The Moment of Lift
The history of mankind's attempts to fly is replete with individuals strapping on feathered wings and jumping off steep precipices. They were merely replicating what they believed allowed birds to soar: wings and feathers. They failed to understand it was ‘causal mechanism’ that enables certain creatures to fly - eventually identified by mathematician Daniel Bernoulli - called lift. Whilst there is definitely a marked upswing in sentiment since the start of the year, there is still residual malaise. Real estate brokers, not normally known for their innate pessimism, are still downbeat: only 52% of brokers considered the market outlook to be strong, which is a decrease from the 85% who felt the same way a year ago according to the UBS Evidence Lab survey of US Commercial Real Estate brokers. The dim outlook for the office sector in particular is reflected in the 42% decline in global investment last year, compared to a 28% drop in overall property investment. Offices have received a pretty bad rap and we argue that cause is not correlation, and the consensus sentiment is misguided.
Some anecdotes of the negative attitudes towards office investments are illustrated as follows: WP Carey remarked in React News: “We’re steering away from offices because we see very little confidence in that sector – and that’s a global message. It’s very hard to prescribe mission criticality to an office building because the cost of relocating from your office compared to a manufacturing plant is extremely cheap. It’s even harder to say offices are mission critical when everyone has been working from home for the past two years”. Krysto Nikolic, Global Head of Real Estate at ICG echoed these sentiments and pointed out that in recent years, the demand for office spaces was largely dominated by technology companies. In challenging economic conditions, particularly tech, the concern is where the replacement demand will come from.
There is already a consternation over how to fund more than $16bn in loans that are backed by New York City commercial real estate and set to mature in 2023 according to Trepp data. The volume of debt maturing this year is 30% higher than in 2022, due to the fact many loans were extended during the economic turmoil of the past three years. While there is an option to extend many of these loans again, the current economic climate may not be conducive. Added to the economic malaise is the need to reach net zero targets. Buildings account for 39% of global energy-related carbon emissions, according to the World Green Building Council. Roughly three-quarters of that comes from running them; the remainder from the construction process. According to a study by researchers from New York University and Columbia University, New York offices could face a loss of nearly 40% of their value between 2019 and 2029, amounting to $453 billion.
Likely as a result, Scott Rechler, CEO of property developer RXR, is reportedly planning to give some of his Manhattan office properties back to the lenders after a review of the company's properties showed some no longer making economic sense. Rechler has an envious history of good timing; selling his company before the 2008 financial crisis and later spending $4.5bn on discounted office properties, albeit Rechler also still sees opportunities and expects to make about $2bn in high-yield loans this year for office and multifamily projects that have run short of cash. Others are also seeing opportunities ahead.
Whilst PwC anticipate that economic headwinds will persist into 2023, their analysis also predicts that inflation has peaked, more than 300,000 workers will return to the labour market and that there will be an easing in political and market uncertainty. The results of their 26th Annual Survey also show that 63% of UK CEO's have no plans to postpone deals in the next year.
In the Knight Frank London Breakfast that took place this week, of the survey of 600 clients in the room, 34% chose offices as one of their top three investment targets - higher than the 33% that chose Logistics. Indeed, the former John Lewis department store in Birmingham will now be converted into office space by Hammerson rather than build-to-rent apartments. The 247,000 square feet store will be transformed into 200,000 square feet of workspace, to be known as "The Drum". Indeed, office investment transactions in Belgium, Ireland, Italy and Spain from July to September 2022 were above the five-year third-quarter average.
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New offices will also cater to new working practices to compete with some of the comforts of home. According to property consultancy Cushman and Wakefield, office spaces used to allocate 60% of their area to desks. However, recent changes brought on by the pandemic have caused a shift, with workstations now occupying only half of the space in new and refurbished offices, while the amount of space dedicated to amenities, such as such as meditation rooms, bike storage and showers, has increased from 5% to 20%.
Mahdi Mokrane, the Head of Investment Strategy and Research at Patrizia, also sees an opportunity, as the higher interest rates and higher capex requirements force many existing office holders to sell. The significant premiums commanded by office assets that are certified green (they see premiums of up to 25%) in markets such London, Paris and Berlin allows capex to be underwritten with more certainty and at appealing levels of return.
Savills are confident that there also remains a market for offices without all the ‘bells and whistles’, but even this stock is going to need to meet certain minimum sustainability levels. This will mean investors will have to navigate a fine line between easily lettable, good quality, non-prime stock and assets that are becoming unlettable and at risk of being obsolete. Exactly where the dividing line sits between the stock that can be refurbished, and that which cannot, is taxing researchers and investors. According to Savills, three-quarters of the UK office market, a third of Italian offices and a quarter of those in Ireland do not meet the minimum energy efficiency standards that are set to take effect by 2030.
The cost of upgrading a building to meet 2030 standards is estimated by Savills to be around ￡40 per square foot, in addition to normal refurbishment expenses. While landlords in expensive areas like the West End or City of London may be able to handle these costs, owners of buildings in smaller towns might not be able to afford them. Landsec estimates that upgrading its ￡11 billion portfolio to meet the EPC B grade will cost a net of ￡135 million, while the privately owned Crown Estate predicts costs could reach ￡1 billion. Even if the cost of transition is lower than expected, commercial landlords and investors will still need to find $1.65 trillion to finance the green transition.
The contrast in future performance between the must-have office and the must-nots might be stark. According to a report by MSCI, "2023 Trends to Watch in Real Assets", London office prices will need to decrease by 29% to align with buyer expectations and seller asking prices. Whilst the Deloitte London Offices Crane Survey from summer 2022 found optimism in the office sector, pointing towards an increasing supply shortage through to 2025. J.P. Morgan Research predicts an exceptional supply shortage in the London office market towards 2025, which they believe will result in increased rental growth. Tim Leckie, Head of J.P. Morgan's European Listed Property Team, says there is almost no space available in some parts of London and expects strong demand for prime office space to grow by 38% by 2030.
The Boeing 747 was the quintessential airplane that shrank the world and revolutionized travel. Its last ever plane rolled off the production line in Everett, Washington, on January 31st. The 747’s early appeal was partly down to its sheer size. Now, many travellers make shorter journeys than long-haul rather than the transatlantic trawls the 747 was designed for, meaning airlines need smaller, single-aisle planes. The 747 served the purpose in a zeitgeist of globalisation, mass travel and cheap oil. But as traveller predilections have changed, it is not unsurprising it is being replaced by the Boeing 787 (which is also 45% cheaper to run). The equivalence to the office sector vis a vis favoured and out of favour buildings should be obvious. The almost uniform negativity towards the sector is not.