The office sector remains the largest of the three traditional commercial property investment sectors, outshining industrial and retail – and is currently valued at around £208 billion in the UK, according to David Hourihan, programme leader Real Estate Master at the University College of Real Estate Management.
Presenting the latest Bayfield Training webinar on An Introduction to Office Investments, Hourihan explained the different types of office properties and their characteristics, as well as outlining the current state of the market and the impact that the current political uncertainty and Brexit is having on investment.
4 types of office investment
Hourihan explained that there is a broad spectrum of investment types within the office market. These range from “the trophy type to the diamond in the rough – a property that would need a lot of asset management to release value from it,” he explained.
Prime properties are defined as core or core plus, while a secondary type of investment in terms of quality is viewed as value-added or opportunistic.
Prime, or core, office investments appeal to longer-term domestic and international strategic investors, including both institutional and high net worth individuals. Such investors seek a secure return largely generated from an ongoing property cash flow, such as properties with long term net leases and tenants with excellent credit ratings. These properties are viewed as landmark or trophy office buildings and are situated in major urban markets.
Although overall returns (the internal rate of return) in the core category can be below 10% in the current market, Hourihan said that investors view the returns as offering an attractive premium in comparison to other types of investments such as stocks and bonds.
2) Core Plus
A core plus investment offers a slightly higher rate of return at around 9-12%, reflective of increased risk due to factors such as shorter leases, higher vacancy levels, poor tenant covenant strength, a slightly off pitch location and the age of the building.
A secondary or value-added office investment may be located in recovering primary, secondary or even tertiary markets, have a poor tenant mix or high vacancy rates and the passing rents may be below market levels. “These types of office investments may only appeal to the brave-hearted office investor who is happy with the higher risk inherent in these investments,” said Hourihan.
Finally, the opportunistic investment is one that requires a restructure of the investment to reposition the property or brand through refurbishment or extension. Typically the value here is backend loaded and achieved on the sale or refinance of an asset. Such investors tend to be well-capitalised and have a high risk tolerance, Hourihan explained.
Understanding ever-changing needs
The key concept in property investment and asset management is the idea of protecting and improving assets through proactive management. Failing to do so means that: “obsolescence will inevitably creep in and essentially undermine the value of our investment,” said Hourihan.
As part of this he said it was important to recognise changing trends in the office market and their impact on evolution of modern office design to ensure that asset relevance is maintained. He highlighted large floorspaces that allowed flexibility in the 80s to atriums in the 90s, coworking and hotdesking in 2000s and the increasing importance of energy efficiency more recently.
5 ways to futureproof office investments
“The rapid rate of change in our work environment continues and if we are to avoid obsolescence then we need to look at ways we can future-proof our office investments,” he said. He outlined five suggestions from RICS for futureproofing properties:
- Plan for technological advances
- Improve wellbeing to boost productivity
- Go green to improve buildings and people
- Keep office design simple
- Consider the whole lifecycle from the start
Standard terms of an office lease
When assessing investment returns from an office investment Hourihan said it was critical to understand how cashflow is being generated from the asset, which means in turn understanding how the tenant lease (or leases in a multi-tenanted investment) are structured. “This is a really important consideration.”
5 key clauses of a modern commercial lease:
- Tenants payments to the landlord
- Market rent
- The rent review process
- Landlord’s responsibility for insurance and reinstatement
- Tenant’s responsibility for the state and condition of the property
Size and structure of the UK office market
Hourihan outlined the main urban areas for office investment, with London dominating.
- London and its sub-markets (the largest with low vacancy rates, limited new build and strong levels of demand)
Current state of the market
Uncertainty as a result of Brexit and its impact means a subdued office investment market, with many domestic and international investors adopting a holding position until the uncertainty clears.
While that means many will be hesitant to invest for braver investors there will be bargains to be had, according to Hourihan. “This situation will inevitably present opportunities for opportunistic investors seeking to pick up discounted deals as more conservative investors withdraw from the market in order to reduce their levels of exposure during this time of uncertainty.”
Although central London has seen activity levels drop Hourihan said the regional UK markets have seen a larger decrease in occupancy levels with key cities including Bristol, Edinburgh and Glasgow reporting falling demand.
The current state of the market means UK office yields are likely to soften and move out, lowering capital values and leading to a weakening in property values over the next three years.
After Brexit greater clarity should stimulate investment demand, said Hourihan but in the meantime it’s the safest investments that will be most successful, he said. “Defensively structured portfolios holding core/core plus properties with limited exposure to retail will perform best over this uncertain time.”