Originally published June 2021.
As space requirements fall for offices and retail, residential will fill the gap.
Much of the reflection on post-pandemic shifts in property has been focused on individual sectors, but how these interact with each other will also be key to the outlook for the urban locations where real estate is clustered. And while it is premature to declare the death of cities, their built environment is likely to change significantly.
Once the virus passes, global cities’ clusters of high-productivity industries and their strong amenity will continue to draw workers, residents and tourists. This attraction has historically underpinned a resilience to even the most extreme shocks, and Covid-19 isn’t expected to be different. But there will be changes, with property at the forefront. Offices will take a major hit as the rise in home-working reduces demand, curbs development and squeezes investor incomes over the longer term. Demand is set to shrink by around 10% across global markets over the decade, and city-centre offices will bear the brunt.
As cities re-emerge post virus, the initial exodus of urban residents to suburbs is likely to slow
Home-working will also influence residential markets, as people will have less need to live close to their workplace. But as cities re-emerge post virus, the initial exodus of urban residents to suburbs is likely to slow. And a supply of obsolete retail and office space will create opportunities for city apartments, though a desire for bigger units and constrained incomes will limit investment performance.
For retail and industrial, Covid-19 gives a nudge to pre-existing trends, but city dynamics are likely to be affected too. In-town retail will continue to be hit by internet competition. Within this, shopping centres and high streets that rely on daytime worker populations and transport hubs are most exposed. For industrial, urban logistics should see upside from increased online penetration.
The most important implication of all this is that there will be less traditional commercial real estate in cities, with a contraction in office and retail space. This is not a trivial change. Office and retail have become less important for investors over time, with their share shrinking steadily from around 80% at the turn of the century, but they still accounted for about half of all global transactions in 2019 (see the chart). This shift is now likely to accelerate.
Assuming that the urban flight is limited, residential provides the best alternative to fill this gap. This will be not just apartments but also other types of accommodation, such as student housing and care homes. Initial downward pressure on prices and solid demographic drivers will be important for sustaining demand, though as noted the desire for larger apartments to accommodate more home-working may limit returns.
The hospitality sector is also set to play a role in urban renewal. These industries are currently in the doldrums and there will inevitably be some post-pandemic losses. But vaccines should allow tourism and leisure spending to revive quickly. Leisure will be vital in filling the gaps left by exiting retailers. In addition, there may be opportunities for converting excess office space into hotels.
Another probable growth area is logistics, specifically last-mile assets for online delivery to densely packed city populations. This alone is unlikely to fill the gap entirely, however, as requirements will be in suburban areas rather than in the city centres where existing retail and offices are mostly located. In addition, environmental concerns may eventually bring a backlash against the costs of this convenience. Nonetheless, these urban sheds are set to become more common.
Gateway cities are well placed to absorb structural change, with a significant advantage in amenity and attractions
While these structural shifts are relatively clear, it is harder to pick winners and losers. Here the interaction of economic and social factors with property market dynamics will be complex. Gateway cities are well placed to absorb structural change, with a significant advantage in amenity and attractions. And a new role could emerge for medium-sized cities, with the creation of more ‘liveable’ towns based less on shops and offices and with more leisure and living space. For other cities, regeneration may be the only option for obsolete commercial space.
Cities will be changed by the pandemic, but their key role in fostering clusters of high-productivity industries and in drawing people together to live, work, shop and travel will not. Consequently, investors will still find returns from property assets, though they will have to look beyond the certainties of the recent past.
