Office investors that can either start digging foundations in the next 12 months, are willing to take a refurbishment risk, or have deep understanding of local supply and demand dynamics have a once-in-a-generation opportunity to make money.
When Swedish construction company Skanska bought the site of London’s Monument Building in the summer of 2012, the UK economy stood on the brink of a third recession in four years.
UK economic output during the 2008 – 2016 period was expected to match or under-perform Japan’s “lost decade”. Meanwhile, the eurozone was in the grip of an escalating debt crisis: over the course of a year, Greece, Spain and Cyprus would all receive bailouts.
Skanska spent £13 million on the site, before investing another £33 million developing an 88,000 square foot office block with four terraces and spectacular views. The building completed in 2016, when occupiers were competing for prime office space. Skanska sold the property to Credit Suisse a little over a year later, netting £118 million.
We like to think we’d make comparable calls in similar situations. Researchers call it “hindsight bias” and it gives us a tendency to downplay the risks that others faced to net outsized returns. Rarely do real estate developers and investors get the chance to really prove their worth - there is often just a narrow window in each cycle to do the right deal near the nadir – but for people with the right skills and access to capital, one of those moments has arrived. Indeed, we think the turbulence created by higher borrowing costs and the shortage of ‘sustainable’ buildings present real estate investors with a generational opportunity to make significant returns.
Granted, UK office owners and investors now face hurdles that are more daunting than those buying in 2012. For starters, the base rate stands at 5.25%, rather than 0.5%, and sentiment surrounding offices is poor.
Sellers are still having to accept significant discounts to quoting prices to get disposals over the line. Indeed, the future for many office buildings remains uncertain given the massive cost it takes to bring older properties into line with the sustainability standards required by occupiers and investors.
Key questions remain unresolved. The costs of the energy transition are broadly consistent, regardless of local rents, and so penalises properties that command lower rents. Few were feeding these upgrade costs into their cashflows as recently as 2019, but today 100% are factoring in these expenditures to their cashflows. There’s now a need to inject new money.
Lenders are understandably hesitant. The decline in office values differs by building with a few considerations at play, especially if it’s a secondary or a stranded asset. But, today, many investors face a mix of recapitalisation and additional capital expenditure for the energy transition. Falling interest rates will help, but only to a point, and markets are pricing in a ‘higher for longer’ macroeconomic environment.
Even for those with capital, the upgrades can be hugely complex. Hitting EPC B by 2030 might require an overhaul of a building’s mechanical and electrical (M&E) systems, all while fully let to a dozen tenants with staggered lease expiries. Our building consultancy and leasing teams are doing fantastic work in navigating these issues with our sustainability framework, but these challenges go some way in explaining why UK office investment volumes are running at 14-year lows.
Investment volumes will recover slowly during months ahead. Well-capitalised investors with the skills to execute upgrades are already finding pockets of value. GPE said in November that it had become a net buyer of London property for the first time in a decade by seeking out “old, time-expired buildings that need improvement . . . at very attractive prices”. LandSec is also expecting to be acquisitive next year as ‘buying opportunities emerge’ as the prices for good-quality property stabilise.
AEW believe the outlook for next year is ‘increasingly optimistic’ with the crunch that has squeezed the values of Europe’s best buildings nearing its end. The group, one of the first to call the bottom of the market, outlined in a revised forecast that it expects commercial real estate returns for the best warehouses, offices and stores will be about 9.2 per cent a year in the four years through 2028, with the UK set to post the best performance.
Blackstone’s CEO, Stephen Schwarzman echoes the opportunity that European real estate currently presents, and his intention to deploy capital into what he described as ‘very, very good buys’ in data centres, warehouses and student housing sectors. He didn’t mention offices, but the sentiment is encouraging.
More will emerge in the months ahead, and while much of the focus has been on satisfying a shortage of prime, grade A space, I think investors are far too bearish on a large slice of UK offices.
Available prime, sustainable office space is now so constrained that occupiers may need to look at alternative options. For example, as of Q3 2023, availability of Grade A office supply in Central London equates to just over 1.4 years of demand (based on three-year average take-up levels). The majority of corporates are very sensitive around their scope 1 and scope 2 emissions, as these figures are appearing in their yearly accounts, creating an ever-stronger focus on accountability. Never has the type of real estate they occupy been more important.
Whatever happens, there won’t be enough prime, sustainable office space to go around. That brings good grade B stock in strong locations into play, depending on the scale of the shortfall. At that point, landlords and their tenants will need to come together to determine what can be done to upgrade buildings to the right specifications. Those discussions willinevitably focus on how to raise the capital to do the work and the rental values required to transform an asset to an ESG compliant standard.
Many occupiers won’t agree to set new benchmarks, but some will, and it only takes a handful for higher rents to crystalise. Indeed, we’re already seeing occupiers set new records in supply-starved locations – see Ryze Hydrogen’s decision to take 28,500 sqft in Oxford at £63.50 psf. Or take the core West End market in London. Grade A vacancy rates reached 1.06% as of Q3, and constrained supply is continuing to apply upwards pressure on prime rents, which have already reached £150psf, up 7.1% year-on-year.
To be sure, raising the money to capitalise on these themes remains very difficult. Obtaining funds to invest in core real estate will remain particularly challenging while fixed income pays such attractive returns, but the situation in capital markets should only improve. Volatility in the economic data continues to make forecasting particularly challenging, but our colleagues at BNP Paribas believe the Bank of England will cut rates rapidly – to 4.25% by the end of 2024 – and new sources of funding will emerge as sentiment recovers, with international capital set to be the first mover.
UK commercial real estate already looks a good bet relative to some European peers. Poor sentiment in the wake of Brexit meant we didn’t see yield compression or ERV growth akin to other key European markets such as Germany and France. We moved into the downturn early and it’s now reasonable to expect that we emerge first.
That will take time, but conditions are already ripe for anybody able to start digging foundations in the next 12 months, willing to take a refurbishment risk, or understands local supply and demand dynamics in sub-markets that will see the biggest overflows of occupiers seeking to find prime sustainable office space.
Skanska enjoyed a few comparable tailwinds when it purchased the Monument site in 2012: availability of office space in central London was running below long run averages, for example. But, with take up significantly lagging long run averages and no end to the economic turbulence in sight, it took some foresight to make the right call.
Investing in UK offices in 2024 comes with even bigger big risks, but we think the market-defining deals of the next cycle will be executed over the next two-years. Indeed, some are probably in the pipeline already.
Etienne Prongue is CEO, BNP Paribas Real Estate UK
