The following article, by Palace Capital's Executive Property Director Richard Starr, on the topic of flexible office valuations was published by CoStar.
Comment on flexible office valuations by Richard Starr
Before the pandemic, flexible offices or co-working, the property world used to provide only `serviced offices’. But hasn’t owning offices always been about providing a service? It’s only in the current cycle that many landlords have woken up to this fact.
Office owners will be thinking about this even more right now, as they watch their assets sit empty and hear from their tenants that they are going to increase staff homeworking.
We expect more corporates to operate a `hub and spoke’ approach, with a London hub and regional spokes, allowing them to make savings on their rents and allow their staff to undertake less time on a painful commute.
At the same time, flexible offices are expected to make a strong comeback, as those same tenants explore expansion through shorter leases without wanting to be restricted to long leases which cannot account for unforeseen circumstances…like pandemics.
But while landlords and tenants are rapidly embracing the new flexible offices world, will valuers keep pace with these changing patterns as well?
A number of property owners and their customers are transforming how they operate, but the message hasn’t changed the basis of valuation, which is still based on the pre-WeWork and certainly a pre-coronavirus era.
The investment value of an office property a new ten-year lease to a low risk company may be valued at around a 5% net initial yield, while a new three year-lease to the same company would be valued at 7%. Why?
Let’s look at all the arguments.
In London since 2010 the share of flexible (including serviced and co-working) workspace as a proportion of total office stock has risen from around 2% as high as 20% by some estimates.
The UK’s co-working population is estimated at 1.3 million, with more than 700,000 people using a co-working desk every day, so the die is cast – this isn’t a passing trend.
While some estimate that up to 30% of flexible workspace users are students or academics, JLL says in its report, `Disruption or Distraction – what next for the UK flex space market?’, that flex space could represent up to 30% of some corporate portfolios by 2030.
It continues: “Despite these strong fundamentals, the sector still accounts for a relatively small proportion of UK office stock…over the next five years more than 10 million sq ft will be added to the stock and flex will account for 8.5% of the total office stock by 2023.”
It’s fair to say that property owners historically wanted to limit their exposure to the flex sector due to the impact on investment value. There are higher costs and time required to extract value so seeking long leases was always the goal.
But there is still evidence of buildings trading at a discount where flex space represents more than half of the office space, albeit the number of deals is limited.
And if a property owner benefits from a buzzing and vibrant asset, a property which offers the opportunity to renew leases regularly rather than every five years, what’s not to like?
There will always be the case for an institutionally long lease to a rock-solid covenant with five yearly reviews – occupiers spending large amounts on an expensive fit-out may want nothing less – then it is right that valuers attach a premium valuation to these properties.
But why penalise the property owner who is pursuing a more dynamic but just as lucrative strategy through a flexible approach? Particularly when that persuades a tenant to sign a new lease, and help to re-populate city centres.
Flexible and turnover rents are common in other sectors such as student accommodation and hotels. Whereas student accommodation blocks would once have only traded at a premium if leased directly to a university, institutions accept that assets leased to management or operating companies can be just as secure.
So, the stigma attached to `operational’ real estate has been removed in some asset classes, and in my view, this will happen in the office sector as well.
The fundamental component for all valuation remains its location and London does not have a monopoly on strong property fundamentals.
At Palace Capital, we back England’s regional towns and cities – Manchester, Liverpool, York, Southampton and Newcastle among others – because we believe their growth prospects are at better than London’s.
When flexible workspace grows to levels matching London in our regional cities the dam will begin to burst – valuers across the UK will at last begin to fully appreciate the workplace revolution that is transforming how owners and occupiers approach property across the UK.
Central London will recover after Covid-19 – but regional cities will present a compelling alternative as well. Over to the valuers to reflect that in the months to come.