Will empty retail and office space lead to the next economic crisis?

Commercial real estate is in trouble, there is no doubt about that. What shops are letting are attracting rents of as low as 50 per cent of what they were pre pandemic. Office space is being reduced and some companies are failing to renew leases as homeworking looks like becoming a permanent feature of office life.

Property crises in the past have often led to a banking crises, and alarm bells are ringing in those hallowed banking halls. The question is, have the recent signs of economic recovery in the sector been overestimated by the central banks and the financial watchdogs? Have they underestimated the threat posed by an industry that’s in danger of breaching debt covenants and with asset prices collapsing right, left and centre?

With a rather opaque market like commercial property it is impossible to assess at this stage the full extent of the damage caused by the switch to home delivery and home working. Property values are slow to reflect the new situation until leases run their course and properties come onto the open market. But surveyors are already significantly marking down rents for new lets.

One useful guide to real estate values in the commercial sectors is the price of shares in quoted real estate investment trusts and Reits. These have been substantially hit, severely affecting the value of peoples’ pensions and other investments.

Banker concerns

The Bank for International Settlements, which is the central bankers’ bank, estimates that in the UK, US, Europe and Japan the pandemic has has wiped away Reits’ cumulative valuation gains over the last five years. By comparison, the general quoted stocks on the main markets (FTSEs and S&P500) had regained all their losses within 18months.

Property deals are falling out of bed, property companies are trying to raise new money in the corporate bond markets and are tapping their unused bank facilities. Industry experts openly admit that many commercial properties in the US and UK are now worth less than the debt that was used to buy them, and delinquencies similar to the levels experienced in the 2008 financial crisis, particularly in the US, are beginning to escalate.

The longer the pandemic goes on with travel, hotels, retailers and office work severely affected the more the financiers worry that the resulting widespread value downgrades, defaults and eventual foreclosures could spill over into the general economy.

Major UK retailers like Marks and Spencer, which announced 7,000 job cuts in August, are busy closing loss making stores. In the US and UK many household retailing names such as Brooks Brothers and Debenhams have also fallen into bankruptcy, hastened by the growth of Amazon and other online suppliers.

There are lots of large corporate entities across the world currently looking at the impact home working, or partial homeworking, will have on their future needs for office space. A massive rationalisation programme is underway by many corporates aiming to make offices safe work spaces while reducing overall space requirements.

Government support

Requests for public support for the commercial property sector fall largely on deaf ears in Government, no doubt because hand-outs to big business are pretty unpopular with the general public. One industry expert at Colliers International, speaking about the Government’s accelerated Towns Fund says:

“The current Government funding will barely provide enough for a new bus stop for those 101 towns that are selected to receive between £500k-£1million to spend on projects in their areas. The figure needed is more like £96million per town. If the Government has such a vested interest in regeneration and transport, it needs to look at the wider picture and all financial instruments available to local councils.”

A major problem is no one yet knows how long the crisis in the commercial real estate sector will last. Business travel could take 12 months or more to pick up again, leaving hotels in limbo, though many are now housing asylum seekers. Office leases are sheltering landlords from the full effects of the downturn — offices tend to have long leases — and there’s much uncertainty around high streets, with some looking decidedly healthy while others totally forlorn.

So, what of the opportunities?

In this economic climate the need to change and adapt commercial space one way or another – repurposing as the industry terminology would have it, in other words adapting or re-using space – is likely to be a long-term saviour of the industry. It’s about adding value to what could otherwise be obsolete properties, certainly properties with little or no occupier demand.

This is not a new concept by any means: developers have been spotting opportunities to re-purpose existing buildings for ever, but an important caveat here is that the full effects of the pandemic, the way the cards will fall as things return to normal, it still difficult to predict.

With the wider economy and Brexit in the mix, it’s hard for anyone to see what’s going to be in demand in a give locality and some properties won’t suite alternative uses. However, where there are opportunities for adapting buildings, the conversion can be used to incorporate advances in technology and green environmental considerations.

Relaxed planning rules on conversions

Relaxation of the planning rules mean that from the 1st of August this year developers are allowed to convert a wide range of business premises into residential apartments and flats.

Office to residential conversions are already allowed under permitted development rights (PDR), but as from 1st August these rights were extended to include Covid hit vacant shops, restaurants and gyms.

There are of course some safeguards. To be eligible for these conversion rights, developer’s proposals must meet specific limitations and conditions set in the legislation. In some cases a prior approval application is required and even where a scheme meets all the PDR criteria developers can ensure that a scheme is lawful by applying to the planning authority for a lawful development certificate (LDC). In all cases initial consultations with local planners is essential.

However, a recent study by insurers Zurich UK warns that some of these conversations could lead to poor quality housing if the quality is not properly controlled. Office and industrial conversions can be tricky when trying to meet recognised residential space requirements, and they may be vulnerable to overheating in summer.

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