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A closer look at the latest data from the commercial property market.
Office sector fragmenting in face of workplace revolution
There’s a wide range of opinions on the future of the office, with strident positions being taken by those who have the largest interest in one outcome or another. What scraps of anecdotal evidence are to be found are seized upon as proof by one camp or the other to bolster their position.
At one extreme, there are those who say that regular office attendance is over for ever, while at the other end of the spectrum some think that we will be back to our pre-Covid ways within a few short years. The reality is that it is too early to know how employers and employees across the breadth of the economy will react, and what shape the office market will eventually take. Nonetheless, despite all the uncertainty, there are a few known factors that will set the context for how the sector evolves.
There are three key factors supporting change. The first is technological. While videoconferencing has been widely available for many years, its adoption had been relatively slow before the pandemic. Now there can be few office-occupying businesses that haven’t used it to communicate with colleagues and/or customers. This widespread exposure lays the groundwork for businesses to make educated choices as to whether remote working suits them.
The second element is behavioural. Employers have seen that remote working can work and that productivity does not have to suffer.
The third is financial. Many businesses are enthusiastically eyeing the potential savings from working remotely and holding meetings virtually.
However, most employers and employees have also concluded that full-time remote working has many drawbacks, which have become increasingly apparent over time. These have been most pertinent in relation to onboarding new employees, developing existing staff, and driving new business. While it is easy enough to maintain the status quo, it is far more difficult to grow or evolve a business without meeting in person. Given these negative factors, most large employers seem to have alighted upon a ‘hybrid’ model. Yet there are very few details to date, and it is those details that will determine the impact on the office market.
Commercial property returns
- Investment research firm MSCI reports that commercial property values rose by an average of 1.5% in June, while growth of 2.6% in Q2 represents the strongest quarter since Q4 2014. This continues to be driven almost entirely by the industrial sector, while many retail and office segments are still recording month-on-month declines.
- Industrial values are up by 6.6% over the second quarter and 10.9% in the first half of the year. On average, values in the sector are now 15% above their pre-Covid high. Capital value growth has been consistently strong across all regions for both multi-let and distribution.
- In contrast, the office sector is experiencing significant divergence. Office parks in the South East have seen value growth of 3% in Q2, seemingly driven entirely by science parks around Oxford and Cambridge. At the other end of the spectrum, average office values in Scotland, Wales and the Midlands are down 2.6% in the quarter.
- The retail sector is also seeing a broad spread of returns, as a nascent recovery in retail warehouse values deposes supermarkets as the top performing retail format for the first time since 2017. Quarterly growth of 2.5% and 2.0% respectively contrasts with declines of 2.6% and 2.7% for shops and shopping centres.
Capital growth to end of June 2021 (%)
Source: MSCI UK Monthly Property Index
Investment market activity
- £6.5bn of investment deals transacted in June, making it by some distance the most active month of the year to date. Overseas investors were prominent, accounting for £3.9bn of the total, including the six largest deals to close in the month.
- The highest value transaction was the sale of Arlington by TPG for £714m. Brookfield acquired the management platform alongside the 1.6m square-foot portfolio of 36 business parks. The assets are predominantly located within the Oxford-Cambridge-London ‘golden triangle’ for scientific research and development.
- Brookfield also completed on 30 Fenchurch Street, EC4, for £635m, while Singaporean real estate investment trust Suntech REIT acquired 3 Minster Court, also in the City, for £353m. The respective initial yields of 4.4% and 4.5% reflect the strength of demand for prime central London offices despite ongoing uncertainty around the impact of changing working practices.
- The student sector has sprung back into life in recent months with acquisitions by APG, Greystar and Lone Star. In June, GIC invested £171m into its London Student Accommodation joint venture with Unite, to acquire assets in Wembley and Whitechapel at a purchase yield of 4%.
- The industrial sector continues to attract a wave of capital from all corners of the investor community, with £1.7bn in June taking the annual total to £7.4bn. Savills Investment Management, ICG-Longbow, Blackbrook Capital, Patrizia and Aberdeen Standard were among those closing deals in June, all reportedly transacting at sub-4% yields.
Investment by sector (£bn)
Source: Property Data
- The latest view from Knight Frank on benchmark yields suggests that investor confidence is spreading beyond the red-hot industrial segments, including to some parts of the market that were heavily impacted by the pandemic and resulting restrictions.
- The retail warehouse sector seems to be undergoing a dramatic turnaround in investor perceptions, with prime and secondary benchmarks hardening across formats for the second consecutive month. Somewhat remarkably, all benchmarks are now keener than they were at the start of last year, before the onset of Covid.
- The student sector has seen a number of notable deals in recent months, and, as a result, Knight Frank considers that prime yields for long Retail Prices Index (RPI) linked leases in London and the regions have hardened by 25 basis points (bp) to 3.25% and 3.5% respectively. They also suggest that prime yields for direct-let assets are likely to come in from pre-Covid levels.
- Prime yields for supermarkets with long RPI-linked leases hardened by 75bp during the pandemic, which had opened up a 100bp differential with similar assets on open-market reviews. This gap reduced by 25bp in June, with the benchmark for the latter now thought to be 4.25%.
- Allsop’s commercial auction in July raised £67m, similar to levels in May and June. Of just over 80 lots sold, 28 achieved a price in excess of £1m, delivering an unusually high average sale price of £1.6m. The highest price achieved was for a TSB in Edinburgh, sold for £3.6m at a yield of 7.5% despite having just five years remaining on the lease.
- Six retail units let to Boots were sold, reportedly achieving an average 20% premium against bids received via private treaty. One such asset in Southgate (north London), with eight years remaining on the lease, sold for £1.765m, representing a yield of just under 3%.
- The latest IPF Consensus Forecasts, published at the end of May, reflected increased confidence in the short-term outlook. Previous predictions of a 2.5% decline in capital values this year were replaced with expectations of marginal growth of 0.1%. Given that 3.5% has already been delivered in H1, this may well turn out to be too pessimistic.
- Contributors still expect rental values to decline this year, by 1.7%, but predict that a return to rental growth next year will drive healthy capital appreciation of 2.3%. Over a five-year horizon, the average forecast was for annualised rental growth of 0.8% and capital growth of 1.2%.
- The strongest consensus was for continued growth in industrial, with all 20 contributors predicting capital appreciation over a five-year horizon, with a mean forecast of 3.6% per annum. This is expected to be well supported by rental value growth, with a mean forecast of 2.7% per annum.
- There was a very wide range of predictions for the office sector, with annualised capital growth forecasts ranging from -3.4% to 7.7%, giving an average forecast of 1.3%. The West End of London is expected to marginally outperform with annual growth of 1.7%.
There is no doubt that the way most office workers interact with their workplace will be dramatically changed from the pre-pandemic world, with many spending fewer days in the office each week. This will in turn mean fewer passengers for train companies, fewer cars in station car parks and fewer customers for retailers in stations across the country.
It has a direct impact on the number of coffees bought on the way to work and the number of diners for weekday lunches.
However, the impact on office space requirements is not so linear, as office occupiers must provide space to accommodate peak occupancy, not average occupancy. The office may be a ghost town on Monday and Friday, but if it’s as busy as ever on Wednesday then there is limited scope to reduce space requirements. Businesses will try to get around this by prescribing which days individual workers or teams are in the office, but this will only help to significantly reduce peak occupancy if the majority of staff come in for less than three days a week.
Some reduction in office space requirements for large corporates is likely, perhaps by 10% to 20%, but the real story will be how this is delivered. Typically, most corporate occupiers will have an HQ building in a prime location in London or a major regional centre, with a supporting cast of older buildings in less prominent locations. Most occupiers will retain the former: these are seen as important for impressing clients and retaining staff, and could be used within a hybrid model for team-building and training days.
The real question is what happens to the latter. A ‘hub and spoke’ approach for corporates has been promoted by some commentators, but it’s not entirely clear what purpose this serves unless a physical presence is required in multiple locations. Smaller occupiers typically have more limited scope for reducing space per employee, and the shortfall in demand therefore seems likely to fall most heavily on larger-floor-plate assets in fringe locations. Such assets often have little obvious appeal beyond a cost advantage, and they cannot hope to compete on that basis alone with the couch or kitchen table.
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