The economic macro is getting more supportive for real estate and REITs. Positive real interest rates remain restrictive – less so after the Federal Reserve’s jumbo 50-basis-point rate cut last week – but the Bank of England kept rates at 5%, with the yield curve righting as short-term interest rates fall below long term.

Office angles: high-rise City offices face higher risks than low-rise West End alternatives

Mike Prew

Real estate investors are staying on the sidelines, with debt appetite low and selective – retail is out of favour and offices are polarising. Yields are adjusting for illiquidity and thin trade in investment markets, making the ‘V’ in NAV (net asset value) more subjective than normal.

We see similarities between offices today and shopping centres in 2017-18. Mall values halved in 2016-20, driven by capital market pressure. This was systemic across all shopping centres, and prime assets provided no sanctuary, with retailer company voluntary arrangements rendering shop units unfinanceable. The same scenario is unlikely to affect offices, however, so this looks like a slow-mo repricing.

We conclude that there is more risk of under-demand than oversupply in London offices, in which case real net-effective rents could be falling and the ‘drop-build-sell-repeat’ developer model could be broken.

Meanwhile, in the ‘concrete and clay’ of offices, pricing seems to be warped by valuers referencing a new breakaway asset class of ‘ultra-prime’ green offices – but the breakaway is likely only 2% to 3% of stock. REITs are guiding to ultra prime rental growth of 6% per year, and supply is expensive or even loss-making to deliver. Great Portland Estates projects that Clifford Chance’s new HQ at 2

Aldermanbury Square, EC2, will be worth less when complete than it cost to develop.

Between the green and brown bookends, London offices are dominated by mid-range grey stock. CBRE’s Sustainability Index notes a close alignment between the values of green and brown retail and industrial buildings, but in offices it observes a 20% gap between energy-efficient assets, rated EPC ‘A’ or ‘B’, and those ranked ‘C’ or below.

Lots of London office debt is due to mature in 2025-26. Back-of-envelope estimates put the total at £20bn to £30bn, which equates to the value of the entire UK REIT sector.

Following the global financial crisis, REIT debt disciplines have improved but banks are amending and extending again to avoid non-performing loans. Some are routing loans via debt funds for more favourable capital treatment, which has taken over as the main source of real estate loan origination.

The private equity narrative is of a soft economic landing and five-year swap rates falling to 3%, bursting the dam wall that has held back the money overhanging the market. This might be feasible for ‘beds, meds and sheds’ – where there are high barriers to entry, simple structures, low depreciation and high conversion of income to earnings – but the traditional sectors could see less support.

Shopping centre operating costs are potentially underestimated, with a gross 8% initial yield likely netting down to around 6%, with a wall of stock on offer on the discount rack as we see consumer retrenchment and durable goods deflating. We note Hammerson’s refinancing of Irish mall Dundrum Town Centre from a coupon of 1.9% to 5.5%, but it also needed an estimated €220m (£184m) cash injection. REITs may need to cushion loan covenants in joint venture security pools with equity patches like this.

We incorporated information from data services business CREFi to access public filings from global corporate registries, land registers and charge registers. CREFi uses extraction technologies and sector knowledge to structure data from documents to create discrete loan-level intelligence matched to underlying secured assets. It is impossible to represent the whole UK secured lending market due to current regulatory disclosure frameworks, but this extensive dataset enables us to zero in on refinancing ladders, building values and loan coverage ratios in REIT forecasting.

Offices are technologically exposed, with hybrid working, decarbonisation and AI challenges leading to costly repurposing and reductions in office space to manage vacancies and greening costs.
The convenient truth of a wall of money meeting the wall of debt meets an inconvenient truth of higher costs and accelerating obsolescence, which the valuers do not appear to be fully factoring in.

Stock selection is now a choice between buying growth assets expensively or recovery opportunities cheaply. We maintain the City of London is higher risk with a shrinking central business district, while the West End is like Paris – lots of low-rise period buildings – where greener refurbishing is a planning requirement by Westminster council. EPC ‘A’ offices look expensive but there is potential value in band ‘D’ for those with the expertise and capital to improve efficiency.

The office correction is likely to be gradual, multi-year and debt-driven in a near-deadlocked market, with the dynamics of tenant markets moving more quickly than capital markets, as operating costs increase faster than rents.

Mike Prew is managing director at Jefferies