Pressure on the purse strings!

Written By:

Darren Mansfield, Knight Frank

17 May 2023

5 minutes to read

Categories: Publication M25

For the occupier:

Cost pressure has mounted via a three-pronged attack - rent, rates and service charges. Although overall occupancy costs are circa 15 per cent of general operating expenses and smaller relative to staff costs, the components of this cost have risen significantly in the past year.

Rental increases across the South East have averaged 3% as a collective market, but the range of movement has varied greatly. Analysis of 54 markets across the South East indicates that 21 locations registered an increase higher than the 3% benchmark. The consequence of this rise is that occupiers seeking to renew or relocate must negotiate from a higher initial quoting rent.

Similarly, service charges have risen. Although not inflation driven, as buildings and estates have become more complex, the array of services provided by owners, and associated pass-on costs, have increased. More fundamentally, though, the rise in energy prices has filtered through. Energy costs have increased by more than 25% since the beginning of 2022. Under most commercial leases, the tenant will have a direct contract with the utility supplier. Still, some utility costs are part of the service charge for communal areas. These are not controllable by the tenant.

On the 1st of April 2023, the new rating list went live and reflected the changes in the property rental market from April 2015 to April 2021. For occupiers in the South East, the revaluation has been particularly significant. The Knight Frank study area for South East offices incorporates locations from the South East and East of England regions as defined by ONS. These two regions have registered the highest increases in England and Wales at 20% and 26% respectively.

Assessing the main markets across the Southeast shows a broad range of increases from a low of 2.9% to a significant 60.8%. To cushion the impact of the revaluation, the Government have introduced a 30% cap on increases in liability for this rate year. However, the cap will not apply where the property wasn't previously assessed, meaning businesses leasing new buildings will face the full amount of the increase.

The Rates Payable for 2022-23 have been compared to the projected Rates Payable following the revaluation in 2023-24 for key locations below.

The pressure of rising costs has equally impacted the market's supply side.

For the developer:

The costs associated with construction increased sharply in 2022, with the rise driven by continuing disruption to manufacturing and supply chains, shortages of labour and products, and inflated energy prices making vital components more expensive. As of March 2023, the BCIS General Building Cost Index forecast is up 7.1% compared to the same juncture in 2022. Materials costs are up 8.1% over the same period, having registered a double-digit rise the previous year. Onward, material costs are forecast to continue to rise, albeit more modestly, until 2028.

For construction projects, the availability of a workforce is a particular problem. The latest employment statistics from Oxford Economics indicate that construction-related labour has reduced by 10% since 2019, whilst job vacancies have risen by 65% since before the pandemic.  There are roughly 244,000 fewer workers in the construction sector than three years ago, primarily due to workers returning to the EU, retiring, or pursuing other employment.

The lack of skilled labour is feeding through to salary expectations. Salaries in the construction industry increased on average by 2.5% in the South East in 2022, making the cost of labour another contributor to the decreasing viability of projects. According to BCIS, labour costs could rise 6.3% in the coming year, driven principally by labour shortages and the cost-of-living crisis.

To help bridge the labour supply gap, the Government has added construction workers to the shortage occupation list, thus relaxing immigration rules to attract migrant workers within the construction industry to the UK.

For the debt-backed investor:

Elevated cost pressures and the rapid rise in base rates led to tightening credit conditions as lenders reassess how to price risk in 2022.  Lower levels of liquidity have reduced transaction volumes, although financing remains available for high-quality assets. 

In 2022, interest rates hiked unprecedentedly, resulting in the cheapest debt available at a minimum all-in rate of 6%. The market is principally dominated by larger banks, albeit an increase in alternative lenders has supported any shortage in finance. Rather than availability, the affordability of debt has been the issue. Senior lenders insist on lower loan-to-value levels in the high-rates environment to bring debt service coverage ratios back to acceptable levels. An opportunity for alternative lenders who are less risk averse has emerged if they offer an additional slice of financing to sit above senior debt to fill the gap.

Current market sentiment will allow for a further 25 bp hike, up to a peak of 4.5%, subject to the inflation rate reducing as expected. Whilst the environment is challenging, debt solutions are still available for investors coming up for refinance. These solutions are generally in the form of a combination of lower leverage senior and high leverage mezzanine, which enables investors to hold on to the asset whilst building in flexibility to allow disposal once the market recovers.

Final word:

Combining all these cost pressures will undoubtedly challenge market activity in 2023. Each will factor in its own right but must also be considered in the context of broader market shifts. The Green Agenda, for example, is not only influencing market behaviour but also costs by implication. The balance of these pressures will differ according to market position, but 'Cost' will surely lead the narrative in 2023.