Counting the cost

According to a recent Royal Institute of Chartered Surveyors (RICS) UK commercial property survey, the cost of living crisis and Bank of England interest rate hikes have led to caution across the commercial property market, with 43% of respondents now reporting that the market is entering the early stages of a downturn.

Financial pressures

A cost of living squeeze impacts on consumer spending. This can filter through to demand for commercial property. If demand weakens against rising interest rates, we could look at downward pricing adjustments on some commercial properties, says Chris Donabie, investment partner at Naylors Gavin Black, an independent commercial property consultancy.

“The rising cost of debt is likely to hold back the building of new developments, which would make refitting older developments more cost-effective when looking to secure tenancies,” he says. “But the most interesting investment still lies in industrial properties; they can be a good hedge against inflation as rents may rise ahead of debt costs, where interest cover is important to lenders.”

Certain sectors of the commercial property market, such as supermarkets, industrial property and warehousing, remain resilient and demand for such investment properties remain high, says Yasar Kaushal, real estate partner at commercial law firm, Primas Law. However, general demand for most retail and hospitality properties is waning, as these sectors have suffered badly from the impact of Brexit, the pandemic and now inflationary pressures.

“The recent volatility in interest rates and rising inflation are pointing to a downward pressure on prices as investors are keen to ensure that there is a sufficient margin between the rental yield and interest rates,” he says. “However, it is still early too early to quantify this and therefore investors are reverting to a ‘wait and see’ policy before making any firm decisions on acquisitions and disposals.”

Supply chains and shortages

Supply chain issues are also having an effect on the market, says Donabie, with increased lead-in times for things such as steel and cladding on new developments that his firm have been working on: “This has been most recently caused by the conflict in Ukraine which has resulted in shortages and delays in deliveries. Rising energy prices have added to the cost of many materials and we have also seen this within the development sector with rising development costs. In some cases this has led to questions as to viability of the subject development.”

Construction materials are not only more expensive but often harder to come by, says Richard Ellard, partner in the commercial property and development team at Thomson Snell & Passmore. Indeed, Lendlease’s restoration of Manchester Town Hall, for example, is reportedly facing a £17m overspend due to shortages of steel, plaster and timber. 

Some of the reasons for supply-chain issues relate to the lack of production during the pandemic but other factors such as the labour required to ensure the smooth running of the world’s supply chains is unavailable, Ellard adds. “Brexit bureaucracy and the conflict in Ukraine are also having an impact on the production and distribution of raw materials and building products.”

Contractors also face increased energy costs and labour shortages, he says. “Not only is this a big issue for current schemes but it also has a negative impact on confidence and viability when developers, contractors and end-users are considering future projects. Property and construction lawyers will need to think even more carefully about contracts and where the risk sits for costs overruns, variations, time delays and events of force majeure.”

Collaborative contracting and alliancing arrangements in supply chains need to be developed and become the ‘go to’ approach, says David Vayro, head of built environment projects at Primas Law. “Fluctuating costs and the strategies for risk-sharing around increases in pricing during the lifecycle of a project are becoming the norm. This is not going to be a short-term issue and construction contracts need to reflect a more structured and fundamental risk-sharing regime from the perspective of the client, right down through the supply chain.”

Energy costs

Businesses are finding that they are paying between 5-20% of their income on energy causing energy costs to eat into profits and operational costs, says Joanne Cummings, commercial property partner at Spencer West. This is having a direct effect on operation of the business.

Up to 53% of SMEs are expected to fail or reduce their operations

“According to the Federation of Small Businesses, up to 53% of SMEs are expected to fail or reduce their operations as a result. This will undoubtedly affect the commercial property sector. As a means of protecting as many businesses as it can, the government has announced the energy bill relief scheme. This means SMEs are no longer forced to find their own solutions by either negotiating new providers or taking steps to reduce the amount of energy used. The plan is not, however, available to larger businesses, meaning some may collapse as a result of the lack of support. This will lead to more insolvencies and vacant properties. The more commercial real estate is available, the lower the rents will become.”

Business rates relief

Aside from energy costs, business rates are one of the biggest costs for businesses occupying premises and, although a revaluation is expected next year, there was no references to this in the mini budget or its review by the new chancellor. This is leading to further anxiety by tenants and landlords alike, says Cummings. “Landlord and tenants are hoping that business rates will reflect the lower rents that many tenants are currently paying which will give businesses some relief. As it stands, businesses have been kept largely in the dark and this too is likely to affect tenants’ decisions on whether to expand, downsize, vacate or maintain the same arrangement.”

Business rates are always an issue, says Donabie. During a time where costs for developers of new sites are having their margins squeezed by the rising cost of lending and materials, it is another cost they could do without. “Currently commercial developments are liable to begin paying business rates not long after practical completion of a property, and when building a speculative development where pre-lets are not guaranteed, it becomes an additional cost. This could further hamper new developments, especially if we find ourselves in a time where business investment slows. It will be interesting to see how this is tackled by the new government.”

New regulations

As well as the squeeze caused by the cost of living crisis, new building safety and fire safety regulations will also impose significant burdens on developers and institutional investors, says Guy Evans, associate in the property litigation team at Thomson Snell & Passmore. “Remedial costs will fall to developers who carried out the defective work, but also on institutional investors such as pension funds who have bought freeholds as long-term investments. This could present a further risk to funds’ financial stability. While the cost of remedial works should not fall on individual leaseholders, the increased costs of complying with new fire safety requirements will fall to them, potentially further squeezing household budgets.”

The government’s continued insistence of pressing ahead with its phased implementation of further Minimum Energy Efficiency Standards (MEES) for commercial properties, with a gradual ratcheting-up of the current Minimum Energy Rating of E on commercial property lettings to a Minimum Energy Rating of B by 1 April 2030 will also impact the sector, says Kaushal. 

“There are people who question how realistic this is especially given the age of much of the UK’s industrial and office buildings. Retrofitting such buildings with modern HVAC systems and insulation may be extremely expensive. Property owners will be hoping for the government to provide tax reliefs and grants to mitigate against these costs,” he adds.

Ground rent reform is also a key consideration for the market, says Ellard. “This will have affected some landlords who relied on ground rent income on long leasehold properties because from 30 June 2022 under the Leasehold Reform (Ground Rent) Act 2022 only a peppercorn can be charged but it is not retrospective so income streams from existing portfolios are unaffected.”

Increasing litigation

Where there is geopolitical turmoil and companies trying to stay afloat, there is likely to be an increase in litigation, says Jay Bhandal, commercial real estate partner at gunnercooke.

“There’s likely to be more litigation around how and when contracts can be ended, be that leases, agreements for lease, development agreements or building contracts. It is also anticipated there will be increased litigation around variations to the cost of works and insolvencies in the supply chain,” he says.

Dan Leone, associate solicitor in the dispute resolution team at Slater Heelis, expects to see an increasing number of cases dealing with the forfeiture of commercial premises due to the non-payment of rent / rent arrears. He adds: “I would also expect to see an increased number of cases coming through relating to commercial lease renewals, where the parties are unable to agree the terms of a lease renewal (to include the amount of rent to be paid), with the court being required to make a determination.”

COVID-19 hangover

Meanwhile, coronavirus (COVID-19) continues to bite. The adjudication process dealing with COVID-19 arrears came to an end on 26 September 2022, but they are still an issue, says Daniel Thomas, head of litigation at Primas Law. “While many people thought this process would be extended, it has not been. The government has not addressed this at all and it looks as though it has been overlooked. It would make sense in the current climate for the parties to still look to the protocol to try to agree terms as new tenants are hard to come by in the current climate,” he says.

With the adjudication process having ended, some landlords will undoubtedly be looking to take action against tenants who have not reached a compromise on their arrears, However, says Kaushal, landlords will be fearful of taking back properties unless they have a clear plan for reletting them, given the potential for incurring substantial business rates costs during void periods. 

“On some new lettings, tenants are insisting on the inclusion of pandemic clauses where rents are discounted (or even cancelled) during any future lockdown. The likelihood of acceptance depends on the relative bargaining positions of the parties. Some requests will be reluctantly accepted whereas others will be robustly rejected,” he adds.

Registration remains an issue for buyers, sellers, landlord, tenants and funders alike, says Ellard. The HM Land Registry’s (HMLR) registration backlog – caused during the pandemic and the Stamp Duty Land Tax holiday – has contributed to the increase in recent years in the time it takes for Registry applications to be completed.

Economic crime obligations

Adding to registration woes are those imposed by the Economic Crime (Transparency and Enforcement) Act 2022 (ECTEA), which the government decided to fast-track in response to Russia’s invasion of Ukraine. The act aims to strengthen the UK’s fight against economic crime, with new measures that include: a beneficial ownership register for overseas entities holding UK real estate; the strengthening of unexplained wealth orders; and making it easier to prosecute anyone involved in sanctions-busting.

Ellard says: “This impacts overseas entities and those transacting with one. ECTEA came into effect on 1 August 2022 and means that overseas entities that own land will need to be registered on the Register of Overseas Entities at Companies House. There are transitional provisions in place but any party engaged in a transaction with an overseas entity will need to be able to navigate the new rules in order to have the transaction registered at HMLR.”

The act’s introduction is likely to cause additional ripples in the commercial property market, says Harry Wilshaw, a paralegal in the new build property department of Lewis Denley. “The commercial property market is attractive for many international investors due to its potential returns and high rental yields. Although the act has certainly been a step in the right direction to track assets belonging to international owners, it has come with the cost of putting certain investors off from investing due to the increased ‘hoops’ that they will have to go through compared to before.”

In addition, he says, law firms are reconsidering their position in acting on behalf of international clients with insurers increasing premiums due to the rising exposure and risk posed to firms. 

“With international investors and law firms being affected by the recent changes brought in by introduction of the act it is clear that this will have a disruptive impact on the investment being brought in from overseas into the commercial market. However, the introduction of stricter rules placed on international investors was necessary to combat and reduce the impact of money laundering in the UK property market and hopefully going forward will become a familiar and accepted procedure for all international investors,” he says.

Affordability issues

As the cost of living crisis bites, we are likely to see a rise in the use of conditional contracts by property lawyers, says Wilshaw, as the properties clients were previously looking to purchase may become less affordable. “We are also seeing lenders imposing stricter conditions on mortgages. It has therefore been important to advise clients on the risk posed should they fail to adhere to these conditions. Contracts are beginning to become more conditional to ensure that clients have that flexibility should their financial position change or if the commercial project they had previously envisaged become less economical.”

With respect to leases, a change in how rent reviews are calculated in future is also likely, he says, with a move away from the use of the retail price index or consumer price index to calculate rates, to be replaced by a specific nominated price index or a merging of indexes together. “This would reduce the inflationary risk posed to respective tenants upon any rent reviews provisions. Additionally, solicitors may encourage tenants to negotiate the inclusion of a break clause to become available sooner throughout the lease term to ensure that they have the flexibility to get out of their lease should the projected increased rent become too financially constrictive.”

Taken together, the ongoing cost of living crisis and tightened government regulation suggest gloomy prospects for the commercial property market in the short- and medium-term. So what could the government do to improve matters?

The radical reform of business rates is long overdue, but the government needs to bring forward a significant raft of public infrastructure, services and building projects to stimulate and provide steady demand in the market, says Vayro.

“Criticially, but realistically unlikely, the release of public projects needs to be procured and delivered with the express objective of enabling SME construction entities to participate fully in the programme. The EU Procurement Rules had the effect of driving the control of projects into the hands of relatively few major players, with SME constructors and suppliers seeing very little of the upside, which gradually trickled down to them. Local procurement, local labour and other devolved features have numerous beneficial effects, not least being in delivering income and spend into local economies which is desperately needed,” he says.

Bhandal urges property professionals to remain open-minded, despite the pressures on the commercial property market. “Where one sector struggles, another will emerge. Weakness in the pound may encourage a greater rate of investment from overseas, for example.”