Commercial Property

UK real estate carried some of its positive performance momentum from 2021 into the early part of 2022. However, this year will likely be one defined by the proverbial ‘game of two halves’ as some of the strong performance in the first half of the year is expected to be unwound moving forward. With sentiment towards UK real estate weakening, investment volumes have slowed as the market pauses for breath and takes stock.

Over the first half of the year, performance remained very positive and, at an all property level, the UK real estate market delivered a total return of 8.1% over the first six months of 2022 (MSCI Balanced Portfolios Quarterly Property Index). As expected, the industrial and logistics sector continued to drive the market and posted a total return of 13.3% in the first half of the year, whilst over the same period the office sector once again provided the weakest performance at 3.3%. The retail sector recorded performance and provided a total return of 8.0%, but much of this positive performance was attributable to the retail warehouse sector, which provided a robust total return of 14.1% in the first half according the Company’s MSCI benchmark.

Transaction volumes in the first half of 2022 remained very robust and UK real estate recorded the strongest first half investment volumes since 2015 according to Real Capital Analytics with £31.2 billion transacted over this period. However, approximately two thirds of the activity occurred in the first quarter of 2022. Investment volumes were £10.2 billion in the second quarter of 2022, which was lower than the Q2 10-year average of £13.5 billion.

The slowdown in investment activity towards the end of the second quarter of 2022 can largely be attributed to the emergence of a less accommodative monetary policy environment as the Bank of England tries to bring inflation back closer to its target rate of 2%. This has resulted in slowing economic growth expectations, rising bond yields, and an increased cost of capital for debt-backed real estate investors, which has caused weaker sentiment towards UK real estate at this time.

The industrial sector experienced a record year in 2021 in terms of both performance and transaction volumes and carried this momentum into 2022. However, with the weakening economic environment, the sector has begun to slow and investor sentiment has begun to cool somewhat. Whilst reflected in a slowing level of transaction volumes, occupier markets have seen strong performance, with leasing driven by the imbalance between supply and demand. Amazon’s announcement in April 2022 that it was to reduce its operational estate surprised the market, but we believe this statement was primarily focused on the US and, more importantly, that occupational demand is and has proven to be more multi-faceted and deeply diverse than being wholly reliant on one operator or business segment. The industrial sector continues to benefit from longer term thematic tailwinds and rental value growth should remain positive in response to tight supply levels, but return to a more normalised growth rate.

Polarisation within the office sector has been gathering pace as both occupiers and investors continue to narrow their focus on best in class office assets with strong environmental credentials. There have been increased reports of positive letting activity in the office sector over the second quarter of 2022.

But, according to CBRE Ltd (‘CBRE’), the central London vacancy rate remains elevated at 9%. Secondary accommodation accounts for approximately 70% of all available accommodation. Overall office demand is expected to fall as a poorer economic outlook weighs on job growth across the market, placing additional pressure on occupational sentiment. However, Grade A ‘future fit’ office assets, in prime locations, are anticipated to be more resilient in this weakening environment, whilst the outlook for secondary assets is much more challenging.

The UK retail sector was showing tentative signs of green shoots at the start of 2022, but momentum, particularly in the occupational market, is expected to experience a marked slowdown as the current cost-of-living crisis and slowing economic growth puts pressure on consumer spending. This will be more acutely felt in the consumer discretionary and fashion-led part of the market. Essential, discount and convenience-led retail is expected to be much more resilient in this environment, but not entirely immune to the cost-of-living pressures facing UK households. Retail sales volumes fell by 0.5% in May 2022 and, in the three months to May 2022, by 1.3% when compared to the previous 3 months, continuing a downward trend that began in summer 2021. Foodstore sales provided the largest contribution to the fall in sales over May, as sales fell a further 1.6%. This supports the view that consumers are seeking to reduce their outgoings in the face of rising costs.

Strong demographics and structural tailwinds are expected to continue to drive interest in the alternative sectors, particularly in healthcare, build-to-rent and student housing over the medium-tolong term. With the occupational pressures facing the office and retail markets, investor allocation to alternative sectors more generally is expected to grow. However, these sectors are not immune to the weakening macro environment and a focus on quality will be important to ensure performance remains resilient.

Portfolio performance

The Company’s portfolio delivered strong outperformance against its MSCI IPD benchmark in the first half of the year. For the six months to 30 June 2022, UKCM portfolio’s total return was 11.2%, significantly ahead of the benchmark return of 8.1%. The property portfolio continues to show outperformance over 1, 3, 5 and 10 years. Total return performance was particularly strong in Q1 2022 at 8.8% v 4.9% for the benchmark with performance still positive but slowing in the second quarter, which was in line with our expectations, at 2.3% against the benchmark return of 3.0%.

The table below breaks down this return by sector with all valuations undertaken by the Company’s external valuer, CBRE. The portfolio delivered an income return marginally below benchmark of 1.8% (benchmark 1.9%) over the first six months of the year, but this was offset by greater capital value growth than the benchmark, 9.3% vs 6.1%. Portfolio-level outperformance has been driven by the Company’s strong overweight position to the industrial sector which again delivered the strongest returns of all the major sectors. The Company’s exposure stands at 63.9% weighted by capital value at the end of H1 2022. The office and retail assets within the portfolio also significantly outperformed their benchmark over the first half of the year.

Industrial

The Company has maintained for some time a strong, strategic overweight position to the industrial sector which continues to be well placed to benefit from the structural changes that have fuelled tenant demand for space such as the growth e-commerce and renewed demand for storage of inventory due to the disruption of global supply routes. Whilst demand is likely to taper down from the heightened levels seen in 2020 and 2021 it is still expected to outstrip levels of supply leading to rental growth, particularly in strategic locations and those where supply of industrial land for development is restricted.

In the first half of 2022 the Company’s industrial holdings delivered a strong total return of 12.5%, albeit this was behind the benchmark return of 13.3%. The six-month industrial income return of 1.4% which is below the benchmark level of 1.6%. As the strongest performing segment of the benchmark, our strategic overweight allocation to the sector enhanced overall portfolio returns. The Company’s industrial holdings are split respectively between multi-let industrial estates at 45% by capital value and 55% by capital value in single-let big-box distribution units in strategic locations throughout the South-East and the Midlands. In general, the multi-let estates offer more immediate prospects for asset management, and therefore opportunities to grow income, whilst the distribution units tend to be longer let and offer secure income streams with the opportunity to capture growth at rent reviews and lease renewals. We expect that returns from the sector will be driven by rental growth and would expect some yield weakening throughout the rest of 2022 as a result of interest rate rises. This will be most pronounced initially on very low yielding London / South East assets but is likely to have a knock-on effect to the rest of the sector.

Office

The Company has a low exposure to the office sector of 13.3% against the benchmark weighting of 25%. The office portfolio significantly outperformed the benchmark with a return of 6.1% vs 3.3%. It delivered an above benchmark income return of 2.3% vs 1.8% for the 6-month period reflecting that its office exposure being elsewhere in the South East or in regional cities where yields are generally higher.

Over H1 2022 a strong capital return of 3.8% was also delivered by the office portfolio significantly ahead of the benchmark level of 1.5%. Capital growth was driven by positive asset management at assets such as 2 Rivergate, Bristol where a lease extension was agreed with the Secretary of State and at Craven House in London where a strong rent review settlement was agreed. There was also the positive impact of acquisitions completed in Q4 2021 particularly Kantar House at Hanger Lane where the value is underpinned by the redevelopment value of the site which has significantly increased.

The polarisation of the sector is expected to continue with occupiers strongly favouring best in class ‘future-fit’ properties with access to amenities and excellent ESG credentials. The Company is focused on ensuring all its office assets meet, or can meet, these standards and as a result of this analysis the decision was made to sell 9 Colmore Row, Birmingham in July for £26.48 million. Full details are provided on page 16.

Retail

At the end of the half year, the Company’s weighting to retail was 12.4% compared to 22% in the benchmark. The portfolio comprises supermarkets and retail parks dominated by either bulky goods retailers or convenience and discount operators. These tenants have generally emerged strongly from the Covid-19 pandemic and should prove to be robust in the forthcoming challenging economic environment where spending is likely to be focussed away from non-discretionary items. The Company has no exposure to shopping centres and its only remaining high street shops are part of the office investment at 81 George Street, Edinburgh which are well let. At the end of Q2 2022 there were no vacancies in the retail portfolio which reflects the strength of these locations and their appeal to tenants.

The quality of the Company’s retail holdings is further demonstrated by its total return in the period of 16.7% against 8.0% recorded in the benchmark. This was principally driven by much stronger capital growth in the period of 14.0% against 5.3% for the benchmark with the majority of this performance derived from the retail park element of the portfolio. These assets closely match those sought by investors in 2021 and H1 2022 in that they are well-located and let to tenants suited to the surrounding demographic at sustainable rental levels, and they have therefore benefitted from the strong yield compression seen in this sub-sector of the market.

Within the alternatives sector we saw positive total returns of 1.8% delivered over the first half of 2022 which was below the benchmark level of 5.1%. The Company’s alternatives portfolio at the end of the period was split evenly in terms of capital value between three cinema-led leisure schemes in Kingston upon Thames, Glasgow and Swindon and four hotel / student housing assets, of which three are developments and therefore will not fully contribute to portfolio performance until completion. The Maldron Hotel in Newcastle which is let on a long-lease to Dalata and trades strongly is the fourth non-leisure asset within the alternatives sector. Rent collection levels at the leisure assets have normalised which contributed to an above benchmark income return of 3.5% v 2.4%, but this was offset by a capital decline of 1.6% in the portfolio whilst the benchmark recorded capital growth of 2.6%.

The Company’s student housing development in Edinburgh completed in time for the 2022/2023 academic year. Within the period the Company agreed an attractive 20 year lease, which includes annual index-linked rental uplifts, with the University of Edinburgh over its asset at Gilmore Place, Edinburgh substantially derisking the operation of this asset. UKCM also committed to the funding of a 305 bed Hyatt Hotel in Leeds which is scheduled to complete in mid-2024.

Investment activity

Following the significant levels of investment activity seen in 2021 there have been fewer transactions completed in the first half of this year. In May, the Company committed to the development of a highquality hotel in central Leeds which will complete mid-2024 with a 25-year franchise agreement in place with Hyatt Hotels, one of the leading global hotel brands. UKCM is funding the development for a total commitment of £62.7 million. The hotel will be operated under a lease by Interstate Hotels & Resorts, a 50+ year old global leader in hotel operation, with UKCM’s rental income based on the income generated from the operation of the hotel.

The 140,000 sq ft hotel’s 305 rooms will be split between the short stay Hyatt Place and the long stay Hyatt House brands. The upscale hotel will provide meeting rooms, a gym and several food and beverage options, including a rooftop bar with its own dedicated entrance and on completion should be one of the best quality hotels in Leeds. The acquisition is in line with part of UKCM’s strategy to increase its exposure to alternatives and to invest in operational real estate sectors that are expected to deliver resilient rental incomes. On completion the asset is expected to have strong ESG credentials with a target EPC rating of A and an expected BREEAM rating of Excellent.

After the reporting period in July, the Company disposed of its 68,400 sq ft central Birmingham office, 9 Colmore Row, to Birmingham City Council at a price of £26.48 million, ahead of the asset’s book cost and at a premium to the latest valuation. In addition to securing a strong sale price, the disposal is in line with the Company strategy of exiting risk assets and those in need of capital expenditure which will not enhance value. The building’s current EPC rating is D and this will require to be improved to meet forthcoming Minimum Energy Efficiency Standards legislation, with an expectation these costs will primarily fall upon the landlord.

The Company has financial resources totalling £24 million available as at 30 June 2022 to utilise for further acquisitions including the post-period receipt from the sale of Colmore Row, and allowing for future commitments and the dividends paid in August 2022. We are exploring sectors offering higher initial income returns but with some future capital growth potential with a focus on best in class regional offices which meet future occupier demands in terms of access to amenity and ESG credentials and well as further assets in the alternatives sector which offer strong fundamentals and robust incomes.

Asset Management and Rent Collection

Rent collection rates have normalised throughout the first half of 2022 and have largely returned to pre-pandemic levels of collection. There continue to be some tenants within the portfolio that pay rents by agreement on a monthly basis as opposed to quarterly however once these are adjusted for rent collection for the three billing periods covering the start of this year, 99% of rents due have been collected.

The Company benefits from low tenant income concentration due to its diverse tenant mix of 227 tenancies across 41 assets, with its top tenant, Ocado, accounting for 6% of contracted rental income. In total the portfolio’s top ten tenants account for 36.9% of total rents at the end of June 2022.

Occupancy levels in the portfolio increased to 98.5% at the end of H1 2022 which reflects a void rate approximately one fifth of the MSCI Benchmark rate of 7.7% at the same period. The portfolio occupancy rate is also an improvement on the position at the end of 2021 when the occupancy rate stood at 97.9%. This minimal level of vacancy reflects the work undertaken by the asset management team in securing income for the Company as well as the quality and appeal to occupiers of the assets themselves.

Asset Management highlights within the period included:

• As previously mentioned, at Gilmore Place in Edinburgh, the Company’s student housing development, a 20 year lease has been agreed with University of Edinburgh at an annual rent of £1.238m per annum. The rent is increased annually by CPIH with a cap and collar of 1-4%. The development is due to complete in time for the commencement of the 2022/23 academic year.
• At Temple Quay in Bristol, the Secretary of State has extended its occupation of the Company’s 70,000 sq ft HQ-style office building for a further three years which includes an increase in rent to £1.72m per annum. The asset is located in a prime location within Bristol’s office core directly opposite Temple Meads railway station which is due to benefit from an investment of £95m into to the station and surrounds. The lease is now outside the Landlord & Tenant Act and the deal therefore secures the opportunity for a future redevelopment in this excellent location.
• A new tenant was secured for Unit 12, Newton’s Court, Dartford following a comprehensive refurbishment and environmental upgrade of the property. Paak Logistics UK Limited has taken a new 15 year lease without break over the 67,300 sq ft unit at a rent of £942,816 per annum, representing a 27% premium to the ERV at the start of the year and demonstrating the continued demand for high quality, well located logistics space. This also sets a new headline rental tone for the estate of £14 psf per annum and the lease incorporates 5 yearly upward only open market rent reviews. The achieved rent is significantly ahead of the original underwritten rental level when the refurbishment commenced demonstrating the potential within the portfolio to capture strong rental growth. In line with the Company’s ESG priorities the building’s EPC was improved from a rating of D to A through the refurbishment works which included using energy efficient materials and installing photo voltaic panels.
• Also at Newton’s Court, Dartford, Unit 6 was let to Rodenstock UK Ltd on a new 10 year lease with a tenant only break option in year 5 over the 6,650 sq ft unit which had recently fallen vacant. The agreed annual rent is £89,775 per annum equating to £13.50 psf per annum, which is 6% ahead of the unit’s previous ERV at the start of the year. Overall Newton’s Court, Dartford has experienced 9% growth in market rents in the first six months of the year.
• The rent review from June 2021 over the accommodation at Craven House, Foubert’s Place, London the Company’s 20,100 sq ft West End office, was settled 5% ahead of ERV at an increased rent equating to £54 psf per annum. The prominent building is situated adjacent to Carnaby Street and is let to film and television production company Molinaire until June 2026.
• St George’s Retail Park in Leicester became fully occupied within the period as Autoglass completed a new 10 year lease with a tenant break on the fifth anniversary at a rent of £52,500 per annum in line with ERV. The park has been substantially repositioned following extensive letting activity on 2021 and boasts an attractive line-up of strong tenants including Next, Home Bargains, DSG and Iceland

Environmental, Social and Governance (‘’ESG’’)

The Company received a three star rating and was second in its GRESB peer group for ESG performance and made its 2022 submission in Q2. The Company also obtained a Gold Star from EPRA for ESG reporting in 2021. UKCM is working towards the long-term commitments within its 2021 Annual Report of Net Zero Carbon for landlord emissions by 2030 and Net Zero Carbon for all portfolio emissions by 2040.

A number of asset-specific initiatives have been completed within the period such as the ESG-focussed refurbishment of Unit 12, Newton’s Court, Dartford detailed above. The Manager continues to assess all assets within the portfolio for potential opportunities to improve ESG performance and also to ensure that the buildings can comply with forthcoming Minimum Energy Efficiency Standards legislation in a commercially sensible manner.

Investment Outlook

Looking forward we expect some of the strong first half 2022 performance to be unwound over the second half and, given the current market environment, our overall outlook for the next 12-18 months has been revised downwards.

By early September 2022, the spread between UK real estate and UK 10 year gilts reached the lowest level since 2008 as the UK 10 year yield peaked at 3.1% in response to increasing inflation and interest rate expectations. We expect the yield on the UK 10 year gilt to remain at or above this level in the near-term adding pressure on UK real estate yields to move out to maintain an appropriate yield buffer. On top of this, with rising debt costs driven by tightening monetary policy, a number of leveraged players have begun to step back from the market as the cost of debt outstrips yields in several sectors making its use in these sectors prohibitive. As a result, we are now beginning to see some repricing across the UK real estate market, driven predominantly by interest rates ‘re-rating’ and an increased cost of capital impacting yields.

Investors are anticipated to take a more risk off approach towards UK real estate in the second half of this year and we expect polarisation of investor focus to widen, as investors target best in class assets which should provide more resilient returns in a weakening environment, with greater scrutiny on the sustainability of income streams. ESG considerations are expected to become even more integral to investor decision making and asset underwriting. This trend was expedited as a result of the Covid-19 pandemic, but with the current energy crisis and pathway to net-zero, the case for integrating ESG considerations across all UK real estate sectors has never been greater. An even greater emphasis on ESG requirements for both acquisitions and developments is already underway.

The government’s huge fiscal stimulus was always going to cause interest rates to rise further, but the large market moves since the government’s economic agenda was announced suggest even higher rates will be necessary to restore confidence in UK assets. We are sceptical on what is currently priced by markets, but a period of high and sustained rates is likely increasing our conviction that the economy will soon be in a recession. Whilst we expect a slowdown in the market in the near term, we also expect inflation to fall through 2023 into 2024 as a result of interest rate tightening from the Bank of England before a cutting cycle starts. When the overall cost of debt does in time move lower and become more widely available as the economic environment and investor sentiment towards UK real estate improves, UK government bond yields will also move lower. We therefore expect a relatively short period of increasingly tight spreads over the next 12-18 months, before UK real estate begins to look more attractive. Opportunities within the market should emerge once repricing has occurred and a rebound in real estate performance is anticipated

Portfolio strategy

Inflationary pressure, and rising interest rates, we remain positive on the ability of your Company’s portfolio to deliver positive rental, and so earnings, growth. Our strategy has been fashioned with this in mind by targeting those areas of the market most likely to benefit from positive structural changes and so experience positive demand versus supply over the coming years with the ability for active asset management to enhance income. Embedded across your Company’s strategic thinking is an awareness of the current and future implications of environmental, social and governance factors, collectively ESG, with the Company’s February announcement of its net carbon zero targets of 2030 (landlordcontrolled emissions) and 2040 (all emissions) a focus for asset management and investment decision-making. Whilst, as highlighted earlier, we do expect some negative repricing of real estate over the short term we also believe winners and losers will emerge. We look to maintain a diversified portfolio to reduce specific risk which we achieve by maintaining a wide spread of tenants, geography and a diversified property sector allocation – but importantly diversified across those sectors and assets we believe will deliver better rental growth and value prospects rather than simply spreading across a benchmark. The bulk of the portfolio comprises a solid bedrock of assets with strong fundamentals, durable income streams and a low risk profile. Layered on this is a select group of assets allowing the team to add value and rent through more active management and, in some cases, controlled development exposure aiming to drive superior income and returns. And across all an aim to maintain relatively low levels of gearing from our low cost and flexible debt facilities.

Although we may consider selective disposals in the logisticshttps://prd-cdn.aberdeenstandard.net/distribution and industrial sector to recycle to higher yielding stock, we wish to maintain a strong allocation to this important part of the market in high demand locations and fit-for-purpose property. We believe this sector remains well placed to deliver rental growth as we continue to see growing demand from the twin engines of continuing e-commerce penetration plus the growth expected in the demand for UK on-shoring of goods as the country adapts to disrupted global supply chains. Both, we believe, will lead to a growing demand for distribution space in a market still short of the right supply.

We remain keen on parts of the alternative property ‘beds’ sector, particularly selective student accommodation and hotel opportunities, which can also offer the opportunity for enhanced returns versus traditional leasing models. Our latest commitment is to a Hyatt Hotel due to open in Leeds city centre during summer 2024 which will supplement our hotel investment in Newcastle and two student developments at Exeter and Edinburgh.

The office sector potentially offers the greatest scope for divergence of returns and opportunity, as ever with care. Not only is it exposed to the force of an evolving model for how business and employees use an office, but it is also approaching regulatory hurdles to be met on energy efficiency in buildings by 2027 and 2030. Many offices will require significant investment to meet these.

It is very easy to imagine business embracing the potential of agile or flexible home working to reduce office occupancy costs, but also allocating that smaller overall budget to higher quality offices to attract and retain staff to encourage regular office participation for the business community benefits that can bring. And so we believe extreme bifurcation is the watchword for the office sector. Those assets in strong locations displaying flexibility, with good built-in or locally available amenities, strong e-connectivity, multi-modal transport links and sustainability are likely to emerge best placed to capture this focused demand. The reverse is likely to be true for those that do not with the potential they become ‘stranded’ economic assets requiring investment to meet regulations that is not rewarded by demand and rental growth. We are interested in opportunities in this thin slice of the overall office market, those asset-specific opportunities representing offices of the future. Conversely, we may disinvest from those assets we do not believe pass muster on this test and indeed our sale of Colmore Row, Birmingham, fits that category.

We believe that the Company’s well-let portfolio of scale, which is heavily weighted towards future-fit sectors, and offers good prospects for rental growth, is well placed to deliver positive relative performance with good potential for future earnings growth.