Over the past 18 months, the UK has seen substantial fluctuations in property values, largely spurred by the ripple effects of rising interest rates. 

Michael Dean

Michael Dean

However, a significant divergence between commercial and residential property values has emerged. While commercial values have plummeted rapidly, residential values appear, on the surface, more resilient with downward movements only just beginning.

The pivotal role of rising interest rates is clear when examining the commercial property sector. As interest rates climb, borrowing costs for investors rise in tandem, exerting a downward pressure on commercial property prices; higher interest rates necessitate higher yields to service that interest. The Bank of England’s persistent interest rate hikes to curb inflation have been a key trigger in the rise in yields and the consequent fall in values.

According to recent RICS data, the UK Commercial Property Index registered a 14.4% decline over the last 12 months, while data from the Office for National Statistics reveals a 2.7% drop in commercial real estate prices during the same period.

Vacant offices are being torn down to be replaced by multi-let industrial estates

The re-evaluation of property needs by businesses, spurred by the surge in remote working and evolving consumer behaviours, is another significant factor in the changing value landscape. Many have downsized office spaces or migrated to more cost-effective locations, resulting in weakened demand for commercial properties. Lower future rental value expectations also weigh heavily on commercial property values, and, inversely, on yields, if there is a lower prospect of rental growth.

The situation is exacerbated by UK institutions, particularly open-ended funds, being forced to sell their property holdings to meet investor redemptions. This scenario of ‘forced sellers’ significantly accelerates the fall in commercial property values.

One of the attractions of institutional real estate ownership is the reduced volatility via ‘mark to market’ value adjustments. However, when funds are forced to exit assets, their rushed sales of institutional-grade stock set the bar for the rest of the market, which in turn may spur further redemptions.

shutterstock_2363920103_cred Sean Aidan Calderbank

Source: shutterstock / Sean Aidan Calderbank

Not static: electric car charging stations offer high value for landowners

The residential market is yet to see a similar wave of forced sales, despite buyers’ reduced ability to service mortgage payments due to rising interest rates. Homeowners face less pressure to sell, partly thanks to regulatory safeguards such as bank stress tests that cushion against higher mortgage costs, combined with low unemployment ensuring people have paying jobs to service their loans. This explains the fewer distressed sellers in the residential market.

Notwithstanding this, higher-for-longer interest rates will have a depressing effect on the growth of residential prices, in spite of the demographics and supply imbalances that have characterised the past 25 years of the housing market.

Grab an opportunity

So, while a crash in the residential market (at least in nominal terms) seems unlikely, it also appears that double-digit growth seems off the table in the foreseeable future, even if base rates fall 1% or 2%, as this will be anticipated by the swap markets already.

So what of the opportunity for commercial property? We may be approaching a generational buying opportunity. With traditional commercial assets such as offices being valued significantly below replacement cost, the potential for alternative uses creates opportunities for even the most unloved commercial assets.

Industrial rents and yields mean that outside the M25, there is a better than 50% chance that industrial use offers the best residual land value (often above residential), so much so that vacant offices are being bought and torn down to be replaced by multi-let industrial estates.

New opportunities do not stop there. Children’s nurseries, community churches and electric vehicle charging stations offer new, high-value options for landowners to enhance value.

Furthermore, whereas falling interest rates are priced in to the residential market, they typically have a more elastic effect on commercial yields, as commercial investors are often more likely to have floating rate commercial mortgages.

This means that when rates start to fall, yield reductions should be expected in turn, reversing the downward trend in values.

Throw into the mix a possible post-election bounce next year following a newly elected government and even traditional commercial sectors may benefit from rental growth again.

So while holders of residential property will experience a less turbulent downward leg of the latest property cycle, it’s quite possible that for the next 18 to 24 months, investors brave enough to selectively target quality commercial assets will see greater opportunities for capital growth in the medium to long term.

Michael Dean is director and co-founder of Avamore Capital