Knowing where to look – investment opportunities in London’s post-Covid-19 offices
By Jonathan Gilbert, Investment Partner at Hartnell Taylor Cook – For decades, London property has been an attractive prospect for both domestic and overseas investors. Whilst the oversea investment in residential property has always been well established in London, in the last 15 to 20 years, there has been a shift to also incorporate commercial assets.
This is owing to the regulation, maturity and transparency of the commercial real estate market – as well as tools like full repair and insurance leases, which place the responsibility of maintaining a building on the tenant.
However, throw a global pandemic into the mix and – like many markets across the globe – the future of London’s offices in particular has been questioned. With the Government’s campaign to return workers to workplaces hampered by a 'second-wave' of coronavirus infections , have offices retained their appeal and quality for both tenant and investor?
Where were we before Covid-19?
Put simply, prior to the pandemic, offices in general were a sound and profitable investment. But the assets that were really in demand were those that catered to all the needs of an increasingly discerning and sophisticated tenant. While a simple refurbished space might have satisfied occupiers in 1990s, this certainly is not the case in 2020. In recent years, workers were becoming increasingly aware of, and less likely to compromise on, their workspace needs, with greater demand for on-site amenities, good transport connections and facilities that support their wellbeing. It was these kinds of existing grade-A spaces, as well as the spaces that had grade A potential, which were the prime investment opportunities.
Where do we go now?
Since the Government asked the country to work from home in March, some commentators have questioned whether offices will retain their value, as many businesses have earned their home working stripes and proved they can operate remotely.
However, take a look at the core data and it is clear that investor activity remains. Despite a dip in Q2 of this year, London topped the list of global cities
for cross-border investment in the office market, with a total volume of GBP3.3 billion invested in the city’s offices in H1.
Translating this into conversations within the market, it seems that the sentiment matches the statistics. We have heard talk that some offices are either currently at, or are approaching, full capacity, with existing tenants often keen to expand into additional space in prime locations. This relates to a handful of largely branded offices in well-established business locations across London, such as King’s Cross and Farringdon, which are close to national and international transport hubs and equipped with an array of amenities like break out areas and gyms. Clearly, assets that encompass every need of the modern-day professional still remain hot property.
However, one cannot ignore the country’s new-found home working habits. Naturally, some businesses have been prompted to reassess their space requirements, resulting in some exiting their leases (although often temporarily) and others seeking smaller spaces to accommodate a workforce that operates remotely for part of the week. There is also the separate issue facing tower buildings across London, where landlords need to find a way of accommodating for both social distancing and accessibility. These shifts are causing some stock to re-enter the market, which will lead to a material reduction in rental values (especially for grade B assets).
The result? A market of two halves: a wave of second hand and below-par stock, which we expect to hit the market in Q4, vs other top-quality assets. We believe the demand for best in class space we saw pre-pandemic will still increase and accelerate the polarisation of the market going forward.
For investors turning to the office market for potential yields during this economic uncertainty, there are indeed opportunities. However, set against this mixed backdrop, the key is knowing where to look.
Although investment activity dipped after the UK lockdown began in March, deals are now re-emerging and there should be an increase in market activity in Q4. This is partly because vendors typically launch property into the market in September, but also because there has not been a substantial reduction in investor appetite despite the cancellation of sales during the lockdown. We know that capitalised investors are likely to be seeking opportunities post-lockdown.
However, with tenants negotiating reduced rents against the current financial background, investors should anticipate reduced returns in Q4 and into 2021. Alongside downward pressure on rent, there is upward pressure from tenant incentivisation, so they should also anticipate some margin on their yield. With lengthy refocus and on prime assets and demand for new kinds of spaces that can accommodate social distancing measures, most assets still present yields.
In the longer term, investors would also be wise to keep an eye on a couple of key trends. Firstly, there are opportunities to deploy cash outside of urban hubs in business parks. Whilst suburban offices have seen a decline over the last decade, after they were very popular in the late 20th century, they have recently witnessed renewed interest as employees seek to commute by car and may soon find themselves back in the mainstream.
Secondly, with businesses acknowledging that some employees prefer a combination of home and office working, investors should also monitor levels of demand for smaller spaces. There has also been a seismic shift in the relationship between tenants and landlords, with tenants now demanding more flexible leases with shorter terms, as well as a downward trend of tenants pushing for Covid-19 rent cessor clauses. A compact but five-star office could be the key asset in the years ahead, but this trend may take several years to materialise into an increase in potential yields.
UK vs the rest
In August, a report released by Morgan Stanley showed that British office workers were returning to their desks much slower than their EU counterparts – namely, Germany, Italy, France and Spain. It has since sparked debate over whether other EU metropolitan centres are striking a better balance between city regeneration and public health, and whether EU markets might present better opportunities than the UK.
However, it is crucial to remember that the UK Government’s Covid-19 response plan has affected these statistics. The Coronavirus Job Retention Scheme (CJRS) has been extended until the end of October and, upon its departure, we may see more employees head back to workplaces. Also, statistics released this week from Smart Buildings Data found that UK office occupation has increased by 120% since the start of September. Although the UK Government’s return to work campaign began in late July, it is only now kicking into gear.
While activity and demand in other UK markets have dipped significantly, London’s offices we believe will remain desirable. There are still a great number of buyers out there and deals over high quality assets (which are fully let for 5-6 years or more) have continued throughout lockdown. For those with cash to invest, all signposts point in the direction of opportunities for the investor within offices – if they know which assets are worth their time.
All this said, the current climate is unpredictable and this inevitably means that there is a higher level of risk involved in investment. For example, anyone willing to buy vacant property is likely to get a better deal at the moment, but there is little short-term gain. The fortunate thing is that as property goes through cycles the conditions facing the market today will not ultimately decide value. Only time will tell where demand is going, and it will not be a couple years down the line until we have a far greater measure of the post-Covid landscape.