In the early months of 2020, the UK market for premium office space was booming. No more so than in central London. Immediately before working from home became mandatory for millions across the UK, the construction rate for new office buildings in central areas of the capital had reached new record hights.
Commercial property investors were not acting out of step with the market. Retail-focused commercial property has been under pressure for some time with online shopping eroding footfall in malls and on the high street for several years now. But offices were doing well. In January of this year, the property consultancy JLL forecast that businesses looking to secure office space in central London would be forced to pay record rents.
Construction had not kept up with demand and rents were expected to hit £90 per sq ft for the most sought-after floors in the City of London – around £5 or 6% up on 2019 levels. Commercial property investors promptly upped the intensity of breaking ground on new properties.
With business confidence boosted by the December 2010 general election result and the construction rate for new office buildings having dropped on Brexit-uncertainty over the past couple of years, office investors got busy. The biannual Deloitte crane survey found record numbers of new office projects broke ground over the six months to the end of March. A total of 45 developments that will host over 5 million sq ft of office space broke ground – 42% up on the same period a year earlier.
Will Companies Reduce The Amount Of Office Space They Use?
Less than 3 months later and the outlook for the UK’s commercial office space sector has changed dramatically. Most office-based professionals have been working from home since March. Many if not most will continue to do so for the next few months at least.
Several huge companies, from RBS to Facebook, have already said all staff whose jobs allow it will work from home for the next few months at least. They expect that many will continue to work remotely, or part-remotely, permanently. UK property services firm Avison Young has told its 1600 employees they can work from home until the end of 2020.
Others, especially in the tech space and including Twitter, have intimated they will adopt a full remote-choice policy.Big tech is not as big an employer in London and elsewhere in the UK as the financial and other services sectors. But it has a habit of setting influential trends and RBS’s statement already suggests major employers in the UK will follow suit.
One of the biggest considerations will be the expense of adapting crowded open-plan offices to those that meet new social distancing norms and regulations. Many companies who might, all things being equal, prefer to maintain an office-work environment, will see their resolve tested. Keeping 6 ft between desks could see as much as a 60% increase in space requirements.
There will also be new standards and requirements when it comes to office hygiene that will cost money. More handles will have to be replaced by automatic solutions, rest room facilities upgraded, common and social areas adapted. Fabrics may have to be replaced with new alternatives with anti-microbial properties, air conditioning systems upgraded and ‘deep cleans’ paid for after hours. That may well be enough for many companies and other organisations to open up to the alternative of full of part remote-work.
Office Workers Happy With Work From Home
The next consideration is that a lot of office workers are quite happy with their newfound work from home lifestyle. Surveys indicate that the loss of the social aspect of working is a trade many are willing to make in return for escaping the daily commute.
A Colliers survey of 4,000 people working from home found that 81% wanted to continue to do so for at least one day a week. Crucially, the same survey found 73% estimated their productivity was either the same or higher working from home.
The property consultancy estimated around 11.8 million Brits work in offices. As long as the 6 ft rule remains in force, 7.8 million will have to keep working from home. 76% said their work/life balance has improved with the commute time taken out of the equation.
Last month Barclays chief executive Jes Staley commented “the notion of putting 7,000 people in the building may be a thing of the past.”
James Walker of Colliers told The Times newspaper there is a genuine possibility that the office sector may have changed irrevocably over the course of the past few months and C-suite executives are seriously considering that possibility and what their strategy will be:
“It’s a hot topic right now. This is coming from the C-suite level. Over the next 12 months, all large corporations will be looking at how they occupy space.”
And they are not just discussing the immediate future and how existing offices and working arrangements may have to be adapted. They are also considering what it means for the longer term. How will office spaces and office work have to be redesigned?
What Does The Future Hold For The Investors That Own Billions Of Pounds Of Office Space?
Everything discussed presents serious questions for the investors that own the office spaces sitting empty and with an uncertain future across central London, the rest of the UK and wider world. Are office building still viable assets? Or has the business model been so badly, and quickly, broken that it will take years for the market to readjust to a new reality?
For the companies that rent office space, there are two forces at work. They may well forever, or for the foreseeable future, have less staff working from company offices. On the other hand, they will need more space for those who are working from the office.
For landlords, the big question is if the balance will ultimately result in a net loss or gain for office space let. Mark Allen, chief executive of Land Securities, the London Stock Market-listed REIT that owns a portfolio of £6 billion of office property, with a pipeline for another two million sq ft over the next two years is optimistic:
“Whereas we may see fewer people in the office at the same time or working across a broader range of working hours, employers are likely to require more space.”
However, with a struggling share price to prop up, Land Securities has seen its value drop by almost 60% since October 2015 and 40% since February this year, there is an argument that it is Mr Allen’s job to paint the rosiest picture possible.
Others are less sure. Commercial property REITs have already been hit hard by the slump in the bricks and mortar retail sector as demand has gradually shifted online and there are fears the office market may be about to undergo its own sea change.
The noises being made by major office renters is that they are rethinking their strategies. Keith Froud, managing partner at the law firm Eversheds Sutherland, told The Times newspaper that his company, which employs 2500 staff spread across 10 UK offices, plans to spend less on office space and reallocate savings to improving their technology infrastructure for remote work:
“Our physical location will remain a really important part of how we work and how we do business, but people have been able to see the benefits of remote working and see that technology works. In the fullness of time, we will be redirecting investment away from office space to a degree into things like technology, which will enhance that flexibility even more.”
Tony McCurley of Deloitte Real Estate also, however, remains optimistic. He is confident that, at least in central London, the impact of the pandemic will be restricted to rebalancing office supply. Low vacancy rates were a problem before the lockdown and he believes that over time, demand dropping from recent highs to the equivalent of average ten-year take-up rates, will mean the new office space currently under construction will be absorbed.
The current consensus of those within the industry is that while office spaces will need to be reconfigured, and new buildings designed in a different way, the Covid-19 pandemic does not spell the end of the office.
Daniel Hajjar of British architectural firm HOK, which designed the Barclays Bank HQ its chief executive Mr Stanley hinted may no longer be needed, thinks that while there will be changes, there are still compelling reasons why companies will still prefer offices to remote work. Mr Hajjar comments that “companies generally like to consolidate their workforce. And it makes a lot of sense.”
Large offices bring companies of economies of scale. Only one canteen is required, one gym space, one reception area, one cooled server space and so on. Decisions can be made faster when communication is in person and it’s easier to foster team spirit, loyalty and organisational identity. Ultimately, the argument is that we are a social species by nature and most office-based roles involve some degree of collaboration with colleagues.
But some economists warn that the potential trend towards more remote work is not the biggest danger the office market faces. The consultancy Capital Economics is more worried about the impact the expected recession will have on unemployment. Manufacturing and hospitality are expected to be hit hardest but office workers won’t be immune.
Amy Wood, a property economist at Capital Economics says that they “do not expect that job losses will be fully recuperated in all countries, even by the end of 2022.”
Are Hammered Commercial Property Funds A Buy Opportunity?
For investors that currently hold commercial property REITs or are invested in other property funds, many of which are currently suspended, the question is whether to lock in losses by selling. Or to hope that office market professionals are right to be optimistic and hold on in the hope of recovering at least some of the losses sustained over the past few months.
The picture is muddied by the fact that most commercial property funds have portfolios that span both retail and office properties. Few are a pure play on offices alone.
Investors that do not currently have exposure to the office and wider commercial property market might wonder if today’s rock bottom prices represent an opportunity. Funds are trading at significant discounts to the theoretical market value of their assets.
Land Securities currently trades at a discount of around 55% to its net asset value even after it wrote down the value of its portfolio by 8.8%, or £1.18 billion, to reflect the early impact of the Covid-19 pandemic, as well as ‘ongoing structural challenges’.
The company only collected 63% of the quarterly rents it invoiced for in March and the quarter ending on June 30th is expected to be worse. Landsec’s share price is down around 40% since the beginning of the market sell-off. Rival commercial property fund Hammerson is the only peer to have taken more of a hit on its market value, down almost 80%. British Land is 35% off its 2020 high, set at the beginning of the year.
Analysts at Morgan Stanley expect Landsec, and other commercial property funds focused on office and retail assets, to remain under pressure for the next few months. But that Landsec’s strong balance sheet should see it bounce back. The investment bank wrote:
“We expect a deep recession to drive down NAV for longer, but argue that the shares are overly discounted for their return profile on offer, in particular in the context of the strong balance sheet the group has maintained in recent years.”
The company has a “severe but plausible downside scenario”, under which it is braced for a 75% reduction in rent receipts from retail and specialist tenants, and a 20% reduction in rent receipts from office tenants over the next year.
Landsec has sufficient cash reserves to see it through such a scenario, with its loan-to-value covenant remaining less than 65% and interest cover above 1.45x, for a period of at least 12 months.
Not all commercial property funds are in such a reasonably strong position and investors considering taking a risk on picking up a bargain, on the hope the office market bounces back, would do well to pay particularly close attention to the levels of indebtedness at REITs and other funds.
The same could be said of investors that hold existing investments exposed to commercial property and are considering whether to sell or hold. How much is offices, how much is retail? And how precarious are debt levels?
The office market may bounce back as industry insiders say it will. The remote work trend may slow down considerably as soon as life begins to return to normality. But it may not. And there is also the question of how bad the coming recession might prove. There are competing factors and it will probably be a couple of years before we see how persistent the influence of the current pandemic will prove to be.
Commercial property funds do look like a bargain at the moment. But there is an open question of whether current portfolio valuations, even those written down to take account of the pandemic, are actually realistic in the medium term.
It’s fair to say that investing in commercial property funds right now would represent a risky move. And when it comes to investing, risky moves tend to either result in a significant gain or a significant loss. More conservative investors may well be better waiting for the dust to settle. Adventurous investors who are willing to bet on office life returning to relative normality over the next year, will see current valuations as a bargain worth the risk. But a risk it is.
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