Investors rush to convert office space as homeworking re-shapes the marketplace

According to the Financial Times (FT), property investors have pumped around £2bn into converting under-used and unwanted London office space as the trend to Working from Home (WfH) continues, and as it looks like becoming an embedded employment practice in many inner city offices.

Property agents CBRE say that around £1.3bn of London office space has been bought up at bargain basement prices over the last 12 to 18 months, with plans to convert the vacant space to alternative uses. Other deals now in progress amount to a further £700mn, say the agents.

Ed Bradley, head of London office investment for CBRE told the FT that around 10 per cent of all new investments in the sector now represent a significant proportion of all new investment generated, as companies adapt their businesses to new patterns of hybrid working.

Mr Bradley said the trend is on an unprecedented scale for these conversions of mainly secondary office space, to be converted for new uses outside the traditional city office market.

Market slowdown

The UK commercial property market has slowed considerably since last year as higher interest rates have begun to bite. Tightening monetary policy was a significantly factor over the second half of last year, resulting in a decline in buyer activity, with sizeable adjustments downward in valuations.

According to CBRE, the figures for all commercial property values dropped by around 20 per cent year to date as a result of many institutional investors changing their asset allocations, with the sharp rise in government bond yields.

With major structural change, such as WfH and online retail affecting office and retail commercial property, a trend accelerated through Covid, better returns on other financial assets are leading traditional investors to see commercial property in a different light, value wise.

Positive industrial and logistics

Contrary to office and retail, the industrial and logistics sector has seen an outstanding almost 60 per cent rise in values, but now it appears the sector has become overheated given the tougher environment where money has become much more expensive.

Otherwise, all the main UK commercial property sectors – particularly secondary – have experienced substantial declines in value since late last year following what looked like a fairly positive turnaround and correction immediately after the abatement of Covid.

Slower decline

Although values have continued to fall in 2023, there are signs that the rate of decline is slowing. Experts in the industry feel that the speed and depth of the price correction experienced in the latter half of 2022 could now have worked its way through the system. The conclusion is that there are definite signs of new interest by investors.

This has been particularly the case as said with the trend for re-purposing from office and some retail space to student accommodation, hotels, laboratories and leisure. CBRE’s Ed Bradley told the FT that:

“We have seen several examples of alternative use investors outbidding traditional office investors by 10 to 20 per cent.”

Examples cited are the conversion of the former Ted Baker headquarters near St Pancras station into lab space, given its convenient location near hospitals and universities. This development is being financed by the Singaporean sovereign wealth fund. The Millbank located Nobel House is being converted to hotels and serviced flats which will be conveniently located near the Houses of Parliament.

Demand for high-end office space

Demand for high-end office space has held up well but less desirable properties and locations means that leases are not being renewed for that use. This trend however coincides with increasing demand for research facilities, and international student and tourist accommodation following the worst excesses of the pandemic.

Not all office buildings however will lend themselves to be easily converted due to their physical construction, planning restrictions and the investment that would be needed to make a viable alternative use. Here values will suffer most.

The forecasts

Overall, average capital values for commercial property are forecast to end 2023 below where they started the year. Given the outlook for more interest rate rises until inflation is brought under control, back down towards the Bank of England’s sustainable 2 per cent target, nothing much will change – property values are set to remain under pressure.

Outside of the office and retail sectors, rental growth expectations are positive for industrial and logistics according to the latest RICS UK Commercial Property Market Survey. Both prime and secondary industrial space, according to the survey, are edging higher, which indicates that the recent downturn in industrial values is due to higher interest rates and not a shift in occupier demand or requirements.

No let-up for inflation

There’s no letup yet in the inflation outlook with the Office for Budget Responsibility predicting it will remain above 6 per cent for the rest of this year, though stronger than expected data coming from the Purchasing Manager Index is signalling an up-tick in industrial activity, after the major contraction during Covid.

While employment levels remains rock solid across the UK, which is helping sustain tenant demand for commercial property, regardless of the state of investor demand, there are signs this could change. Interest rate hikes have a delayed reaction as mortgage holders and borrowers are often on legacy fixed rates until renewal dates arrive. There are serious and credible concerns that there could yet be a further downturn in the economy, though a full blown recession is thought unlikely.

Property agents unaffected – flight to quality

Meanwhile among all these commercial property difficulties, there’s a failure to dent the prospects for the major property agents. Market movement, sales and conversions, it all seems like “grist to the mill” for the likes of Knight Frank, a company that hit record revenues in 2022. The agent whose stock in trade is the sale and leasing of commercial properties, as well as residential accommodation, internationally, says it is benefiting from a “flight to quality”.

What is meant by that is businesses are opting for “greener” and more modern buildings in an attempt both to reduce their carbon footprint and to adapt their space requirements their for staff in a post-pandemic era.

Chairman of Knight Frank, William Bearmore-Gray, has said about last year:

“…for our London leasing agents it was probably one of their busiest years. The majority of the interest we are seeing is from companies which realise very clearly now that the office is a strategic tool to attract the best talent and increase productivity.”

A similar story emanates from agents Cushman and Wakefield who report a record number of office moves in 2022. This reflects the move to hybrid working (WfH), with most companies wanting less space in modern and better located buildings.

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