UK commercial real estate needs a reset to avoid a debt trap

COMMENT Commercial real estate in the UK faces challenging times. The recent 14 consecutive base rate rises have squeezed borrowing capacity and cooled lender sentiment. Office occupancy levels are falling as hybrid work arrangements persist, and upcoming changes to energy efficiency benchmarks may render millions of sq ft of commercial real estate illegal to let. These headwinds contrast markedly with the preceding decade, when a benign credit market fuelled rising asset values. Until recently, “stressed real estate” was embodied by occupiers’ liability issues. Difficult trading conditions in sectors such as retail, and hospitality and leisure, combined with high tenancy costs, represented an insoluble problem for some occupiers. However, as high interest rates herald the end of easy-access leverage, property owners are increasingly exposed. Bayes Business School estimates that the UK’s commercial real estate market debt totalled £178bn in June 2023, much of which will reach maturity in the coming months. All of this in a debt market where loan-to-value ratios and debt service requirements differ markedly from recent “norms”. In this changed environment, challenges will persist, but there remain opportunities to reshape and manage liabilities to ensure fundamental assets values are protected in the long term. Rental pressure Observers of UK real estate will be familiar with company voluntary arrangements and their prevalence in recent years as a tool for occupiers to compromise lease liabilities. Seasoned observers will also know that ubiquity is not the same as efficacy. A cursory review of the insolvency statistics for recent years shows that a significant proportion of CVAs ultimately failed, with the company then filing for insolvency. Too often the CVA was not robust enough to effect the meaningful change required to prevent a financial failure. The shortcomings of the CVA were partly addressed by the introduction of the restructuring plan in the Corporate Insolvency and Governance Act 2020. Subject to certain conditions, the restructuring plan provides an alternative to the CVA which allows the proposal of a plan that compels certain stakeholders to accept a discount on their debt, thereby reshaping the balance sheet to align with true asset values. This is increasingly important, as the real estate “voids” caused by excessive lease liabilities have been exacerbated by the trend of hybrid work, set in motion by the Covid-19 pandemic. The pandemic shifted corporate attitudes to employees “remote working”, laying the groundwork for a reversal in a historical trend of commercial occupiers expanding their footprint. For many firms, high business rates, utility costs and inflation have made the decision to downsize more obvious. While a residential rental crisis runs parallel to stalling demand for commercial spaces, structural factors make it unfeasible for most office buildings to be converted into residential homes. As it stands, vast swathes of what were once trophy assets of real estate portfolios risk becoming white elephants. In 2025, the government is set to further ramp up energy efficiency requirements for all commercially let buildings. According to the Department for Levelling Up, Housing and Communities, this will mean that 70% of office space in the City of London is in breach of energy efficiency requirements, and therefore unlettable, unless the owners implement energy efficiency upgrades. For commercially let property to be compliant, and therefore financially viable, many buildings will require significant investment in sustainable retrofitting. As debt finance costs increase, the cost of compliance with the new regulations could be prohibitive. This has already depressed property values, with asset prices discounted against the cost of the changes needed. That is not to say that the market is irretrievably broken. There are fund managers whose portfolios tell a different story, with strong occupancy levels and solid income streams – often where underlying properties are well-located and with strong environmental credentials. Location has always been a definitive factor in determining value in the market, but sustainability has had an increasing bearing. In stark contrast to the modern, ESG-friendly developments garnering high rents is the vast cohort of buildings built in the 1980s and 1990s which are left behind as environmental regulations increase. A new kind of investor Hardening macroeconomic conditions, changing working trends and tougher environmental standards are pushing the UK’s commercial real estate sector into a slow-motion liquidity crisis, and a surge in restructuring is on the horizon. A large portion of fund managers involved in the sector have tracked a rising market, but this “passive” approach means that many are now ill-equipped to respond to growing market pressure. The sector is ripe for new and active investment approaches. Forward-looking fund managers can reshape balance sheets using the specialist restructuring plan and thereby fund upgrades to underlying portfolios. Change is coming, and investors must act to succeed in a sector at a crossroads. Robert Russell is UK head of restructuring at DLA Piper Photo © DLA Piper