Broken Windows

·      Offices the dominant, but declining subset, of institutionally owned real estate

·      Flexibility of short term debt attractive

·      Serviced office portfolio at 65% occupancy

Institutionally owned real estate, globally, totalled around $10 trillion at the end of last year and offices still dominate the share of total investment volumes – even last year – but that has steadily been decreasing each year for the last decade. In one recent survey, City office sector prospects featured 17th in a list of 25 choice investments of investors. However the choice of words, particularly in politically correct 2021, is important. In a subversion of Dr Robert Cialdini’s experiment, subtle changes to language can have dramatic changes to action: simply changing a few words on a hotel bathroom notice to remark that the majority of fellow guests reuse their towels, encouraged guests to do so by more than 26%. Which is why when we read in a large publication last week about “The Death of the Office”, we were thrown by the inflammatory title. Offices were indeed created as cathedrals to corporate vanity rather than corporate efficiency but the most transformative aspect of offices is less the buildings themselves than the sheer amount of time we spent in them.

Bank bosses exhortations for employees to return to the office has little relevance to offices as an investment per se, but are focussed more on office culture, promotion and pay. One boss went so far as to say “if you want to get paid New York rates, you work in New York,” and added that if “restaurants were filled with diners, offices should be similarly stocked with employees.” Sentiment such as this seem to have been dominated by financial institutions, less so for non-financial services firms. Still, we think this shift is structural. Gladwell’s “broken window” theory, which posits that so long as visible misdemeanours are allowed to go unresponded, crime will worsen, is, we think, very similar to bank bosses mindsets that without the visible pre-Covid norms, corporate culture will deteriorate. However, the world has changed. For the first time in its 35 year history Manhattan’s Le Bernardin is discarding its longstanding “jacket required” dress code for example. Culture over time, evolves. Indeed, some bank bosses relaxed their own dress codes well before the pandemic: flexibility in office attendance is just the next iteration of that evolution. Neither is anyone or any institution immune: Dan Labbad, chief executive of the Crown Estate opined that “the organisation that I inherited was very successful for 260 years. But I think there is recognition from everybody… what got us here is not going to get us to where we need to go.”

A more pertinent parallel is what this means for the office lending market. PGIM recently commented that for sectors that are poised for rebound or recovery after a correction – such as offices – debt strategies offer an interesting entry point. This is analogous to the comment from our note last week where a large PE sponsor said they would rather access the space via debt rather than equity. Pricing core debt can provide downside protection against further capital value falls, and higher up the risk spectrum, lending can offer opportunities to capture some of the benefits of value appreciation as office assets move through their recovery cycles. Short-term debt is especially interesting at the moment because it provides flexibility to capitalize on market improvements and also has the benefit of providing protection against higher interest rates. “With the flexibility in short-term debt, as maturity approaches, the proceeds can be used to redeploy at a more favourable point in the real estate cycle and potentially at higher lending rates.”

In the late 19th century, the inventions of the light bulb and elevator were transformational for offices. More employees could be squeezed into larger spaces for longer hours. In 1911, Frederick Winslow Taylor published “The Principles of Scientific Management,” which advocated a factory-style approach to the workplace with rows of desks lined up in an open-plan room. “Taylorism” inspired an entire discipline devoted to squeezing more productivity from employees. Again, this too is evolutionary history. The CEO of the British Council for Offices said the BCO would “almost certainly” be revising the recommended space per person upwards in the wake of the Covid pandemic: current BCO guidance recommends 86 sq ft to 108 sq ft for each workspace. “To get people back to the office, it has to be better than their homes.” What impact it has on the serviced offices sector – The Office Group portfolio’s occupancy is 65% today – is debatable, but we think long term its utility is the tail end of this evolution.

Cialdini’s experiment was based on the concept of “social norms”, i.e. you would be inclined to lower your energy bills if your neighbour was paying less than you. Investors are the same: just this week, three clients are under offer on significant London office acquisitions and all of them have accretive debt terms in place from a multiplicity of lenders at attractive pricing. Both investors and lenders expressed caution on City offices only a short whilst ago. Do as they do, not as they say.