Following a year of high interest rates, geopolitical uncertainty and inflation, the real estate sector would be forgiven for feeling a little worse for wear. However, when LB caught up with some of the industry’s leading partners, their outlook for 2024 was more positive than might be expected. While investment in traditional real estate transactions is down, opportunities in new areas of business are booming and the City’s lawyers are ready to diversify.
2023 dealt the real estate sector an enforced pause as landlords and investors grappled with rising interest rates. While the investment market is unlikely to bounce back to full force in 2024, more movement is expected.
‘During 2023 there was a lot less investment activity because of interest rates,’ explains Stephenson Harwood partner and Legal 500 Hall of Famer David Sinclair. ‘New investment requiring leverage cooled and a number of borrowers whose term loans were taken out in a climate of low interest rates found refinancing them challenging. Unleveraged buyers waited on the sidelines waiting for prices to fall. Throughout 2023 there was a reluctance by banks to enforce security, but patience will run out during 2024. We expect to see a lot more sales, ostensibly consensual or openly driven by the banks.’
‘Of all the practice groups within a law firm, real estate is most sensitive to interest rates,’ adds Chris Harvey, co-leader of real estate at Mayer Brown and Legal 500 Leading Individual for commercial property: corporate occupiers and for commercial property: investment. ‘It impacts upon the ability of clients to buy as the costs of debt goes up. The main thing higher interest rates have impacted on is transaction volumes. Broadly transaction volumes are down by at least 50%,’ he explains.
However, that does not mean real estate teams are quiet Harvey adds: ‘Looking at sectors in the UK, the most active areas on the buy side are student housing, private rented sector blocks and some co-living developments. Logistics is also pretty resilient.’
‘In terms of the type of work, you hear a lot about the upcoming wall of refinancing. It is causing some issues, and we’ve also started seeing some sales. It’s a bit like the lender is the back-seat driver. There haven’t been many formal receiverships but there have been quite a few deals where the bank is in the back seat.’
Interest rates are also changing the profile of clients looking to make investments. ‘Interest rates to some extent shuffle the deck. For those clients who are highly leveraged it has a big impact. But for some investors, it will present an opportunity to snap up properties at a discount. We are starting to see more private family offices who are sat on cash wanting to do deals now. Whereas people who need a loan of 70% can’t play,’ Harvey explains.
Jane Edwarde, head of Slaughter and May’s real estate team and Legal 500 Hall of Famer, outlines an industry facing turbulence, but one with several growth areas for those savvy enough to seek them out: ‘Investment in real estate transactions will remain subdued. There is a lot of capital out there to spend but there is also a high degree of caution. The risk of a potential change of government does weigh heavily on people’s minds. There is also a lot of global political instability, plus the cost-of-living crisis, high energy costs, and high interest rates. Investment transactions stall in those circumstances.
‘However, other areas are remaining strong: data centres, logistics, meeting housing supply needs, build-to-rent, student accommodation, life sciences, and hybrid office leasing. Some areas are thriving, but overall there is definitely a subdued investment market that will continue until next year at the earliest, with the election hanging over us and ongoing global political instability.’
As the UK faces numerous societal shifts from an ageing population to increasing reliance on technology, trends in the real estate sector will follow suit. Discussing some expected growth areas, Daniel Norris, Hogan Lovells’ global real estate team head and Legal 500 Leading Individual explains how the firm is tapping into these developments.
‘We’ve seen no end to demand for investment in care homes over the last two years. We just did a £1bn investment over two years for one client, and we are doing exactly the same for another client at the moment. It’s a very active space for us.’
Another key area resisting the real estate slowdown is the explosion in demand for data centres. With capacity in the UK already stretched, this is set to increase as existing infrastructure struggles to keep up. ‘In our data centre practice, we have been looking at the shortage of available capacity in power networks,’ explains Norris. ‘In some parts of the UK, data centre development is having to stop because data centres draw too much power off the grid. All businesses now need data centres and demand is going through the roof. The UK needs to find a way to unlock data capacity.’
The ESG agenda
Amid a constantly shifting legislative landscape, ESG is at the forefront of developers, landlords and occupiers’ minds. Despite Rishi Sunak’s U-turn on the UK’s green commitments at COP26, the real estate industry is bracing itself for upcoming changes, with or without the current government’s backing.
‘Energy legislation will continue to change,’ says Norris. ‘Rishi Sunak has backed down from the climate commitments that we were heading for in 2030, but some of these things have a life of their own. The fact that some of the UK’s climate targets have been toned down probably won’t change the pathway of the UK real estate sector in improving sustainability, because people have really embraced that pathway.
‘The MEES [Domestic Minimum Energy Efficiency Standard] regulation has a 2030 deadline, and everyone has got that into their heads. There are two consequences. Tenants are expecting it, and landlords are already committed to building it. If a landlord has a building with poor sustainability credentials, at some point they’re going to get caught out and they’re going to have to improve it. The property industry is on a pathway that won’t slow down.’
Industry players who are unwilling or unable to adapt face a challenging future. ‘The ESG legislative landscape is of concern. The industry is taking ESG very seriously but not all landlords and tenants can afford to comply,’ Edwarde explains. ‘In the aftermath of all the legislative changes, there will be a two-tier market of high-value compliant buildings and low-value non-compliant buildings, which will become stranded assets in time. It’s a big challenge for our industry about how we improve our building stock.’
This could lead to an increase in office vacancies, notes Sinclair: ‘On the occupational side there is going to be a glut of vacant offices on the market which can’t be leased because of their poor EPC ratings. As offices become vacant, owners will have to decide whether they want to spend a lot of capital to upgrade them or just sell them. It is likely that we will see a lot of vacant buildings on the market where the owner can’t justify the investment return on upgrading them.’
Alongside the legislative agenda there are increasing consumer pressures on developers and landlords to provide more environmentally friendly buildings. Considering consumer demands in 2024, Sinclair says: ‘In the occupational market there will be a demand for highly efficient office buildings. ESG is now top of most sophisticated occupiers’ agendas. Buildings need to be efficient and environmentally friendly, partly because it’s the culture of the organisations and partly because employers recognise that staff want to work in buildings that reflect their ESG values.’
Investment pressure is also ramping up as investors look to green their portfolios. Says Edwarde: ‘It is not just occupier and renter demand influencing how green a building is but also investment demand. The two-tier market might also emerge on the investor side, and we might see more polarisation at least in the medium term.’
This is affecting how developers approach their developments from the get-go. ‘It’s really interesting to see how the energy agenda is changing the UK. It changes how you develop things,’ comments Norris. ‘If you looked at a development 15 years ago, you would have asked: “how many petrol stations do we need?” Now you have to ask, “How many car chargers do we need? Do we need a couple of community charging points or one per house?” It’s really tricky anticipating what will be needed in 20 years’ time.’
Rapidly developing technology is assisting developers to meet these new demands. ‘The other angle is data, AI and tech that allows you to monitor ESG performance is a developing area. It’s so multi-faceted now for developers and occupiers, both when planning a building and then actually monitoring a building after it has been built to make sure it continues to be green and that it is costing less to run,’ Edwarde explains.
In the wake of Michael Gove’s decision to refuse planning permission to M&S for its proposal to demolish and rebuild its Marble Arch flagship store, developers are also having to reconsider how they approach existing assets. As Jeremy Walden, managing partner of the UK and EMEA real estate practice at Herbert Smith Freehills and Legal 500 Leading Individual for commercial property notes: ‘ESG is having a profound impact on the real estate sector. It’s very exciting to see how the industry is responding. One area we are having to rethink is how we address redundancy in assets. The mood has shifted from rip down and replace to repurpose.’ Developers will now need to consider carbon release and retrofitting alongside new development opportunities.
Out of office
As the work-from-home power struggle rumbles on, the aftershocks of the pandemic continue to reverberate across the real estate sector. While some businesses, including several US firms, have instituted four-day in-office policies, other employers are taking a different tack to entice their workforce back into the building. High-spec office spaces, with a host of amenities, are increasingly being offered by employers to encourage office attendance, as discerning employees question the cost-benefit of giving up their home comforts.
‘Landlords are having to provide more amenities in their buildings because tenants are asking for assistance from their landlords to make their offices more attractive to encourage staff presence. Tenants ask landlords to provide a range of wellness amenities including gyms, catering facilities and relaxation areas,’ Sinclair explains.
Walden agrees: ‘We are a lot more attuned to the quality of the space we inhabit now. We’ve seen the ‘hotelification’ of the industry. Office environments have to provide the best possible experiences.’
This has changed the legal support required by both landlord and tenant clients. ‘As lawyers, we are being involved at an earlier stage in the planning process. Occupiers are being more thoughtful about what they want post-pandemic, in terms of flexibility and what amenities to offer to people,’ Edwarde says.
As a result, clients are considering both the size and standard of the office space they take on. ‘Most occupiers are taking on less space but working that space harder. They want it to be a really good quality space with high-quality collaboration options,’ Edwarde adds.
Landlords left with office spaces that no longer meet the standards of an increasingly aspirational workforce will be faced with a difficult choice: invest in upgrades or consider alternative uses for their portfolios.
‘As some office buildings become vacant, we will see them repurposed in response to a change in occupational demand. In Canary Wharf they are talking about converting redundant office buildings for educational and life sciences activities,’ Sinclair notes.
Transition period
While the transaction market remains subdued, ESG, changing office practices and an increasingly varied rental sector looks set to keep real estate lawyers occupied over the coming months. Industry players will have to adapt to stay current, but opportunities are there for those willing to take a shot and diversify.