Challenges and Opportunities in the Scottish Commercial Real Estate Sector: A 2024 Perspective

The UK's property development pipeline, encompassing all asset classes, has faced significant challenges in recent years. Increased interest rates, rising construction costs and the cost of land are just some of the challenges that have stifled growth. Occupiers and end-users are also grappling with their own challenges at the same time, including rising rents, high interest rates and rent caps.

However, there is some cause for optimism for the Scottish commercial property landscape in 2024. Interest rates are stabilising, with expectations of a reduction in the latter half of this year, but most stock is still discounted to a greater or lesser extent. This environment offers equity buyers opportunities to acquire assets at reduced values, a trend that might continue into the second quarter of 2024. Notably, retail thrives in prime locations, student accommodation remains a robust sector due to supply-demand imbalances, and creative repurposing projects, such as converting offices to hotels, are a very positive and welcome trend.

Alan Stewart, a Partner in Morton Fraser MacRoberts' Real Estate team, and Jonathan Seddon, a Partner in the firm's Construction team, have outlined the key strengths and weaknesses within the sector and discuss where the challenges and opportunities lie within the Scottish commercial real estate sector.

Offices

Strengths: Demand is driving record rents.

Weaknesses: Lack of pipeline.

From speaking with clients, the office market in Scotland, especially Grade A spaces in Edinburgh and Glasgow, is showing a positive transformation. A significant emphasis on Environmental, Social, and Governance (ESG) credentials and a demand for inspiring workspaces are driving low vacancy rates and record rents. Aberdeen's market shows improvement, though values remain a concern. Quality and ESG credentials are paramount for new office spaces, whether new builds or refurbishments.

Alan:

"It is really hard to see us going back to pre-pandemic levels of occupancy in the short term. That has a profound impact on owners, asset managers and advisors. That said, well-located office assets with repositioning potential may well trigger some developer interest. Given the negative sentiment generally and lack of any real clarity on the costs of having to retrofit older buildings, I would expect institutional investors, in the round, to remain net sellers well into 2024."

Jonathan:

"People who describe the office market as going through 'turbulent' times don’t understand the sector properly. The office has never had a more vital role to play in terms of wellbeing, breathing life back into city centres and encouraging workers to say goodbye to the home office or, worse still, the kitchen table. Rents will continue to rise and the next big Grade A block to be built in either Edinburgh or Glasgow will be fully let before it's finished."

Retail

Strengths: A shifting retail market may well create opportunities for new entrants, new formats and niche independents to fill gaps and drive footfall.

Weaknesses: Without investment, town centres are going to struggle.

Retail  presents a mixed picture. Some areas, like Edinburgh's St. James Quarter, thrive, while others like Princes Street face challenges. Convenience-oriented retail, such as local supermarkets and well-located retail parks, are performing well, highlighting the sector's evolution.

Alan:

"Obsolescence will continue to be a massive challenge for older retail assets throughout 2024. Changing consumer behaviour driven by online shopping will inevitably mean department stores and shopping centres in particular being repurposed to facilitate alternative uses. The best example of that are the plans to redevelop Buchanan Galleries in Glasgow as an 'urban neighbourhood' combining retail with residential and leisure uses."

Jonathan:

"Manchester is a fantastic example of how public and private investment can breathe life back into city centres. But that type of project is a long time in the making, and arguably that ship has sailed for Aberdeen and Edinburgh. The future is all about either prime, well located, experiential retail at the high end, and convenience shopping in the day-to-day part of the sector."

Hotel and leisure

Strengths: Wide range of hotel operators and developers active across Scotland. Consumer appetite for quality experiences and hotel stays remains high.

Weaknesses: The main threat to the success of these sectors might well be the ongoing cost of living crisis, given that from a consumer perspective this falls very much into the category of discretionary spend.

The hotel and leisure sector is buoyant, particularly in Edinburgh and Glasgow, fuelled by the demand for staycations and corporate events. The sector's success hinges on offering quality experiences, though rising operational costs and the cost of living crisis pose threats. The beginning of 2024 may be challenging, especially for luxury and value market segments.

Alan:

"It seems likely that 2024 will kick off with discretionary spend being impacted badly by the continued contraction in household disposable income and at least until interest rates start falling later in the year. That will impact this sector relatively badly, I would imagine, at both the luxury and value ends of the market. I would expect some opportunities to emerge for investors and developers largely driven by business distress as the year develops. The recent closure of the Virgin Hotel on Clyde Street, Glasgow, being a pretty good example of the stresses in some parts of the hotel sector."

Jonathan:

"I don't see the demand for hotels continuing at the same pace. I think it's a post-Covid reaction that will level off over time."

Living

Strengths: Huge demand will not go away any time soon, if ever.

Weaknesses: Interest rates are a problem for housebuilders. Rent caps are a problem for Build-to-Rent (BTR) developers and funders.

We have been seeing the residential sector, particularly BTR, face challenges from rent caps, even as demand for rental accommodation surges due to rising interest rates and affordability issues. The student accommodation sector remains strong, driven by the growing demand for higher education places and the prestige of UK universities. However, the widening gap between supply and demand, and the increasing focus on ESG values, could reshape this sector.

Alan:

"The BTR and co-living sectors will continue to struggle in Scotland compared to other significant areas of the UK and transactional levels will remain constrained. The development and funding challenges are unlikely to be resolved during 2024 given they are largely driven by a political narrative rather than either commercial, social or other demand lead criteria."

Jonathan:

"It is difficult to see any real momentum in the BTR market in Scotland in 2024, assuming rent caps remain in place."

Student accommodation

Strengths: Asset class has proved itself to be bulletproof.

Weaknesses: If students realise that even if they get a place at a university, they are unlikely to have suitable student accommodation, there is a potential risk that student numbers could start to stagnate. After all, at least a small part of the attraction of higher education is the overall experience.

It is well documented that there is an acute supply demand imbalance in the student accommodation sector across the UK. In March this year UCAS predicted that there could be over a million applications per year for higher education by 2030. The current number is around 750,000 so with so many more higher education places and such a weak pipeline of new beds the supply and demand gap is going to get wider not narrower.

Alan:

"It's hard to see this sector slowing down too much. I see that both Unite and Empiric have recently projected rental growth of around 7% across their portfolios. That said you would think that the number of students going on to some form of higher education has to top out relatively soon and surely affordability of rents may also become an issue at some point, especially given the levels of debt that students are being asked to take on. If the UK becomes a less attractive place for international students to come to then I would expect some contraction of development activity with values driven by rental growth."

Jonathan:

"PBSA portfolios continue to perform well but this is a sector where ESG could well become the number one factor for students in the next few years so the real opportunity for rental and capital growth will lie in refurbished and retrofitted student accommodation in carefully selected locations."

Urban logistics

Strengths: The shift to online shopping will always drive a need for more warehouse space and the big macro-economic factors at play will continue to drive manufacturing back to the UK.

Weaknesses: An oversupply of product may reduce the level of expected rental growth and the sector continues to need to address its environmental impact.

This sector has been growing for the past decade, but experienced a decrease in investment activity and a smaller group of active buyers in the last year, possibly due to rising debt costs and economic slowdown concerns. Cross-border investors were prominent in 2023 and this trend is expected to persist in 2024. With local developers producing more ESG-compliant assets, investment activity may increase later this year. Occupiers are increasingly favouring high-quality, ESG-compliant assets, while those not meeting these standards are likely to be marginalised and priced lower.

Alan:

"While there may be some short-term bumps in the road the longer-term picture for the urban logistics sector, it surely remains positive given the continued growth in e-commerce and adapting supply chains. I think we will see developers responding to those demands by building better quality and larger units."

Jonathan:

"I could see self-storage as a growing sub-sector of the warehousing market. With more and more people downsizing or choosing to live in smaller, town centre properties, particularly the younger generation, but still investing in their recreational and leisure time, personal self-storage solutions could become more and more sought after."

Overall, while 2024 presents its share of challenges for the Scottish commercial real estate sector, there are also considerable opportunities. The emphasis on quality, ESG credentials, and adapting to changing consumer behaviours and market conditions will be key to navigating this dynamic landscape.

We’d love to hear what you think 2024 will hold for the sector – please drop us a message to discuss!