Supply Chain Crisis Poses A New Threat To The Future Of Office Real Estate

Fortunes for the best office real estate and the rest are quickly diverging. Once upon a time, that would have offered a tried-and-tested play for investors: Buy tired assets, bring them up to scratch and sell them on again. But today, it’s not so simple. The supply chain crisis coupled with the climate emergency are having an impact on the process of making offices fit for the future. 

“Prime will still do well, but everything else will suffer,” Hines Senior Managing Director and Head of UK Ross Blair told attendees at Bisnow’s London State of the Market event, held at the Oval cricket ground in Vauxhall. “Build costs are really hard to control right now. If you want to refurbish or build better offices, that makes it very difficult.”

A combination of factors, including labour shortages and a post-Covid surge in demand, has caused construction costs to spike across the globe. In August, UK building materials were 23% higher than one year earlier, data from the UK government Department for Business, Energy and Industrial Strategy showed. 

That is holding back those investors and developers who believe the office has a rosy future.

“When I go into my investment committee, I’m not being challenged on where prime rents are going to go. But I am being challenged on how I will control costs,” Blair said.

“It is very difficult for any developer to stick to a cost budget today and it will get harder: The global inflationary environment will make it hard to predict where costs will go,” Blackstone Head of European Acquisitions Samir Amichi said. 

That creates a benefit as well as a problem, Amichi pointed out. While it makes it hard to refurbish and improve assets to drive up rents, it also limits the amount of new and improved space coming to the market in a city like London, which will keep vacancy low and help underpin rents. 

The thesis repeated by panellists throughout the day was that occupiers will still be willing to pay high rents for the very best office space —  the buildings that will attract workers and offer a better environment than working from home. But if you have old, bland or generic office space, especially in a mediocre location, you’re in trouble.

“The London office market is fascinating,” Patrizia Managing Director of Transactions for the UK and Ireland Phil Irons said. “There is a greater level of risk out there, but prime yields have come in by 25 basis points recently. The BPF published some research recently that said office occupancy at the start of October was 20%. To me, that doesn’t tally with prime yields coming in by 25 basis points.”

He added that prime office yields are currently about 4% and secondary yields about 5.5%, a narrow spread considering the elevated risk for poorer assets. Either prime yields are too high or secondary yields are too low. If secondary yields do rise, it could happen fast, he said.

Perhaps an even bigger factor driving the need to refurbish secondary offices than the need for good amenities is the ESG agenda. The E in ESG, environmental, was the single most cited topic throughout the all-day event. Ensuring office real estate is environmentally efficient and meets investor and government sustainability requirements is a big factor driving the bifurcation in the market between good assets and the rest.

“The first question a tenant used to ask was about rent. Now it’s about ESG, Hines' Blair said.

“Real estate has come a long way when it comes to taking lessons on things like space as a service and learning from the hospitality sector,” Revcap Senior Associate Katie Robertson said. “The next thing will be embracing clean technology to bring offices in line with the required standards.”

Patrizia’s Irons cited a statistic from Cushman & Wakefield that brings the challenge into focus. In eight years' time, in order to lease an office building in the UK and meet government Minimum Energy Efficiency Standards, commercial offices will need to have an energy performance certificate grading of B or higher. Only 4% currently do.

“That means that in the next eight years 96% of offices in London will need to be repurposed,” he said. “That’s scary.”