A unique property company with a first-mover advantage

British Land (BLND) and Land Securities (LAND) own a lot of offices and they let some of them flexibly, but their exposure to this niche is diluted by the many other types of property they hold. Derwent London (DLN), Helical (HCL) and Great Portland Estates (GPE) only own offices: they let some on flexible terms, but by no means all of them. WeWork (US:WE) and IWG (IWG) only provide flexible offices, but they are not landlords.

That leaves Workspace entirely by itself. No other UK Reit is fully dedicated to taking the risks and reaping the rewards of owning and renting out offices on flexible terms. It has been doing this for over three decades, since it was formed out of properties cast off by the defunct Greater London Council, but now it finds itself in the right place at the right time. With companies across the Western world scratching their heads over how much office space they really need after the pandemic, Workspace offers a solution: short-term, low-commitment office leases.

This model runs into issues when times are tough. During the pandemic, Workspace’s rental income collapsed as white-collar workers were forced to work from home. Given the flexibility to cancel their leases, many companies did so. Similar problems could emerge if the UK drops into recession, which the chancellor has suggested might be necessary to tame inflation.

However, if the recession does not happen, or if it is shallow, there is a solid investment case for Workspace shares over the next few years. The model appeals to the idea of a hybrid working ‘new normal’ in which companies might only need an office for a short period. 

Working alone

Proof of demand for Workspace’s offering comes from its surging net rental income – rental revenue less the cost of running its buildings. It saw a bigger increase in net rent than any other Reit that posted full-year results last month. 

This has led to an increase in its property yield – its rental income as a percentage of the value of its assets. This is especially encouraging when gilt yields are creeping back towards the levels seen in September following the disastrous mini-Budget cooked up during Liz Truss’s brief tenure as prime minister. Back then, gilt yields were briefly higher than low-yielding property assets, further driving down property values. In this context, Workspace’s increasing rental yield can only be a good thing. 

In addition to generating a better net rental income, Workspace is also improving its profit margin: earnings before interest, tax, depreciation and amortisation in relation to sales have increased in each of the last two years, and are forecast to exceed pre-pandemic levels over the next 12 months.

Chief executive Graham Clemett tells Investors’ Chronicle that, “bar an Armageddon” recession-wise, he expects demand for its assets from small to medium-sized enterprises (SMEs) will continue, so investors can expect further growth in net rental income, property yield and margins. Clemett also points to the sheer number of SMEs in London as an indication of the depth of the market. 

He says that small businesses account for a fifth of the working population of London, or 1.3mn people. Workspace currently caters to just 4,000 businesses. Although it is the biggest player in terms of providing office space for SMEs, Workspace still only captures a fraction of this demand. The rest of the market, he says, is fragmented and therefore ripe for disruption.

You can see this confidence in Workspace’s increased dividend, which is 20 per cent higher than last year’s. The dividend is still smaller than pre-pandemic, but here too is the prospect of further growth. Consensus City forecasts from data provider FactSet anticipate that the dividend will grow to 29.1p per share by March 2025 thanks to an increase in earnings per share to 33.7p (see table).

Currently, the equity market is ignoring this potential upside. The shares are trading at a sizeable discount to net asset value (NAV) even after the valuation hit the company took, along with the rest of the Reit market, thanks to last year’s mini-Budget. 

We feel this discount is unjustified. First, commercial property values are showing tentative signs of recovery, suggesting that the worst of the devaluation pain has now passed. Second, despite the wider market downturn, Workspace’s NAV dropped a mere 1 per cent on an International Financial Reporting Standards basis from 31 March 2022 to 31 March 2023, suggesting it is unlikely its valuation will fall by the levels the market is pricing in. Part of the reason for the resilient NAV has been Workspace’s savvy asset trading and part of it is because tenants’ demand for assets in its niche has increased post-Covid, which has driven up rents.

Despite the positive NAV picture, not everything about Workspace’s balance sheet is great. The company has a much higher ratio of net debt to NAV than this time last year at 52 per cent. Clemett says he hopes to reduce this by selling properties from its May 2022 acquisition of McKay Securities and using the cash to pay down debt. However, this also means selling into a market where values are down.

Make offices ‘shiny again’

As for whether it will become a buyer in this market, Clemett makes no firm commitments either way – although he thinks there will be “even more value” in six months’ time. If and when it does look to buy, Workspace will have a lot of assets to choose from. Clemett describes its approach as buying neglected office buildings and then “making them shiny again” through refurbishment.

Thanks to the commercial property downturn, the post-Covid existential crisis for second-rate offices, and the introduction of tougher energy efficiency requirements to let buildings, such assets have plummeted in value. In a recent investment survey by agency Savills (SVS), second-tier offices ranked worst for both investment potential and value destruction over the next six months across all real-estate categories. And proposed legislation to increase the threshold for energy efficiency by 2027 and again by 2030 should give Workspace even more opportunities to buy stranded, devalued assets for a bargain and improve them. However, its high gearing does raise questions about its ability to maintain the capital spending needed to do so. 

What’s more, Workspace won’t be alone in pursuit of these sorts of assets. Latest numbers from accountancy company Deloitte reveal that office refurbishments in central London have hit record levels, indicating there are plenty of other players out there looking to turn bad offices into good ones. This can be seen as a positive too, of course. The wider real estate market is now realising that the model Workspace has been pursuing for decades can generate attractive returns. Its first-mover advantage counts for something here and, given the wide discount to NAV, we are optimistic.