The office market has been tough for the last 5-7 years, and it’s been a challenging time for investors, but the market could be reaching the bottom of the cycle, which creates opportunities.
It’s been a tricky market for a number of reasons. Covid opened the door to flexible working, which reduced the demand for office space.
Pre-Covid, in central London, the average time spent in the office was 3.9 days a week, according to research by the Centre for Cities. Then, the country went into lockdown, and everyone had to work from home.
Even as lockdown lifted, there was no immediate rush to return to the office, and businesses started to rethink their space requirements. By last year, the average number of days in the offices was 2.2.
It was the biggest shock to the office market since the financial crash in 2008.
“Some investors got burnt purely because of the market cycle,” says Nick Green, Partner, Trowers & Hamlins.
But while some predicted the end of the office, the average number of days a week spent in an office in London has risen to 2.7 this year.
The return to the office, for at least some of the week, is being fuelled by the recognition that there are benefits to working alongside colleagues, such as easier collaboration and knowledge sharing.
Some businesses now mandate that staff are in the office for a minimum number of days.
“There is a new way of working, and that still involves offices; they might not be as densely populated, but businesses still require space,” says Tom Calnan, Partner, Trowers & Hamlins.
The office that workers are returning to looks very different from 8-10 years ago.
A model in which the amount of lettable desk area was a priority has been disrupted by the arrival of flexible workspace operators, like WeWork, which offered not just a desk but break-out areas, collaboration space and other amenities.
“Offices used to be all the same, it was about a nice atrium and how many people you could fit in,” says William Clements, Partner, Trowers & Hamlins. “You could walk through the city and point to any number of buildings that would do the job.”
Workspace has evolved to facilitate a variety of ways of working. Offices have also become an extension of a company’s brand. It is a statement about the business, how it likes to operate and what it’s like to work for.
Post-Covid, occupiers are more focused on the quality and attractiveness of the space. Rising energy costs in recent years, coupled with net zero carbon sustainability targets, have also made greener buildings more attractive.
It’s evident in market data. JLL’s latest UK regional cities research shows that 48% of office deals were in Grade A buildings, with 60% of deals being in buildings with the top energy performance ratings of EPC A or B.
In London, 55% of office take-up was in buildings rated BREEAM Outstanding or Excellent, according to Savills research.
These occupier trends have to be weighed against stock availability. While vacancy rates are still not where the market would ideally prefer them to be, macroeconomic factors such as rising inflation and the cost of debt have made development far more challenging.
Inflation has come down, and the cost of debt is also showing signs of reducing but there is still a potential lag with delivering new space.
“Buying sensibly now, over the next 12-24 months, it could end up looking quite good for investors,” says Green.
Which means purchasing assets that meet all the requirements of the modern office.
“The right location and best in class in terms of fit out and ESG credentials are key considerations, and it's got to have the right tenants,” says Clements.
And that stands regardless of whether it is an office in London or one of the big regional cities like Manchester or Birmingham.
ESG is not only important from an occupier standpoint but critical to investment strategy. The UK has regulations which require a minimum energy performance rating of E for a building to be leased.
The new Labour government has been much clearer with its messaging around sustainability and the transition to net zero carbon by 2050. This means a strong likelihood of further changes to minimum EPC ratings and other sustainability regulations and more buildings becoming un-lettable.
“Don’t buy anything that is in danger of becoming a stranded asset unless it's a value add opportunity and you've got a plan to refurbish and upgrade to achieve a higher EPC rating,” says Clements.
When compared to Europe, the UK benefits from having more office stock. The size of the market and availability of stock in London compares favourably to the likes of Frankfurt or Paris.
The recent election result has also delivered political stability for the UK relative to challenges faced in countries like France, where voting has had less decisive results.
Cost of debt is also starting to come down. “You will hopefully be able to buy office assets soon with debt that is not going to completely erode your bottom line,” says Calnan.
An alternative approach to investment risk is development finance.
“If you have the resources and the time to build new from the bottom up, that could be a way of making money work for you,” says Calnan. “We need new offices in the brave new world we live in, and the secondary and tertiary office space is struggling – development of new space could be a better answer.”
The office market may have had a challenging time, but it is starting to come through the other side, driven by changing demand and a focus on ESG. Funding development obviously carries a higher risk profile and lease lengths have come down, but if the market is compressing around the best quality stock, it presents an opportunity.
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