“A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty.”

Markets are watching Commercial Real Estate, nervous the sector may implode and create a repeat of the 2008 repeat financial crisis. Smarter investors see weak property markets as opportunity – and are looking for the right assets. Prime office space is worth a look.

Time for one my irregular looks at sectors of the Alternative Asset Markets.

Sentiment is mixed across the multi-sector commercial real estate (“CRE”) markets.

• Many CRE watchers are profoundly bearish – they see imminent recession, the demand for retail and especially office space remaining static or declining, leading to a rising tide of distressed assets as WFH trends become entrenched, and interest rates remain high.
• Some players are bullish – thinking the rumours of massive US banking exposures to busted property deals will be absorbed by capital reserves even as the market stabilises as working-from-home (“WFH”) trends reverse, and interest rates fall. Some see it as a buying opportunity!

If only we had a crystal ball. (And if you don’t, then my guesses in the Morning Porridge are nearly… (ahem)… as useful).

Office space is fascinating part of CRE. Any business wants happy, comfortable, contented staff – making them easier to retain, while modern, state of the art, ESG compliant, sustainable offices are most likely to impress the clients.

At the top end of the property market there is clearly demand for prime office space with top energy efficiency, sustainability and environmental credentials. However, my property chums say anything below prime is a disaster zone – forget repurposing old office blocks into flats; it’s cheaper, easier and quicker to simply knock them down and rebuild something new.

Two recent articles in the UK financial press illustrate perceptions of the sector:

The Front Page of the FT carried Large London office buildings proving almost impossible to sell. Front page? Must be serious! It cites how the normally busy market for London office buildings has stalled. Almost nothing over £100mm has shifted this year… when deals over £1bln were once common. Higher interest rates and hybrid working have changed the market dynamics. The market has become completely illiquid in large scale offices, the guess is about 64% of the London market has fallen in value. As property developers sell current deals to finance the next, any break in sales of existing property quickly slows the market – which hints at the market finding a new equilibrium point at lower prices.

The London financial property market – the City and Canary Wharf in particular – are highly concentrated on the financial markets, leading to considerable vulnerability post WFH and Brexit sending jobs overseas. Canary Wharf – as I’ve written before – is about 17% empty!

The Property Chronicle – a magazine I always read cover to cover, and which occasionally prints my articles – carries “Offices haven’t hit bottom, yet”, in the current edition. It says office space is a “slow moving trainwreck that everyone saw coming.” In the US, distressed accounts for over 50% of total office sales. Firms are cutting back on office space cutting demand as rising interest rates, wages and sticky inflation cut into costs – concluding “the demand for office space does not appear to have hit a bottom yet.”

However, the Chronicle article picks a sweet spot. In the US, the problem is older vintage buildings – newer buildings that meet the highest standards are in demand due to a “flight to quality” and evidence of an RTO (“return to office”) bump.

It’s also clear the pandemic has seriously changed the way people work – many senior staff took the pandemic and the subsequent shift in hybrid working and working from home as an opportunity to exit the cities and move to bigger homes in the suburbs or country. When they come into the office it’s no longer a bus or tube, but a commuter-train or drive. They want offices with parking and close links to major stations. Property Chronical references US stats showing workers hired since 2020 in the US live 2x further from their offices than previous cohorts. That ex-urban shift is significant.

When it comes to the UK, few would deny the quality of life outside London is better, cheaper and potentially more fulfilling. The jobs may not be on the front lines of financial-services, and pay less, but that’s a calculation that doesn’t affect most office workers. We’re seeing a significant shift away from businesses centralising in London towards regional presence in non-London hubs like Manchester, Edinburgh, Yorkshire, the Midlands, Southampton, Bristol and Cardiff. Firms looking for prime office space outside London are finding what’s on offer is limited.

The bottom line is firms still need office space, and as it’s now a buyers market, they may as well pick the best new builds or top quality refurbishments that meet their needs.

The time to buy any market is when others are fearful.

• If you believe the economy is doomed and/or no one will ever need office space again, then office space is not for you. Give me a shout about gold and bunkers.
• If you believe the economy will continue to evolve, and firms are going to keep growing and thus require new office space, then buying when the market is cheap makes sense.

There are additionals to consider:

• Will AI significantly reduce the need for office space, creating a second wave of disruption after WFT? Personally, I consider that unlikely – the AI everything boom is “interesting”, but not proven. People are beginning to ask the question – show me a single example where AI has actually replaced human beings effectively and cheaper? (More on this in a future Morning Porridge.)
• Won’t existing office space become increasingly valuable in a carbon-conscious society – where the carbon-load of new construction will be far greater than refurbishment of older buildings?
• Does the increasing functionality of conferencing mean there is less need for centralised offices in large cities, and a move towards more campus style centres elsewhere? (Offices need to be where the people to staff them want to live?) Or vice versa?

If you want to learn more about the potential of office space, drop me a line. I’m working on an office deal in one of the top regional UK cities that is currently short prime office space. New builds are planned, but are struggling to find finance because of the fear of the usual financiers. There is some supply in the market, but its small and older. If new prime property becomes available in the next few years – as this project will – it will be snapped up by large users.

I have a refurbishment of a prime 200,000 sq ft water-side site which will be available long before anything new comes on line. It will be refitted to create modern ESG compliant office space with EPC A (top Energy Performance Certificate) and BREEAM (certification of sustainable build – knocking down and building new offices is far more carbon-costly than refitting old ones.) The site was acquired at a distressed price and the returns are spectacular…. More to the point, you can walk to a mainline station direct to London and it’s got plenty of car parking space..

The property sector is challenging, but that doesn’t mean it’s not without opportunity.

Out of time and back to the day job…

This article was originally published on Morning Porridge and is republished here with permission.