In the past decade, the U.K. property market represented a major share of the European REIT market. It attracted record investment and the highest numbers of international tenants. Today, S&P Global Ratings sees the U.K. property market being more distinctive than ever, even as (and because) it faces issues its European neighbors don't. Chief among those is Brexit, which is directly affecting offices but is also an issue for retail landlords. COVID-19, the related impact on short-let apartments, and a shift to a work-from-home culture, might be common with European real estate companies, but their effects will also be pronounced in the U.K. For U.K. real estate companies and their mainland counterparts, we see the most diverging paths in the retail segment, while office and residential segments will have more similarities.

Why Has The U.K. Retail Property Market Been Suffering More Than The Continental European One?

U.K. shopping center landlords started to face difficulties from e-commerce and changing consumer habits a couple of years ago, while in continental Europe, the change was more modest, only really beginning to show in 2019 (for more information, see "Europe's Retail Property Market Is Showing Signs Of Weakening," published Sept. 26, 2019, on RatingsDirect). While COVID-19 has accelerated these trends throughout Europe, with no retail property issuer being immune to the pandemic, the stress appears even greater for U.K. issuers. In particular, we now see strong declines in share prices and asset valuations (see charts 1 and 2). We believe there are some structural differences between the U.K. and continental European markets, namely higher e-commerce penetration and the density of retail shops in the U.K., but also a more elevated occupancy cost ratio (OCR; rent as a share of tenants' sales) and putting more burden on retailers. Recently, U.K. retail landlords have shown more acceptance than their European counterparts to increase the share of variable or turnover-based rent, which could fundamentally increase the risk they carry. Lastly, we cannot ignore the impact of Brexit on the U.K. retail sector, with notably international retailers becoming more reluctant to enter the U.K. so long as the uncertainty remains.

Chart 1

Chart 2

E-commerce in the U.K. is well above the rest of Europe

We think e-commerce exacerbates prices pressure among retailers and hampers tenants' demand for physical stores. The U.K. is a more mature market when it comes to e-commerce. U.K. consumers purchase online more frequently than any other European country according to EuroCommerce, with 24% of individuals buying 6x-10x online in the past three months. Moreover, the country shows a penetration rate of 22.3% in 2019, one of the highest rates in the world (see chart 3), greater even than the U.S. and about twice as much than the continental European average. The pandemic has undoubtedly accelerated the rise in e-commerce across Europe, and this trend is quite pronounced in the U.K., where e-commerce would reach 25% of total sales as of June 2020 according to another third-party research provider. In France and Germany, by comparison, the rate would reach 13% and 14% respectively, as of June 30, 2020, compared with 9.6% and 8.7%, respectively, as of Dec. 31, 2019.

Chart 3

In our view, this high e-commerce penetration has affected the performance of physical retailers in the U.K. more significantly than in the rest of Europe, where internet retailing is less developed. The U.K. has a well-developed infrastructure to support e-commerce growth and fast delivery to customers. We anticipate, however, that e-commerce will become more prevalent in mainland Europe, although not evenly, because there are some disparities among countries. For instance, e-commerce in Southern and Eastern European countries is less advanced than Germany or the Netherlands. Retailers and shopping center landlords could also benefit from this lag to adapt their value proposition.

The U.K. suffers from a greater density of retail shops than in continental Europe

According to Statista, the U.K. has the most shopping centers in Europe, with over 1,500 traditional centers, retail parks, and factory outlets. While the number per capita is still way below that in the U.S. (which appears to have the highest shopping centers density worldwide, at about 5x more than the European average), the U.K. sits above the European average per capita, according to a survey of Cushman & Wakefield (more than 2,800 square feet of gross lettable area per 1,000 people in the U.K. versus less than 2,700 in Europe). In our view, this higher number of retail stores creates more competition among retailers and has contributed to the challenging retail environment, leading also to high numbers of bankruptcies or CVA proceedings in the U.K.

A higher OCR burdens U.K. retailers

According to research company Green Street, the largest shopping centers landlords in the UK have OCRs of above 20% (meaning rent level as a proportion of retailer sales). This includes notably Hammerson, Intu, Land Securities and British Land. In comparison, most in the rest of Europe have OCRs below 15%, notably Mercialys, Citycon, Deutsche Euroshop, or Klepierre for a comparable sales productivity per square meters.

Hammerson and Unibail-Rodamco-Westfield (URW) are present both in the U.K. and continental Europe, and for them, OCRs seem to vary by 5% or more between the U.K. and the rest of Europe. While sales productivity (sales per square meter) is higher for URW in its two prime Westfield shopping centers in London than in the rest of Europe on average, this is not the case for Hammerson in the U.K., which has a lower sales productivity than in France. In our view, higher rent cost (see chart 4) is likely to result in thinner operating margins for retail operators, especially when sales productivity does not compensate. In a challenging and competitive environment, we believe it can also explain retailers' difficulties to pay rent and lower rent collection since the pandemic's start in the U.K. Moreover, U.K. retail leases are typically longer than those in mainland Europe, so the disconnect between real rental value and actual rent could prompt retailers to renegotiate more aggressive discounts during downturns.

Chart 4

U.K. landlords are more willing to switch to turnover-based rent, but it just might be a matter of time for European ones

The trend toward more variable, or turnover-based, rent started a couple of years ago with some large international retailers with strong negotiating power, such as H&M, being very aggressive about it. It seems that the pandemic is accelerating this trend, because it gives physical retailers, directly hit by social distancing measures, the opportunity to renegotiate their lease terms. We understand, however, that again the responses across continental Europe and the U.K. are not homogeneous. Shopping center landlords such as Klepierre and URW continue to refuse to move to leases purely based on turnover. In comparison, some U.K. retail landlords seem more open to discuss this, given that they face a more challenging situation. Hammerson has published on its website a new approach to rent, with more flexible leases, including notably a "top-up element based on store performance." A higher reliance on variable rent could change the fundamentals of the retail property sector, in our view, affecting strongly the predictability of cash flow shopping center landlords can receive and, therefore, their credit quality.

Brexit has also taken a toll

Although it is difficult to quantify, we believe that Brexit is disrupting the U.K. retail sector. It could result in higher costs for consumers and imply thinner margins for retailers. In addition, given the uncertainties related to Brexit, we understand that some international retailers have delayed plans to enter the U.K. For landlords, this could affect long-term footfall and attractiveness of shoppingcenters.

London Office Landlords Face Three Threats: The Pandemic, Flex Offices, And Brexit

The London office segment historically represents one of the major European markets in terms of leasing transactions and investments volume. Although we believe the city provides strong fundamentals for office landlords, such as a dynamic business environment, scarcity of good assets, and international attractivity, we think it is facing threats.

The London office market is caught up in the smog that is the pandemic

The prospect of a weaker economy is likely to lift companies' need for office space in most European cities. London might well be affected by weaker demand compared with that of other major European office markets, because we expect a more marked deterioration of GDP than the EU average in 2020. We also expect U.K. unemployment to rise by 2.5 percentage points in 2021 from 2019, compared with 1.5 points in the eurozone (see chart 5). We generally see a strong correlation between the demand for office space and those two macroeconomic indicators.

Chart 5

Seven months after the beginning of the pandemic, the London office sector's take-up has been more affected than some other major European office markets, down by 67% from its 10-year average. The available office space reached 1.8 million square meters as of Sept. 30, 2020, according to real estate brokers. As a result, market vacancy stood at 6.5%, and we see a risk that new deliveries bring additional vacancy. (see chart 6)

Chart 6

Londoners' shift to work-from-home could be more pronounced than that elsewhere in Europe

Work-from-home is another significant consequence of the pandemic. Remote working processes were widely deployed in most European countries in early 2020, as a way to limit social interactions during the peak of infections. We believe this trend will continue to some extent, hampering part of corporates' office space requirement in most large European cities, especially the most densely populated (for more information, see " How Are Lockdown Measures And Remote Working Affecting European Office Landlords," published May 27, 2020, on RatingsDirect). While the national restrictions eased during summer, the return to office has not been uniform in Europe and Londoners are lagging behind other European citizens despite Prime Minister Boris Johnson's calls to be back as early as August. According to a Morgan Stanley research, U.K. citizens spend more time working from home (2.7 days a week versus 1.6 on average in the top 5 countries), and only 49% of them went back to their workplace as of October (see chart 7), up from 37% in August, when the average in Europe's top 5 countries was about 75% (88% in France, 82% in Italy, 79% in Spain, and 75% in Germany). More stringent employers' instructions in the U.K. and the longer London commutes compared with that in many other cities could explain why. We therefore think that the penetration rate and the long-term impact of work-from-home could be higher in London. The reimplementation of work-from-home status that was instructed in October in light of a resurgence of the virus, even if widely adopted in Europe, should further enforce the trend in the U.K.

Chart 7

In London, flex-office providers could also pose a risk

We think traditional London office landlords, whose leases generally exceed nine years before a potential exit option, might be more exposed to the competition from short-term lease flex-office providers. This is because these players are far more prominent in London than any other European market, with 886 sites representing 5% of its office stock (see chart 8). And we think these short-term leases could be favored by corporates during economic uncertainty. At the same time, flex office providers have more volatile occupancy rates, so an economic shock could make vacant office stock flooding the overall market more quickly than long-term lease providers.

Chart 8

The London office market remains vulnerable to Brexit

We see the London office market as particularly vulnerable to Britain's decision to exit the EU, because financial tenants that benefit from EU trade agreements, such as investment banks, might be tempted to relocate outside the UK in order to continue operate across the EU (see "Brexit And The Risks For U.K. Real Estate," published April 7, 2016). This would leave London's office landlords dealing with increased vacancy. So far, financial firms in the U.K. have shifted about 7,500 staff and more than £1.2 trillion of assets to the EU, according to Bloomberg. While the pandemic has put most companies' relocation plans on pause, they might soon resume. Several banks have stated their intention to relocate staff, and we think lawyers and consultants could also follow. We believe a disruptive outcome with the EU could exacerbate the lower demand for office space, especially from large financial institution.

London's Private Rental Sector Might Face Stress While Supply Increases Quicker Than Demand

The pandemic's impact on the U.K. residential real estate market has been by far softer compared with other segments, though more affected than other European residential property markets, like Sweden, the Netherlands, or Germany. Strong demand has outpaced supply in the private rental sector in recent years, especially in larger cities like London, Birmingham, and Manchester.

Short-term lets are flooding the long-term rental market in central London

With COVID-19, the gap between demand and supply has started to ease in prime city centers. Long-term remote working trends and therefore the wish for larger living space has recently led people moving toward suburbs or even rural areas (see chart 9), moreover a flood of short-term lets (such as Airbnb apartments, which are increasingly offered as long-term lets because of travel restrictions and the absence of tourists), primarily in central London, increased supply strongly in second-quarter this year. In 2019, there were more than 80,000 active Airbnb listings in London, over 3x more compared with cities like Berlin. According to U.K.-based residential real estate property company Hamptons, more than a third of homes in London that were previously short-term are now for long-term leasing. According to Savills Research, rents for prime houses in London fell by 1.1% and 2.6% for flats in the quarter, but rents in markets up to an hour out of the city increased 0.8%. Uncertainty remains as to whether the deurbanization trends will be prolonged, how fast the market can absorb the additional available stock, and how long it takes for tourism and international travel to return, moving some of the stock back to the short-let market.

Chart 9

Affordability remains a key issue in the London rental market

Even if rents are stabilizing or even slightly falling in London, affordability remains a significant factor (see chart 10). On Sept. 16, the mayor called on the national government to give him power for implementing a two-year rent freeze, similar to Berlin's current regulation, to ease the pressure of unaffordable rents on Londoners and protect them from being forced out of their homes due to rent increases. The government's temporary extension to the evictions ban finished at the end of September. In terms of regulated rental markets, where rents tend to be more affordable, such as in Sweden or Germany, the average tenant stay is much longer, supporting occupation and rent stability for landlords (see chart 11).

Chart 10

Chart 11

Regulated European rental markets have proven the most resilient segment during COVID-19

Among rated European residential landlords, peers with a focus on regulated markets seemed to be largely unaffected by the pandemic. Occupancy levels remained the same to pre-COVID-19 levels with monthly rent collection rates close to 100%. Although U.K. based residential landlords continued performing well since the start of the pandemic compared to other real estate segments, operational key performance indicators however were less stable. Grainger PLC (BB+/Stable/--), with about two-thirds of its portfolio on London and the South East, reported a drop in occupancy to 91%, with rent collection standing at 95% for August. The company reported flat like-for-like rental growth, adjusted for an average occupancy decline of about 220 basis points, in our estimate. Luxembourg-incorporated residential property company Grand City Properties S.A. (BBB+/Stable/A-2) has also reported an increase in vacancy levels to 8% in second-quarter 2020 from 4% in first-quarter 2020 for its London portfolio, worth about €1 billion.

Chart 12

Looking Ahead

COVID-19 has accelerated many of the issues facing U.K. real estate companies, in addition to creating some of its own. Some of those issues, such as lockdown and travel restrictions, could abate with the pandemic; others, however, could transform the respective sectors. For retail, it's e-commerce; office space is dealing with the ramifications from Brexit and more work-from-home; and rental units could have to contend with tenants leaving cities for more space in suburbs or rural areas. How well real estate companies navigate these challenges will affect credit quality.