Is this the belated 'office real estate apocalypse'?

On the evening of 23 March 2020, the way we thought about offices changed forever. White-collar businesses around the country were ordered to operate remotely – in many cases for the very first time – and they had a variety of experiences doing so. Some went back to the office almost immediately after the pandemic was over, observing that digital collaboration was no match for physical collaboration in their particular industry, some have had a slower and less absolute return to the office, and some have ditched the office altogether.

The complicated picture presents a continuing challenge for the world of office development. For decades, commercial landlords have made billions by building high-end office space in cities such as London and letting it to large multinational corporations on long leases. But the pandemic has called into question the basics of this model: existential questions over office space, specifically how much of it we need and of what it should comprise, are now paramount. The future of office development will define not just the fates of the publicly listed developers who depend on the model – such as British Land (BLND), Land Securities (LAND), Derwent London (DLN) and Helical (HLCL) – but the future of work.

No going back?

There is no question that demand has fallen since the pandemic began. In London, property agency Savills (SVS) calculates that as of June this year the percentage of offices which are not leased to anyone – known in the industry as the ‘vacancy rate’ – sits at 9.1 per cent for the City and 6.2 per cent for the West End, compared with 5.4 per cent and 4.2 per cent in February 2020. In a sign of how unprecedented this drop in demand was, Savills said in February 2020 that it expected the West End vacancy rate to fall to 4 per cent that year.

It is worth noting that, even though agencies such as Savills, CBRE (US:CBRE), JLL (US:JLL) and Knight Frank produce some of the most reliable data on the office market, it is in their interests as office dealmakers not to paint too negative a picture. This is why when fellow agency Lambert Smith Hampton (LSH) opted to press release some harsh truths about the office market last month it quipped that it was “breaking rank” by doing so. According to LSH, around three-quarters of businesses in the south-east of England are seeking to reduce their office space, with over a quarter seeking to reduce office space by 40 per cent or more. Based on this, LSH said that up to 26mn square feet (sq ft) of office space, equivalent to twice the entire office stock of Reading, could be “rendered surplus to demand over the next decade” in the south-east alone.

It is a bleak picture, and one coming from a company whose fortunes are tied to the office market recovering – which LSH does ultimately believe it will. But for now, with interest rates on the rise and the economic backdrop worsening, it is not hard to find similar predictions. For an even starker assessment from a neutral observer, look no further than a paper published last month by business professors at Columbia University and New York University. In a rather ominous document titled, ‘Work From Home and the Office Real Estate Apocalypse’ the academics predicted a $500bn (£423bn) “destruction” in the value of US office real estate.

Economist Stijn Van Nieuwerburgh, one of the authors of the paper, tells Investors’ Chronicle that although the paper is based on New York and the US office market, the exact same conditions apply to London and the UK office market. “I don’t want to pin myself down on a number for London because I would have to calibrate the model for the formula we used for London [...] but I have a hard time imagining it would be very different because for me the fundamental issues are all the same,” he says, describing the collapse in office values as a “train wreck in slow motion”.

The reason for the “slow motion” nature of this shift is to do with the length of office leases. Whereas residential tenants can up and leave a building with mere months' notice – or less in some jurisdictions – most commercial tenants do not have the same level of flexibility, needing to wait for a break or an expiry in the lease before exiting it. And because 73 per cent of office leases in New York and 66 percent in the US have not come up for renewal since the start of the pandemic, Van Nieuwerburgh’s paper says “rents may not have bottomed out yet”.

The picture looks similar in the UK where, according to data from Savills, the percentage of office space which had a lease expiry or break scheduled against it in 2020 or 2021 was just 6 per cent for London’s City and West End markets, 4.6 per cent for Manchester and 2.9 per cent for Birmingham. This suggests that in the UK, much like in the US, most office occupiers have yet to be given an opportunity to decide how much office space they need going forward.

Buy, sell or remould

This leaves office developers with some tough decisions to make. They can either sell their office assets to someone else willing to take on the risk, plough on developing new ones in the hope of demand, or redevelop them – either to make them better quality or to change them to another use such as residential. Voting for the first option, Derwent opted to sell a 104,000 sq ft vacant West End office building to an undisclosed buyer for £85mn earlier this month. Institutional buyers are opting to plough on, however: Axa Investment Managers' alternatives arm snapped up 50 Fenchurch Street in the City of London this month with plans to build a 650,000 sq ft office – adding another striking skyscraper to the City skyline.

Yet Axa IM is in the minority, with recent data revealing that the vast majority of developers in London are either opting to redevelop space they already own in order to make it more lettable or opting not to develop at all. According to the most recent Deloitte crane survey this year, the amount of office space on which developers started construction for the six months from October 2021 to March 2022 fell by a third – and a record 91 per cent of those construction starts were for refurbishing space rather than building new.

Refurbishment of office space as opposed to new development has several attractions. Most obviously, it is cheaper for commercial developers to work with the space they have rather than buying land and pushing a new building through the planning and construction process. Growing awareness of the climate crisis presents another issue for new development. According to the International Energy Agency, the buildings and construction sector accounted for 39 per cent of energy and process-related carbon dioxide emissions in 2018. Many of these emissions come from the energy needed to run a building – what are known as ‘operational’ emissions – but a lot comes from the emissions related to construction – what are known as ‘embodied’ emissions. For a top-of-the-range, central London office building, the UK Green Building Council calculates that these embodied emissions can account for 35 per cent of an office’s lifetime emissions.

Traditionally, councils granting planning permission have been largely focused on the operational emissions and energy efficiency of buildings, but they have begun to notice that in order to meet their own net-zero climate targets they also need to target property developers’ embodied emissions. This is exactly what happened in Westminster when Marks & Spencer’s plans to demolish its flagship shop and replace it with a shiny new office building were rejected by the council largely because of its concerns around embodied emissions.

Developers are aware of their need to factor the environment into office development too, in large part because of the demands of their investors, their tenants and their tenants’ employees. All three are demanding greener buildings which is, in turn, driving the so-called “flight to quality” theory, popular among office developers but also referenced in Van Nieuwerburgh’s paper. It theorises that while overall demand for office space has fallen – and may continue to fall – demand for high-quality, energy-efficient space remains the same if not higher. There is data to back this idea up: Savills calculates that 91 per cent of all newly leased space in the City of London for the year to June is ‘grade-A’ – ie the highest-quality space –  compared with a 67 per cent long-term average pre-pandemic. 

Government regulations for higher-quality, energy-efficient buildings is also coming for office developers. By 2025, all commercial buildings must have an Energy Performance Certificate (EPC) and the government is also proposing forcing all commercial buildings to have an EPC of B or higher by 2030 – a standard which only 11 per cent of commercial buildings in England and Wales with EPCs currently meet.

Yet, developers will not be able to bring tenants back with green, high-end offices alone; they also need to offer attractive lease terms. This means they can either choose to lower their rent or make the lease more flexible. Many are opting for the latter. Last year, Land Securities revealed it intended to quadruple the size of its flexible office brand’s footprint, Grosvenor Estates launched its own flexible workspace brand and British Land added another 48,000 sq ft to its flexible workspace offering.

Add all these factors together – the popularity of redevelopment rather than building new, growing awareness of the climate crisis, demand for quality and demand for flexibility – and what you end up with is an office development sector increasingly driven by plans to refurbish low-quality office stock, replace it with higher-quality stock and lease it out on more flexible terms than before. This is the strategy being espoused by the likes of Derwent, British Land, Land Securities and Helical, but not everyone is on the same page. Earlier this month, a shareholder revolt at Palace Capital (PCA) caused the company to u-turn on its strategy to use the proceeds from a warehouse portfolio sale to refurbish its existing offices to a higher standard and then re-let them alongside buying new office assets. In a complete about-face, the company said it would instead distribute the proceeds from the sale to shareholders, and three directors left the business with immediate effect “in light of the amended strategy”. Evidently, how developers should approach office development going forward is far from an open-and-shut case.

If office developers don’t want to develop new assets or refurbish existing low-quality stock, what other options do they have beyond selling? They can change the use of the building, but this too comes with problems. Since the government’s introduction of permitted development rights (PDR) in May 2013, developers have had the ability to convert office space into residential space without the need for planning permission. In one sense, the legislation was an overwhelming success in that many developers took up the opportunity to turn unwanted, low-quality office stock into housing, but uproar quickly followed when politicians and the public realised the types of homes being built under PDR were often far from satisfactory. Many councils have now banned PDR.

Residential is not the only change of use option available to office developers, though. The Ned, a lavish five-star hotel and private members club in the City, was previously low-quality office stock. Meanwhile, industrial developers such as Prologis (US:PLD) and Bridge Industrial have been buying office sites in London with plans to turn them into warehousing, although this will likely involve demolition and rebuilding which – as the Westminster case has proven – is no longer a popular move with local authorities concerned about emissions.

Thanks to the “slow motion” nature of the fall in office values and the expiration of leases, the future of office development post-Covid will be a conversation that developers, tenants and local government will still be having five or even 10 years from now. But whatever happens, office development will never be the same as it was.