U.K. lease events show occupier demand continues strong

First, an explainer: what do we mean by “lease events?”

In the U.K. and for “traditional” real estate sectors (retail, office and industrial), a lease typically lasts for several years (5, 10 or 15 depending on asset type and quality). Frequently before the end of a lease, the tenant will have a “break” option—the opportunity to terminate the lease at a specific date(s) (typically 5 years in a 10-year lease, or 10 years in a 15-year lease). Except for a rare incidence of default, a lease usually ends by the exercise of a break clause or by its natural expiration.

At each of these points—the arrival at the date of a break clause or the date of the end of the lease—three things may happen as listed below and as shown in Figure 1. Given income is maintained, the first two are good outcomes for the investor; the third (when not deliberate) may be thought of as a poor outcome.

1. The incumbent tenant may remain, either by non-exercise of the break clause or by signing a new lease (renewing).
2. The incumbent tenant may depart (either by exercise of a break or at natural lease expiry) and a new tenant may lease the space.
3. The incumbent tenant may depart (either by exercise of a break or at natural lease expiry) and the space may remain vacant.

Figure 1: Lease event outcomes

Lease event outcomes appear most favorable in retail…

The most authoritative record of lease event outcomes in the U.K. is published by MSCI. The data is extremely time-consuming to produce and, therefore, the most current available datapoint is the end 2023 (released in November 2024). Figure 2 shows the balance of outcomes at break and expiry for key real estate sectors (the chart allows users to toggle between data on break and expiry; the axes are identically scaled to enable easy comparison by flicking between the two). The balance figure is the sum of the frequency of the two positive outcomes minus the frequency of the third negative outcome. A positive figure indicates that for those units subject to break or expiry in a given year, a majority were occupied at year-end, whlie a negative figure indicates a majority were vacant at year-end.

Figure 2: Balance of outcomes at break and lease expiry by sector

Lease events tend to be more favorable to investors in stronger rental markets…

Understanding long-term norms and more recent trends in outcomes at break and expiry is useful for underwriting assumptions and portfolio modeling. To this end, Figure 3 plots the outcomes balance at both break and expiry against estimated rental value (ERV) growth in the prior year. (The chart shows both break and expiry outcome balances for shopping centers, office and industrial, allowing users to toggle between these three. The axes are identically scaled to enable easy comparison).

The chart shows that there is a reasonably strong, positive relationship between lease event outcomes and ERV growth in the prior year. If rental growth was strong last year, occupiers are less likely to exercise breaks or leave at the end of leases, while in those cases where they do, investors are more likely to secure new tenants by year-end. Occupiers seem to be aware of the scope of opportunity (or lack thereof) of securing alternative accomodation in weak and strong markets; investors understand that when competition for space is stronger (driving up rental values), they can capitalize on the opportunity by reletting newly vacant space.

Figure 3: Balance of outcomes at break and expiry vs. ERV growth in prior year, industrial, shopping center and office

…but that relationship has recently been tested to varying degrees

Figure 3 provides historical context and highlights the expiry outcomes balance in the last two years (for shopping centers and industrial) and the last six years (for office) by highlighting those data points. In the case of shopping centers, the expiry outcomes balance has been better than might be expected given the strength of rental growth. The balance has been slightly (in the case of industrial) and markedly (in the case of office) worse than might otherwise be expected in the other sectors.

What do we think is driving this trend?

• In the shopping center market, recent outperformance could simply be a post-COVID rebound. The expiry outcome balance arguably underperformed in 2020 and 2021. This underperformance may be explained by occupiers overcompensating and shedding too much space during the pandemic, a situation they are now seeking to rectify.
• Although driven by investors, we see the same trend playing out for the industrial and office sectors for a mix of offensive and defensive reasons.
  • As Figure 4 shows, a spike in developments and refurbishments occurred in the industrial sector in 2022 and 2023 as investors sought to improve space to capture the significantly higher rental growth being enjoyed by prime stock. Investors could have simply relet stock, perhaps even to incumbent tenants, but preferred to take it back to perform active management and achieve higher income.
  • Development and improvement expenditures rose in the office sector from 2019 onwards. Initially, this was less driven by higher prime rental growth—although that has recently become a factor—and more driven by the need to meet environmental standards for legislative and occupier preference reasons. Investors had little choice but to embark on active management, as space might not have been legally lettable otherwise and/or would not have been desirable to occupiers.

Figure 4: Development and refurbishment vs. prime rental outperformance, industrial and office

Rents will drive returns in the coming cycle

Given the dramatic shifts in the monetary policy backdrop over the last couple of years, real estate will likely not be able to rely on yield compression as a driver of performance to the extent as in the previous cycle. From 2010-2019, U.K. all property returns averaged 8.7% per year, with capital growth of 3.2% per year. Yield compression contributed 2.7% per year to that figure, as the MSCI all property equivalent yield declined from 8.0% to 5.6%, tracking declines in fixed income yields and interest rates. We do not expect such dramatic falls in yields in the coming 10 years, but rather expect real estate to deliver a broadly similar level of performance that relies more heavily on rental growth. Understanding the health and drivers of occupier demand will become increasingly important.

In a break with tradition, the most recent downturn saw positive rental growth persist even as yields corrected. The early 1990s and post-GFC property corrections saw U.K. all property rental values decline by -22% and -12% respectively as capital values fell -27% and -44%. The latest period of prolonged capital value decline was entirely yield driven; rental values grew by 6.6% even as capital values fell by a quarter (all figures according to the MSCI Monthly Index). With no speculative construction boom inflating supply and with economic growth subdued but still positive, occupier fundamentals have remained sound and the supply/demand balance supportive of rental growth.

The above explains why a closer look at the recent trends in break and expiry outcomes, as shown in Figure 5, is so positive. We plotted the break outcomes balance against the expiry outcomes balance for the last five years of MSCI data (2019-2023) for the five main markets, with the arrow showing the direction of travel over that period. Being in or progressing toward the top right corner is ideal. The three retail markets and the office market (albeit from a lower base) show solid improvement in lease event outcomes, while industrial has been stable.

Figure 5: Balance of outcomes at break and expiry, 2019-2023

Higher frequency CBRE IM data suggests occupier strength persisted through 2024

Timeliness is a limitation of the MSCI Lease Events data. The 2023 datapoint being released in the final month of 2024 is not ideal. To try to get a sense of the most recent market position, we looked at our own data for the last few years in an attempt to replicate the MSCI analysis. We hoped this exercise would be instructive to overlay our more recent data onto the MSCI data. However, we encountered two obstacles—sample size and active management—which have significantly curtailed the depth to which we can go in this exercise. Nevertheless, there are still meaningful conclusions to be drawn from the data.

Figure 6: CBRE Investment Management experience of lease events, 2024

Figure 6 illustrates the results of analyzing our portfolio.

• As of the end of 2022, the total ERV of our U.K. sample was approximately £774million. This sounds like a large sample, and it is, however, if a typical lease length is 10 years, and if half of all leases contain a break clause, one would expect that over 2023 and 2024, one fifth of our sample (£150million) would have a lease expiry and one tenth (£75million) would have a break.
• The numbers turned out to be slightly lower. As of the end of 2022, the value of leases expiring before the end of 2024 was around £111million and the value of those with a break before the end of 2024 was roughly £51million.
• Already, our sample of assets with lease events occuring became orders of magnitude smaller, at approximately £162million, reaching a point where it can’t be automatically considered representaive of the wider market.
• Less than half of the leases (weighted by ERV) with a break or lease expiry set to occur before 2024 made it to that lease event; 16% were sold prior, while 37% saw the break removed or the lease extended before the year in which the lease event was set to occur. Just £78million of ERV, therefore, was allowed to reach a break (£25million) or expiry (£53million) date.
  • Of the £25million reaching a break, 80.4% remained let at year-end and 19.6% was vacant—a break outcomes balance of +61 which is in the middle of the range of outcomes on the MSCI sample in 2023.
  • Of the £53million reacing expiry, 53% remianed occupied and 47% was vacant—an expiry outcomes balance of +6 which is again comparable with MSCI 2023 datapoints.
  • In the industrial sector, the sample size is large enough to break out and allow for a meaningful comparison. The break and expiry outcomes balances were +60 and +13 respectively, a little higher than the MSCI datapoints for 2023 (+55 and -5 respectively).

The results of our analysis of 2024 lease event outcomes on the CBRE IM sample suggests that the occupier market remained as healthy last year as had been the case in prior years and may even have improved. Caution around sample size dictates that our conclusion is no firmer than that, but it is nevertheless a welcome sign in a market increasingly reliant on occupier demand for investment returns.

Our overall assessment of lease event outcomes in the U.K. retail sector suggests a strong and resilient market, with a low incidence of vacancy following lease events. The retail warehouse and shopping center sectors have seen particularly strong outcomes, with a high proportion of leases being renewed or relet. While the office and industrial sectors have seen a higher incidence of vacancy, our analysis suggests that this may be intentional on the part of investors, who are actively managing their assets to capture higher rents and future-proof their investments. Overall, our findings support a positive outlook for the U.K. real estate market, with rental growth and occupier demand driving returns in the coming cycle.