Inflation impact

Viability of projects at risk as building costs rise

Big deal: 177 Bothwell Street

Uncertainty around rising costs is casting doubt on the viability of commercial property developments, according to a new report.

Inflation and the cost of capital are affecting investment decisions which are being further coloured by the prospect of recession and its impact on demand for space.

Colin Finlayson, director of Lismore Real Estate Advisors, says the development pipeline in Edinburgh and Glasgow remains “extremely limited” – partly down to a lack of quality sites, but also down to the significant rise and ongoing uncertainty around construction costs.

“Almost no developer can agree a fixed price contract, meaning significant risk around project viability, making funding new development extremely challenging,” he says in the firm’s second quarter review of the Scottish market.

UK pension funds and investment managers continue to seek secure long income defensive stock, particularly in the logistics and purpose-built student accommodation (PBSA) sectors.

Colin Finlayson: cash remains king

There remains a significant weight of capital from overseas investors, particularly from North America, the Middle East and Europe. UK based property companies continue to be acquisitive in the retail warehousing and industrial sectors.

“Cash remains king, as the increasing cost of capital for debt-backed investors is creating an advantage to cash investors – if they can move quickly then opportunities will arise in the second half of the year,” said Mr Finlayson.

“Aberdeen could see a resurgence and be one of the winners over the next six months, with investors seeking out higher yielding stock to balance their portfolios. The Granite City may well begin turning heads, with a yield discount to prime central belt assets of circa 400-500 basis points.

“After a strong Q1, caution in the market is driven by the war in Ukraine, rising inflation and more challenging debt conditions has caused by investors to pause for breath.”

The future of the office continues to be unclear. Post pandemic, 46% of respondents its latest survey believe that the importance of the office has decreased.

Stephen Lewis, managing director, HFD Property Company, which was responsible for one of the biggest ever office deals during Q2, said: “The key factors are the flight to quality and ESG [environment, social and governance]; however, well-being, connectivity and other attributes will also contribute to the selection of one building over another.

“Across our portfolio we are undertaking a significant decarbonisation project to improve energy efficiency, increasing the use of renewable energy and installing infrastructure to support electric vehicles. It’s important for us as a business, but more importantly, it’s something our occupiers are looking for.

Stephen Lewis: greater focus on smart tech (pic: Terry Murden)

“Over the next 10 to 15 years, construction of modern workplaces will evolve and materials used will largely be driven by decarbonisation, both from an operational and embodied perspective

“We can foresee an even greater focus on data and ‘smart tech’ in its broadest sense, including sensor networks to gather real-time information about how occupiers use buildings.

“Looking forward, hybrid working is here to stay but we will see more changes as macro factors influence the way we work. What we haven’t been able to fully determine yet is the impact on the demand for office space. While overall occupational demand for space has reduced, it isn’t necessarily aligned to working from home with more space also being converted to alternative work environments.

“Something that remains to be seen is how policies on remote working might change when the recession bites. During economic downturn, the need to maximise productivity, innovation and collaboration is never higher, and I suspect that will translate into a desire to get people back together more in the same shared workspace.”

Key deals

Following a strong start to the year, Q2 has continued the momentum with transactional trading of circa £612m, up some 104% on Q2 2021. Activity for the quarter was 56% above the five-year average, although the average is obviously skewed by a Covid hit Q2 2020. Excluding 2020, the Q2 2022 figure is 27% above the average.

The standout deal of the quarter was HFD Property Group’s £215m sale (4.50% yield) of 177 Bothwell Street, Glasgow to Pontegadea, one of the biggest regional office deals ever concluded, with ESG credentials driving premium pricing.

Other key transactions included the £30.2m sale of the Premier Inn, Sauchiehall Street, Glasgow, the £16m sale of 123-129 Buchanan Street, Glasgow and the sale of 124-125 Princes Street, Edinburgh for £15.8m.

A number of significant deals, particularly in the PBSA market, are due to complete early in Q3 which Lismore believes should provide a pre-summer flurry before what could be a quiet summer as investors take stock of the macroeconomic environment.

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