The UK office sector is forecast to outperform the prime industrial and retail markets over the next five years, according to new data from BNP Paribas Real Estate UK.
The company predicts annual total returns for prime UK office assets will reach up to 11% by 2028, with key regional markets seeing the strongest growth.
Prime logistics assets are expected to deliver up to 10% in total returns per annum up to 2028 across key markets such as the North West and the Midlands, with prime retail assets located in key luxury shopping streets in Central London anticipated to hit 4% per year over the same period.
Charlie Tattersall, capital markets research at BNP Paribas Real Estate UK, said: “With inflation falling and base rate cuts within sight, there are signals that we are at the beginning of the next real estate cycle. However, we think this cycle will look quite different from the post-GFC era, where ultra-low interest rates and cheap debt helped drive considerable yield compression.
“Firstly, our income return projections for the next five years reflect prime yields having now corrected upwards to an attractive entry point for investors able to source core product. Secondly, we see the bulk of capital growth coming from rental growth, rather than downward yield shift as risk-free rates settle at more ‘normal’ levels. This reflects our forecasts for strong prime rental growth off the back of an ongoing Grade A supply squeeze across core real estate markets and resilient demand for best-in-class spaces across the main sectors. In short, owners of commercial real estate must prioritise active management strategies that reduce obsolescence risk and prioritise tenant retention to generate returns.”
Hugh White, head of national capital markets at BNP Paribas Real Estate UK, added: “[Office] rental growth has helped mitigate the build cost increase over the last few years, however, we believe that major occupiers will begin considering longer leases if this helps support keener exit yields in appraisals and reduce the rental level required. The additional benefit of longer leases will be a return to the life expectancy of office M&E being in line with the lease length, which will reduce the obsolescence experienced by landlords on buildings with shorter leases.
“As widely reported, a number of core investors have been exiting the market. From retail funds due to redemptions, profit funds as these products wind down, to defined benefit pension schemes which are either selling their entire fund to an insurer in a buy out or pivoting towards liability matching income generating assets rather than capital growth opportunities.
“This has led the buyer side of the market to comprise mainly of well-funded family offices and high-net-worth investors. However, looking ahead, we expect institutional capital to return. This will be a combination of the pooled local authority pension funds, defined contribution pension funds, and the insurers who will be recycling the capital acquired though the defined benefit pension buyouts. We are therefore optimistic for yield compression in the medium term. Should interest rates reduce meaningfully in the short term, this will have a double impact on yield compression.”
James Carrington, head of City investment at BNP Paribas Real Estate UK, said: “The London market has essentially reached the bottom and is probably the most attractive major city to invest in Europe right now, and this means capital is coming back. Rental growth is a key driver with continued upwards pressure in the likes of Mayfair and the City, which saw prime rents reach £150/sq ft and £75/sq ft respectively in Q4 2023. Those are attractive numbers and are forecast to grow further over the next 24 months.
“However, given the lack of Grade A new office supply in the pipeline, investors should take note that occupiers are starting to consider alternative options. This is creating a medium term play for good Grade B stock for those willing to lay the groundwork in preparing and upgrading buildings now for this anticipated demand to meet occupiers’ requirements and ESG ambitions. Those who can take on a refurbishment risk, or have good local knowledge of supply and demand dynamics, could emerge as the winners of the next few years. Inevitably this trend will see new benchmark rents.”
James Fairweather, head of industrial investment at BNP Paribas Real Estate UK, added: “Investment in to UK industrial property remains above the pre-covid average as investors are attracted to positive returns driven by sustained rental growth. The suppressed number of deals completing in 2023 can be largely explained by wider macro-economic headwinds. Continued investor appetite in sheds is exemplified by industrial investment rising to represent 25% of all CRE deals last year.”
