If the market is not bracing for the death of the office, it is certainly anticipating severe injury to occupancy levels. Unlike many other corners of the real estate market, shares in major office landlords and development groups have barely recovered any ground lost since March’s crash, and in some cases have sunk even lower.
Whether the deep discounts attached to shares in the sector versus net asset value qualifies them as bargain buying opportunities or value traps, depends on the extent to which demand from employers is maintained after millions of workers shifted to working from home post-pandemic. If there is a sustained weakening in demand, rents should fall and the valuations attached to offices would follow suit.
The number of workers returning to the office has increased by 120 per cent since the start of September, according to data from building management platform Metrikus, and occupation has risen from 15 per cent of pre-lockdown levels at the end of August to 33 per cent at the beginning of the second week of September. That has coincided with the return of children to schools in England and Wales, which has freed-up parents during working hours.
Yet the imposition of fresh lockdown measures in the event of a second wave of the virus could cut short that return of workers to the office in the coming months. Equally, the next year could see employees revert back to pre-pandemic habits of commuting five days-a-week into the office, particularly if a vaccine is found. What seems the more likely approach is that signalled by companies including PwC and Schroders (SDR) - increasingly flexible working.
Since May, companies have been reluctant to make any major decisions over their office footprint and have instead been renewing when the lease demands, which will likely continue for the remainder over this year, says Knight Frank head of global occupier research, Lee Elliott. “You’ll then start to see occupiers begin to think more about transformative real estate moves over the next three to five years,” he says.
It is likely rents will come off slightly, argues Numis analyst Robert Duncan, partly because some landlords in the market will be forced to take lower offers in securing tenants, to comply with the terms of their finance agreements. “But then you get that platform for growth,” he says.
Yet despite an anticipated increase in flexible working, the practical difficulties of gauging exactly how many employees will need to come into the office on any one day will likely mean employers will need to account for more workers than anticipated, says Mr Duncan. “By human nature, the average will never be sustained,” he says.
What may also limit the extent to which employers can scale back the size of the premises they lease is the desire to have more space per employee. That is not just due to coronavirus-security concerns, but also to aid talent retention. “The experience of many employers over the past 10 years is that they unwittingly created really poor working environments and have seen people vote with their feet,” says Mr Elliott.
The supply/demand balance is also more in favour of landlords than in the aftermath of the 2008 financial crisis. That is partly due to the higher level of capital banks need to hold against certain types of commercial property loans, which has limited speculative office developments.
That is particularly the case for prime office space, where the reduction in supply has been most acute. The pandemic will increase demand for quality, Grade A space, in contrast to secondary property, Mr Elliott predicts. “We are going to end up with market conditions where we have a polarity,” he says.
That is also why landlords with a greater proportion of secondary assets than some peers, such as Great Portland Estates (GPOR), are at higher risk of suffering a fall in the net asset value of its portfolio compared with those with more limited exposure such as Helical (HLCL), argues Mr Duncan. “The problem is in the current market any asset that needs capex, that has re-leasing risk, is going to be marked down by the valuers,” he says.
However, the shortage in supply has not just been limited to Central London. There is a total available office supply of 11.3m sq/ft in the UK regions, reflecting a 17 per cent decrease since the end of 2019, according to data from Savills (SVS). What’s more, just over 3m sq/ft of that is Grade A, which when compared to average annual take-up levels, reflects only enough supply to meet the demand for 11 months of take-up, and less than six months in Birmingham, Bristol, Glasgow and Leeds.
“I think a lot of this is driven by the people that they want to employ,” says Knight Frank head of national offices, Emma Goodford. Major cities are not only where many of the UK’s leading universities are located, but are also more likely to appeal to younger people, who are more likely to want to work in “dynamic city centre” locations, she adds.
Palace Capital (PCA) chief executive Neil Sinclair, says in recent weeks it has received three new enquiries for space at its flagship development in York. “One potential tenant interested in the whole has lease expiries in 2021 on three locations and as they want to move to one they have to get on with it,” says Mr Sinclair.
