How does the commercial property market look post-pandemic?

Now that nearly half of the UK population is vaccinated and there is light at the end of the tunnel, people are talking about what the commercial property market will look like post-pandemic. Here we offer some insights from Russell Davidson, a real estate partner with gunnercooke LLP and from Larry Jobsz, Managing Partner at Buchler Phillips, corporate recovery, restructuring and turnaround specialists in London, who are dealing with a number of distressed real estate portfolios.

Perhaps hardest hit have been the hospitality and leisure sectors, which are always among the most sensitive to changes in the economic environment. Typically bearing high levels of fixed costs and operational gearing, businesses in these areas clearly take disproportionate hits to profitability when there is a reduction in revenue.  A notable fixed cost for operators in these areas is real estate, whether that means rent on a restaurant unit or estate, a commercial mortgage on premises such as a club, or a long lease on a hotel. Very soon after the first lockdown commenced in March 2020, several leisure companies, large and small, experienced unforeseen issues around property costs, not least because their operations had been thriving up to that point. Successive lockdowns have closed hotels, restaurants and cafés entirely, although some have been able to replace a small part of their income with takeaway services. While the furlough scheme and the business rates holiday have helped, many establishments have closed, never to reopen. Some 2200 sites closed last year, with branded restaurant chains hardest hit.

Real estate issues have been a timely catalyst for these businesses to future-proof themselves in other respects in readiness for eventual recovery. Leisure and hospitality are ultimately consumer focused sectors where tastes and buying patterns may change. They are highly competitive, with points of difference difficult to establish outside the obvious areas of value for money and superior service. A sustainable strategy for real estate in all hospitality businesses therefore needs to be developed alongside managing other fixed costs as tightly as possible, therefore mitigating the impact of all types of business interruption or unexpected changes in the competitive landscape. Recently these have included improving efficiencies, productivity and cost saving; hospitality-specific issues regarding tax, VAT, HMRC and PAYE; employment issues; cash flow optimisation; asset reviews; leasing and other finance options for equipment.

There is, however, a bright future for the hospitality sector, with approximately three-quarters of small and mid-sized operators thinking of recruiting. Clients in the hospitality sector are predicting a bumper season when reopening occurs and forward bookings are dramatically up on past years. A survey in the last few weeks by Lumina Intelligence revealed that the opportunity to negotiate more affordable rents and the accumulated savings of the public will see the market return to 72% of its 2019 value. People in the sector are resilient and many of those who have lost their businesses will no doubt start again. There are some recruitment issues due to Brexit and international travel restrictions, but the overall mood seems to be more optimistic.

Beyond the high-profile examples of hospitality and leisure, many restructurings of businesses severely impacted by the pandemic have included a significant real estate element. It has been a stark reminder that property, or at any rate the cost of owning or using it, is central to so many enterprises remaining afloat. Of course, both sides of the landlord-tenant relationship have suffered:  owners (landlords) have faced rent defaults and voids as business occupants were unable to operate and may have had to close their doors for good. Equally, businesses able to continue trading, perhaps helped with staff costs by the Government’s furlough scheme will have found that property costs and contractual obligations remained a key concern. Regardless of Covid, the best approach to resolving real estate issues is invariably to find constructive solutions in the best long-term interests of both parties in a contract. This does not only mean mediation, but spending time developing sustainable arrangements that will benefit all stakeholders. These include moving to turnover based lease rents, deferral of service charges and other costs, revised lease breaks, lease extensions and timings of rent reviews.

Many predict the office market to be changed forever. The pandemic accelerated the flexible working trend that was already taking hold plus the continued repurposing of much office space for residential use. Some large tech companies have announced that they will adopt a remote working model for all staff going forward, while others have taken the opportunity to reduce their footprint (and real estate is for many businesses the largest expense after salaries). Yet predictions of the demise of city centres and the office sector are overblown. McKinsey predict a model of workers spending half their time working from home and the rest in the office, with a bigger return to office working for those businesses requiring a higher degree of face to face interaction than can be achieved over a Zoom or MS Teams call. Many businesses that were aiming to embrace full out of office working now realise that it is difficult to train new staff remotely, that some staff suffer stress when working from home and that an entirely remote model gives rise to customer relationship and teambuilding issues. What we are seeing is a move towards shorter, more flexible leases, preferably in buildings offering the ability to scale up and down as required. The serviced office market is expected to grow. There is, however, still plenty of new space coming out of the ground in the city centres and tenants are now signing leases, whereas they were marking time during the worst of the pandemic by holding over existing space. There is still debate about the extent to which city centres, as opposed to regional hubs, will return to life, but young people will continue to move to cities to train and seek opportunities.

Retail has been hit extremely hard by Covid. The sector was already undergoing major structural change since well before the pandemic closed stores for months and turned already thin margins into losses.  A report by The Local Data Company estimates nearly 10,000 large retail stores closed in 2020. John Lewis is the latest example of a previously successful retailer slimming down and moving the bulk of its expected future business online: it is not just old-fashioned department stores which have suffered from the dramatic increase in internet retailing. Yet while the aforementioned report also found there were 32,847 closures in the independent retail and leisure sectors, there were 31,405 openings, many by fast food retailers and grocers.  The new Class E planning use now automatically permits a wide range of business uses, and while it is undoubtedly the case that much retail space will be converted into a mixture of leisure, office and residential uses, smaller independent operators and opportunist international retailers are waiting to see what comes available. We predict a slow but steady recovery of the retail sector, with the emphasis towards destination retailers able to attract customers because of the ambience of the venue and quality of goods. The likely increase in town centre living is likely to drive local retail, particularly food related, provided the goods being sought are not easily available online. The trend will be towards a greater mix of uses in smaller units within town centres and better incentivisation of prospective tenants. One example is LGIM Real Assets “Kingland” development in Poole, where young entrepreneurs have moved into vacant small retail units with no rent or business rates to pay for the first two years.

Nonetheless,  an ongoing shift in shopping patterns will continue to remove ‘traditional’ capacity from  town centres until retailers take drastic steps to adapt to the new order. Too-high rents for the majority of multiples; lack of innovation in-store and slowness to grow online; high staffing needs. Hammerson, once a stalwart of out of town shopping, has completely exited the sector, selling its shopping centres at a massive discount. Established retailers need to think like independent, destinational businesses and provide an engaging in-store experience for millennial consumers who have almost grown up shopping online. Most of these need a very good reason to venture beyond their front doors to partake in discretionary shopping as a leisure activity. Business rates, data security, investment in store technology, price wars and permanent ‘Sale’ periods, not to mention logistics and the supply chain, have forced business owners and management teams to keep moving just to stand still. As in leisure and hospitality, the real estate factor will remain dominant in the viability of businesses, prompting a need to redefine relationships between landlords and tenants for the foreseeable future. Again, these will need to be structured alongside other measures such as stock control and working capital; technology and operating efficiencies; relationships with suppliers; trading with international partners, and support with banking arrangements.

A contrast to the woes of the retail sector is logistics, where it is boom time for those who have warehouses and logistics centres to rent, especially with good motorway access. Online shopping has been accelerated dramatically by the pandemic and is here to stay. Expect a trend of further warehouse construction over the coming years.

The residential market never really closed during the pandemic – viewings and sales still took place and the stamp duty holiday has driven increases in prices in many parts of the country. The estate agents tell us they have rarely been so busy. And while many people say that town centres will be deserted as people move to the countryside in search of an office at home and open space, it is the fact that for practically every sale of a city centre property, there has to be a buyer.

Ideas of city centres emptying are misplaced. We expect to see an upsurge in the number of people living in town centres in the coming years – a trend that will in itself underpin the eventual regeneration of the High Street, albeit with a different type of retailer and a greater emphasis on leisure and lifestyle activities. There will be winners and losers, as always , but history has shown time and again that UK real estate is a resilient asset which gets repurposed as times and economic circumstances demand.