Finding opportunity in uncertain times
The South East office market has experienced something of a perfect storm in recent times. Significant headwinds have derived from so-called 'once in a lifetime' events such as BREXIT, Covid 19 and the war in Ukraine, with each casting a considerable shadow over market activity and general sentiment.
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So, what has this meant for the investor? The starting point begins with the occupational market.
Whilst leasing levels have fluctuated against the backdrop of these major events, occupiers have typically not made 'knee-jerk' or radical decisions about the quantum of real estate needed going forward. There have been examples across the South East markets, but not the great offloading of surplus space characteristic of the immediate GFC period. Vacancy rates have risen but remain well within the boundaries of historical measure. Occupiers principally have set on a path of evaluation since the relaxation of Covid restrictions, and today continue to seek to understand how recent experiences will shape future office requirements.
Lease events will be the main driver of occupier activity rather than a substantial or sustained expansionary activity for the immediate term. Lease events will allow occupiers to right-size and reimagine their portfolios and assets. The focus for occupiers is how they use their accommodation to promote their business and inspire their staff. This typically outweighs large-scale downsizing.
Significantly, occupiers will gravitate towards high-quality, amenity-rich offices that provide users with a first-class workplace environment and experience. Organisations increasingly realise that existing space could be functionally obsolete – a product of a different era of work.
This shift in focus will generate moves, further reducing an already tightly supplied market area. Compounding this impending supply pressure will be physical obsolescence. For example, four in five offices across the South East markets hold an EPC rating worse than the 'B' rating required by 2030.
Does this tightening of supply present an investment opportunity? Yes and no!
The South East has few fully let and stabilised 'Prime' offices that will match high-end occupier and core ESG investor requirements. Assets that fit these criteria prove particularly liquid and, following the capital markets turmoil of late 2022, demonstrate a 15-20% discount compared to last year. Pricing is beginning to stabilise where these assets exist, with The Frameworks in Richmond trading at 5.60%, recent evidence of this. This reflects a discount of c.15% from the most recent peak.
Core-plus strategies are harder to define, with investors targeting traditional value-add returns whilst factoring in increased risk and capital expenditure. How do you reposition an existing multi-let office in a strong location but accommodate a lack of significant investment over the last 10-15 years?
The decision is not without a complicated web of considerations but typically takes two paths. Either commit to an asset management strategy of upgrade work, often with the tenant in situ. The recent double-digit rises in build and material costs mean viability is increasingly a consideration, with higher rental tones required to justify the investment. Alternatively, exit with the remaining income and pass the opportunity on to the next investor. The former is necessary if holding the asset; otherwise, tenant loss is likely. The latter will result in a rebased price, often tracking well below today's book value.
Generally, expect further pricing discounts for older office stock in secondary (or tertiary) markets. Investors holding these assets could be experiencing rising liabilities, both in terms of vacancy and capital expenditure. Many of these assets may lack clarity over their future, with occupiers seemingly favouring core, well-connected newer buildings. Contextualising the asset or site within the Local Development Framework and exploring alternative uses is now an essential step in improving liquidity. That said, today's land values will still be some way behind book value.
Whether in the South East or wider UK, the office market is at a critical juncture. The fundamentals in the main markets remain strong, and opportunities will exist for investors to reprice prime and core plus, where sensible capital expenditure and active business plans help propel the asset into the occupier's focus. However, polarisation in the marketplace is developing, creating a 'best and the rest' offices landscape. Couple this with the increasing concern of EPC regulation; the concern of holding a stranded asset could become a reality for some, meaning exploring alternative use will feature more frequently.
Without question, the business and real estate landscape is changing. A cautionary undertone will accompany every investor decision in 2023, but dislocation periods have historically created new opportunities.