How much is the pandemic changing the commercial property sector?

Could COVID-19 be the catalyst for fundamental change for the commercial property sector? | Rouzbeh Pirouz

How much is the pandemic changing the commercial property sector?

While restrictions are slowly beginning to lift in England, the UK is very much still in the middle of the pandemic at the time of writing. Vaccinations continue apace, with the Government now expediting second doses in the shadow of the potentially damaging Indian variant. Whatever happens over the next few months, there’s no doubt that the global pandemic has changed so much of the world around us. Whether those changes outlast the virus itself remains to be seen. However, I think it’s likely that the commercial property sector will remain in a state of developing flux for the foreseeable future. Here’s why.

The commercial property sector is adapting to new demands

Lockdown restrictions instigated due to the pandemic led to unprecedented swathes of the economy literally shut down. And commercial property has borne the brunt of the heavy restrictions imposed on hospitality and in-office work in particular. Millions of people were forced to stay at home, whether through remote working or on furlough.

Sadly, many also lost their jobs during the height of the pandemic. At the time of writing, England has literally just opened its hospitality sector for the first time in months. This means that indoor drinking and eating can now happen, people can visit family and friends and, at least for some, remote working will go back to commuting.

All of this has altered the way commercial property sector investment works in the UK. An increasing number of retail landlords are looking into changing their leases. The need to replace the traditional rent review mechanisms with rent to instead be based on turnover.

This has obvious ramifications for investors, as the landlord would effectively share the operational business risk with their tenants. Sharing the risk in this way is a completely different approach to decades worth of retail rental practice and shifts the onus onto both tenant and investor.

Sharing risk with tenants in commercial property space

This is not without precedent for investors in alternative investment markets. We’ve already witnessed investors sharing risk in alternative asset classes, but how well this will translate into retail remains to be seen. If it does, then it represents a fundamental sea-change in the way investors will view retail property opportunities.

As with other sectors, most of the trends we have witnessed within commercial property investment during the pandemic are not totally new. Rather, they’ve been sped up exponentially by the pandemic and the enormous changes that have been implemented in the way people live and work.

With retail, consumer spend largely switched to online spending during the months of lockdown. The notable exception within retail can be seen with the major supermarkets, grocery store chains and other essential suppliers. They have inevitably seen profits rise throughout. But for the rest, consumers who hadn’t already made the shift to online e-commerce sites were forced to by COVID-19.

This, of course, left traditional brands and stores with no real omnichannel offering lagging behind their peers. Now that retail stores have reopened in the UK, I’m sure we will see a return to the high street. But whether that is enough to slow down the inexorable rise of online consumer spend is unlikely. I think that some people previously uninterested in shopping online will now stick with it even as we emerge from the pandemic.

At the same time, demand within warehousing, fulfilments and logistics has been increasing precisely because of the marked increase in online shopping. This provides new opportunities for commercial property investors who are looking for an alternative from the traditional commercial retail and office space.

Tenants increasingly demanding flexibility and sustainability

Tenants and occupiers of commercial office space are now seeking flexible property costs from landlords. More employees and businesses are implementing flexible and agile distributed work arrangements, leading to less demand for permanent office space.

Whether the property is retail or office space, landlords will make more use of turnover breaks. These give landlords more flexibility in that they can pivot the use of the property if the tenant isn’t able to pay. It’s possible we will see this permeate the other subsectors of commercial property, with leases and rents linked to turnover and success of the tenant.

Institutional investors are also diving into funding new logistics developments, given the obvious path of online shopping and the strength of brands like Amazon. These logistics and warehousing developments are being backed by institutional investors with leases that have built in rent reviews linked with inflation.

Commercial property in the UK — looking ahead to the end of 2021

Overall, the commercial property market was mixed in 2020. Industrials, some alternatives and logistics did very well, while others dived. While it could be considered logical to expect this year to repeat last, it’s likely that by the end of 2021 we’ll see more nuance within the market.

Commercial property investors need to expect change and roll with it in order to spot the many opportunities that will arise. We need to keep a long-term approach and consider the market as it emerges from the pandemic. In the short term, we can expect a level of economic recovery which will ease pressure on tenants and rents. There will be less overall demand across offices and hospitality, and the market will have to adjust to more flexible working practices from tenants.

The general consensus remains that it’s unlikely that office workers will ever fully return to pre-pandemic practices. This has obvious implications for office space in the long-term, but it won’t be the demise of the sub-sector. We will see it adapt to the new working demands of businesses. Tenants will be more selective and expect more flexibility, different amenities and sustainable offerings from landlords and investors.

There are still short-term risks to contend with in the commercial property sector. Much of the hoped-for recovery depends on the vaccination rollout, and whether another strain disrupts plans. However, we can be certain that fiscal and monetary policy will still support the sector. Commercial real estate has traditionally performed positively during periods of economic recovery, and it can absolutely still deliver stable income returns and capital as part of an investment portfolio.

Originally published at https://www.rouzbehpirouz.com on May 10, 2021.

Co-Founder & Senior Partner at London-based Pelican Partners, a real estate and private equity investment firm. https://www.rouzbehpirouz.com/

Co-Founder & Senior Partner at London-based Pelican Partners, a real estate and private equity investment firm. https://www.rouzbehpirouz.com/