Hear “stranded assets” and you think of oil and gas reserves left in the ground as the world shifts towards renewable energy.
But the phrase is also being used more recently to refer to lower-octane assets that could fall in value thanks to societal changes: the office parks and sub-prime workplaces of the UK.
This isn’t just about Covid-19. True, the stampede of office workers back to the water coolers and meeting rooms of the nation has been looking a little half-hearted. Average UK office occupancy had levelled out at about 20 per cent since the post-summer recovery, according to Remit Consulting, even before the Omicron variant interfered with plans to cajole more staff in.
The bigger question is how changes in work patterns might interact with looming environmental regulations that require commercial property to meet increasingly high standards to remain legally lettable. Buildings must have an energy performance certificate of “C” or above by 2027, and at least “B” by 2030.
Property agency Savills reckons almost 90 per cent of offices in major UK markets fall below the B level, equating to 1bn sq ft that needs upgrading at considerable cost (or somewhere between the size of Guernsey and Jersey).
The fact that many office occupiers had come through the pandemic well, and were tied into leases, was masking what could be ahead, said Zachary Gauge, at UBS. “The market is looking at the cash flows and not at the heightened risk that space will become vacant and that the costs of replacing tenants will be much higher. Valuations for non-prime real estate aren’t accurately pricing all this in, in my opinion.”
This is partly because the effect on the prime slice of the market that everyone pays most attention to — perhaps 10-15 per cent of the total — is reasonably clear, at least in the near term.
Supply of “net zero” buildings is struggling to keep up with demand, as occupiers trumpet sustainable credentials ahead of changes to the rules. Only 44 per cent of London developments due to be completed over the next three years are aiming for the top BREEAM ratings, one of the commercial sustainability standards used in the market.
That is starting to mean a rental premium on greener buildings, which Knight Frank puts at 3 to 13 per cent in central London. This then helps justify the costs of retrofitting older stock. The investment money chasing prime London real estate shows no signs of diminishing. And there are developers, like Derwent London, that are already well advanced with greening up their portfolio and have the balance sheet to buy where opportunities arise.
That won’t be the case in secondary markets, or out-of-favour locations such as office parks.
“There will be owners in lower rent markets who lack the expertise to redevelop buildings, or who question whether it is worth the investment,” said Mat Oakley at Savills. Some may hold and hope, in effect mothballing space. There are already concerns about what that might mean in terms of affordable office space for occupiers who don’t need or want the latest, shiny digs.
A cycle of obsolescence and regeneration is part of the business of real estate development. But the pandemic, coupled with tightening sustainability rules, has the scope to shorten significantly the useful life of relatively new buildings. And the enduring appeal of remote working has given occupiers at both the top and bottom of the quality spectrum a wider range of options.
Taking fewer square feet in a more expensive building is easier when most staff want to be there only half the time. Other occupiers could dispense with the office altogether if the type of cut-price space offered in old or unfashionable blocks simply ceases to be available. Empty or unsuitable offices can’t often easily be rejigged into homes or other useful space. In any case there are plenty of empty shops awaiting a similar transformation, in another real estate blight that doesn’t fall evenly between the UK’s cities and towns.
Healthy interest in top-notch prime offices from occupiers and investors could be taken as a sign that the market remains in fine fettle despite Covid-19. In reality, it is driven by the same forces that could leave other sections of the UK market stranded.
helen.thomas@ft.com
@helentbiz
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