By Tom Leahy on December 9th, 2021
The future of the office is, aside from climate change, the most important issue the property industry faces currently. In the U.K., office acquisitions have accounted for 37% of all direct real estate purchases since 2015, more than double the allocation to second-place industrial, and office properties are the bedrock of many institutional portfolios.
However, a large question mark hangs over the future of the sector. The work-from-home experiment will soon enter its third calendar year and data shows that many workers are still spending time at home. Google’s Community Mobility Report for Greater London shows that visits to workplaces were still 36% down on the pre-pandemic level at the end of November despite the government ending its work-from-home recommendation over the summer. (The government reversed the advice again in early December because of Covid variant concerns.)
U.K. office deal volume in the first nine months of 2021 was 36% lower than the pre-pandemic five-year average. In Central London, transactions fell to an 11-year low in the first quarter of 2021, as shown in the chart on the left. However, at the same time that volume has cratered in Central London, the average transaction price per square foot has increased to a record level. This indicates that demand is focused on the best quality assets and cheaper buildings are not trading at the same volumes as they were pre-pandemic.
The fact that demand is strongest for assets that are desirable to tenants and meet ever stricter environmental standards begs the question: what about the rest of the market? There is the risk that assets which no longer meet these criteria and are not attractive to tenants become stranded, with insufficient demand from occupiers to justify the expense of refurbishing and repositioning them. In effect, the building becomes functionally and technically obsolete.
One has to look no further than shopping centers for an example of this dynamic in a sector already affected by functional obsolescence. Large parts of the U.K. market have never recovered from the structural shift away from retail in response to a decline in occupier market conditions brought about by changing consumer patterns and the rise of the online retailer. In many cases, the income stream from such buildings has collapsed and they become as much a liability as an asset for their owners.
There are plenty of instances of U.K. shopping centers changing hands for a fraction of prior sale prices. In 2006, the 170,000 sqft Paisley Shopping Centre near Glasgow was refinanced at an appraised value of £66.4 million ($87.7 million); it sold in November 2020 for £2.3 million. In 2007, a 40% share in the West Orchards Shopping Centre in Coventry sold at a price valuing the whole asset at £170 million; in February, the asset sold for £4.9 million. While these examples might be outliers, Real Capital Analytics data does show average prices for shopping centers in the U.K. regions are down 70% on their 2006 peak.
The question for office owners is: could the same thing happen to those buildings most at risk from obsolescence because of changing workforce patterns and the push for net zero investment portfolios?
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