Earlier this month, UBS invited guests to its London offices to discuss the fate of real estate after the pandemic. Despite the Swiss bank’s promise of a free breakfast, most attendees chose to dial in from home.
“I’m worried that this is the new normal: people can go into the office but most are choosing to go in less than they said they would,” said Zachary Gauge, head of the bank’s European real estate strategy and research and the event’s host. “If this is the new normal there is fundamentally way too much office space in this country.”
Owners of UK offices, especially in London, have been in an outwardly ebullient mood since pandemic restrictions eased over the summer and workers gradually drifted back to their desks. Would-be buyers have started circling once more — seemingly willing to pay pre-pandemic prices.
Investors with more than £40bn to spend are eyeing opportunities in London, according to estate agent CBRE. But this interest is focused on the thin top layer of the market — so-called “prime” offices which are modern and environmentally sustainable.
Beyond property agents’ bullish forecasts and a smattering of high profile deals, there are worrying signs. Prime offices make up just 10 to 15 per cent of the total UK market. Owners of “secondary” buildings face real challenges in attracting tenants and the prospect of deep valuation falls as a result.
The numbers of workers returning to offices has stalled after initially edging up once restrictions were lifted. UK-wide, average occupancy was just 21 per cent in the week to November 5, little changed from a month earlier, according to Lorna Landells at property data specialist Remit Consulting. This suggested “a reluctance of a significant percentage of the workforce to return to the office on a full-time basis,” she said.
That is a serious problem for office owners but on the surface there are few signs of trouble. Most office tenants have managed to survive through the pandemic. The state-funded pandemic support helped them to keep paying rent, which allowed landlords — typically far less leveraged than they were before the financial crisis in 2008 — service their debts.
In recent deals, investors have shown willingness to pay top prices for modern offices, particularly in London. When the Vatican put its Knightsbridge office up for sale earlier this year, it attracted more than 10 bidders.
The deal is in its closing stages and according to one person close to the discussions, the buyer will pay close to £200m, more than 10 per cent above the asking price. “That says something about the weight of capital targeting London. It’s hard to get in, there’s not a huge amount of [suitable] investment stock in the market so you’re seeing a very strong bidding list,” he said.
This mismatch has driven up valuations and pushed yields down. In London yields are now at 3.75 per cent in the City and 3.25 per cent in the West End, down from 4 per cent and 3.75 per cent respectively a year ago, according to Savills.
“As a London salesman I have to tread carefully. I think [the high demand] is more about the weight of money . . . not because London per se has particularly fantastic attributes at the moment,” said Stephen Down, head of central London investment at Savills.
Private equity investors have become increasingly active in the London office market in recent years. Buyout groups are sitting on record levels of underemployed capital and are battling it out for suitable targets, with property looking more attractive than many other asset classes.
Compared to “highly volatile and toppy equities market and a compressed bond market, real estate looks more attractive as a proxy bond or proxy equity. London, by default, as a mature market with high liquidity is benefiting from that,” said Down.
Gauge said investors should consider two other factors beyond the unresolved question of whether there will be a sustained return to the workplace.
Costs for building owners are set to rise as tenants demand more to make their workspace appeal to returning workers and environmental legislation will require commercial property to meet stringent energy efficiency standards by 2030.
Nick Sanderson, chief financial officer at GPE, a high-end London office developer that is looking to buy and refurbish older stock, predicted the tightening of regulations on energy efficiency would “start to find its way into valuations . . . we’re not seeing much as yet but it could come quicker than people think,” he said.
The prospect of imminent interest rate rises, which would spell the end of more than a decade of loose monetary policy, was another issue. “Real estate in Europe has been on a 10-year bull run. Anything except retail you could have held, given a lick of paint and made a decent return for your investors . . . that’s led to complacency,” said Gauge.
Last week, British Land and Landsec, two of the UK’s largest listed landlords, said it would cost more than £100m each to comply with the new environmental regulations. Both have relatively modern, well-maintained offices.
For the remainder of the London market, “greening costs” would be far higher, said Mike Prew, an analyst at Jefferies. The same would apply to many offices outside the capital.
Owners of older buildings face these extra costs at the same time as vacancy rates tick upwards. According to estate agent Knight Frank, London’s vacancy rate has rise from 5.7 per cent immediately before the pandemic to 7.7 per cent, with older offices hardest hit.
Office occupiers, meanwhile, have dumped millions of square feet of space on to the sublet market during the pandemic, the bulk of which is still languishing, with little demand even for discounted space.
The inertia in this part of the market could be lulling investors into a false sense of security. “When nothing happens, it’s taken as a sign of stability, but it should be a concern,” said Gauge. “There is no one there to buy.”