtedness. This, when measured as a share of GDP, is now approaching its highest level in seventy years as a result of a series of timely and effective fiscal interventions.

Concerns over the behavioural impact of the virus on consumer psychology remain critical despite some signs of a rebound in retail spending from recent lows. And alongside this, there are understandable fears that the risk appetite of businesses will be limited with a stronger inclination to build cash reserves as revenues begin to pick-up rather than commit to large spending programmes.

Meanwhile for the real estate market, underlying structural trends across the sector have not only being exacerbated by recent events but are also being compounded by cyclical distress. Although we currently only have a partial sample for the Q2 RICS UK Commercial Property Survey at this point, it is clear that demand to occupy space has fallen sharply and this is also being reflected in diminishing rent expectations amongst respondents both for the immediate future and looking further out.

The implication of this is that even as the sector benefits from a gradual improvement in the macro picture, a return to ‘business as usual’ seems unlikely. And alongside this, there will be ongoing challenge from tenants as to their ability to make rental payments given the precarious financial conditions many currently face or will encounter over the coming period.

For landlords, this presents a very different set of problems. Inevitably in the short term, a lower rental take will put pressure on returns to investors be they pension funds or other institutions, something which is not without consequence. But looking beyond this, these developments also have implications for what the real estate landscape may look like in the future. Issues around retail are not new but the embedding of ecommerce more firmly in shopping habits will inevitably have significant ramifications for the future of the high street and beyond. As to whether the rise of more agile working sees the footprint of the office sector lessened in quite the same way remains to be seen. Additional questions included in the current RICS survey are certainly pointing in this broad direction.

It is early days in terms of evaluating the long-term impact of COVID-19 on real estate. My suspicion is that there will be some fundamental changes in the way in which engagement with commercial property takes place as well as the usage of the space itself. Some thought is already being given as to what may fill emerging gaps if the retail and office estates are scaled back. Unsurprisingly, much of the focus is on the opportunity for residential given the ongoing shortage of supply in this area. While certainly part of the answer, it is important to recognise that conversion of existing buildings can bring its own problems as recent RICS research highlighted. And as this transformation evolves, it is critical to ensure that it is supported by the application of proper design and construction standards to ensure the end product, be it residential or any other segment of the market is truly fit for purpose.

What next for the commercial property sector?

By Paul Bagust

One issue that has long existed in the commercial property market has been brought into very stark light by the COVID-19 crisis, namely the often-adversarial nature of many landlord and tenant relationships.

RICS with its public interest view and regulatory role has the unique ability to consider perspectives from both sides and has for many years encouraged a new approach to these relationships.

As we emerge from COVID-19 the scale of the challenge is unprecedented. There will inevitably and sadly be an economic backlash that will impact demand and use of property in all sectors. In addition, the experience and lessons learned as a consequence of COVID-19 and the forced move to remote working will stimulate a comprehensive review of the role and integration between the physical and virtual workspace.

For this to work for all parties we must see more collaboration and a deeper understanding of views and challenges on all sides.  

It is certainly true to say that much of the industry has come a long way in building flexibility and partnership into the landlord and tenant relationship

However, COVID-19 has in some instances seen battle lines being drawn and relationships fracturing. It is unclear and concerning to many what will emerge from this.

The new government code of practice that came out on Friday is the result of extensive negotiations between all sides of the property market and it does acknowledge that both landlords and tenants have suffered as a consequence of COVID-19 and that it is in everyone’s interests to adopt a more flexible approach to reaching agreements on rent and service charge payments.

There are concerning stories on both sides of tenants who can pay rent but won’t pay or landlords who are too quick to resort to legal measures where a tenant is in difficulty. Both sides talk of a lack of trust and poor communication on these issues.  

Is this simply the unfortunate reality of COVID-19 or a more systemic and embedded problem in our market?

We can only hope that the new government Code provides a framework for all parties to work in reasonably and responsibly.

The government Code endorsed by RICS is entirely consistent with the RICS approach working across the industry over many years to encourage a more collaborative, transparent and customer focussed approach to landlord and tenant matters

This has manifested itself most notably in the RICS Professional Statements: Service Charges in Commercial Property and the Code for Leasing Business premises

In the 22 years since its inception, the Service Charge Code has had a profound and positive impact on the commercial property sector and has facilitated major improvements in standards of delivery and accountability for service charges. This is reflected in the government paper.

The Code has the stated aim to improve general standards and promote best practice, uniformity, fairness and transparency in the management and administration of services charges in commercial property

The Code for Leasing Business premises has been through several iterations and is now an RICS professional statement setting out mandatory requirements and best practice for all RICS members and regulated firms

It is the result of pan-industry discussion between representatives of landlords, tenants and other trade bodies. The objective is to improve the quality and fairness of negotiations on lease terms and to promote the issue of comprehensive heads of terms that should make the legal drafting process more efficient.

The Code seeks to make it fair and balanced by identifying the terms that are usually important and encouraging both parties to obtain advice from property professionals.

This enables negotiations to proceed properly so that each party can make an informed decision about whether to proceed on the terms that they negotiate.

There has been a great deal of outstanding work over the years on all sides to build partnerships and transparency, but it is clear in some cases we still have an industry that has adversarial and combative relationships at its heart and that trust is in short supply.

RICS will continue to lead in this arena and press for the adoption and recognition of professional standards from all side in the public interest.

The current situation places a huge burden on all parties but there is more that unites us than divides us.

There are no easy solutions but both sides need to start the conversation.

Source: RICS

Image: Marcin Kempa, Unsplash