A lasting change in consumer behaviour, a sector prone to denial, a mounting sense of gloom, and the possibility that everything could yet get worse.
Not retail, for a change, but the UK office market. Soaring borrowing costs mean a correction in commercial real estate is under way, with the biggest UK-listed landlords reporting falling values this month.
Structural change is also biting. The pandemic-induced shift towards hybrid working is enduring, leading to a fall in demand for office space similar to the rise of online retail for bricks-and-mortar shops. The two sectors are certainly different — but there are echoes.
First, a trend can take time to hurt. With hindsight, the expansion of UK retail floor space after the arrival of smartphones in 2008 looks demented: total space grew about 10 per cent over the next decade, according to agents Lambert Smith Hampton. Even as the online share of retail rose, logistics demand soared and retailer failures mounted, so physical growth continued, apparently justified by the “halo” effect of new stores or omnichannel strategies. Once vacancy rates began to rise meaningfully, it was too late: property agent Savills has said as much as 300mn square feet, or a quarter of the market, could be surplus to requirements by 2030.
Office landlords don’t have to worry about multi-location tenants simply vanishing, or at least not with the frequency that retailers have in recent years. But after suggestions that bosses or the young or ambitious would lead the office return, followed by predictions that hot weather, or cold weather, or economic pressure would force a revival, the shift towards homeworking seems here to stay. Occupancy rates are about half pre-pandemic levels, or about 30 per cent, according to Remit Consulting.
That takes time to feed into the market as leases expire. LSH research this summer found three-quarters of occupiers said they planned to reduce space when they could, based on stable headcount, with the most popular option being a reduction of between a fifth and 40 per cent.
That brings us on to another echo: “bifurcation” is the sector’s best friend. Despite a rise in vacancy rates since 2020, particularly in the City, office agents point to robust leasing figures, with most lettings chasing the newest, most sustainable office space. Tenants are willing to pay more for less space, they say, but in a better location and in a building their staff might actually like.
Prime, in the industry jargon, will be fine. In retail, after years of similar claims, it wasn’t: top-quality shopping centres may have cracked last and recovered first but everybody suffered, says Peter Papadakos at Green Street Advisors, who has been forecasting a 15 per cent hit to office demand from hybrid working since mid-2020. The rot in one part of the market can seep into the other.
Expectations for prime office capital values in the next year followed secondary into negative territory between the second and third quarters of this year, according to the RICS, while a previously strong rental outlook was slashed to modest growth.
The real danger now is how a structural change in what tenants want from office space interacts with a cyclical downturn. Retail suffered not just because of online but because rents were too high relative to turnover, both issues which were then supercharged by the pandemic.
The office market doesn’t have the same affordability problem; occupancy bills are perhaps 15 per cent of overall operating expenses and much smaller relative to staff costs than in retail. But that makes the outlook for jobs growth critical, affecting tenants’ willingness to carry excess square footage just in case or to upgrade to fancier digs close to cafés or bars, particularly if the battle to attract staff eases. Subletting is the first sign of trouble, as companies hedge their bets when faced with a recession of uncertain depth and duration.
Whether the retail rumblings in the office market grow louder will be determined as much by the employment figures as the square footage ones.