Move right in

A patchy market, major project delays and market fragmentation do little to reassure potential investors about serviced office. Yet it has pan-European trends going for it, as Shayla Walmsley reports

If your business is likely to go under and unlikely to make a profit anytime soon, you're unlikely to hawk the family jewellery to pay for major investment in a prime glass-and-steel landmark office in London, Paris or Berlin.

That somewhat obvious observation is the basis for current optimism about real estate's new niche: serviced office.

For many investors, it's an insignificant sub-sector that is unlikely to appear in the investment strategy. At best, these cautious investors would be prepared to consider opportunistic investment in passing assets as they become available.

Yet its current and recent advocates - including the €221bn Dutch civil service pension fund ABP and BriTel, the British Telecoms Trustees' pension fund - could well argue that serviced office plugs into a number of trends, including enterprise agendas, flexible leases and regeneration.

Their largely indirect investment targets claim they're also plugging into a rapidly professionalising industry.

"It has become more mature," says Michael Kingshott, chairman of London-based Serviced Office Group. "It used to be a landlord with an old building doing a few alterations in a short-term arrangement. Now it isn't, but it still has a long way to go."
Still, a number of trends look good for serviced office. The first is a strong enterprise sector in some, mostly mature, European economies (see table on page 31). Where there's enterprise, there's serviced office - and mature European markets are the most enterprising, according to figures published by Enterprise, the European Commission's observatory of SMEs.

In all European markets, the majority of small businesses are micro-business - that is, those employing fewer than 10 people. Global enterprise trends tend to adhere to a demographic pattern. Data from the Global Entrepreneurship Monitor (GEM) suggest that enterprise is most prevalent among 25-34-year-old men from middle-to-higher income groups.

For these, the sector offers flexibility and cost-savings, with minimal infrastructure investment.

Yet if the main demand driver is at the enterprise end of business, there is also theoretical demand from larger firms - both overseas investors looking for a representative office, the business equivalent of a pied-à-terre or a glorified postbox, and those unwilling for other reasons to commit to longer leases. Whether this additional demand materialises will depend on how uncertain the business environment becomes.

Enterprises grow; they scale up; they also go under. In the UK, the attrition rate for small businesses dropped from 37% in 1995 to 33% in 2002. Workspace cites the drop as a plus for the sector's investibility - but it is still significant. 

This is a short-lease sector - and that, according to Kingshott, is core to its appeal.  Investing in serviced office is like investing in a chrysalis. This is real estate's transitory state. Compared with the rest of the office sub-sector -where the longer the lease, the less risky the investment - serviced office makes a virtue of transition.
"Small businesses don't know where they'll be in five years' time so you can't ask them to take on long-term liabilities," says Kingshott.

He points out that for property firms and investors, it can be an option for marginal and sub-prime properties earmarked for eventual refurbishment, especially in areas of regeneration.

The point is that a short-term conversion to serviced office will pay for a longer-term conversion to office proper or (as likely) residential.  In other words, setting up a serviced office structure enables investors to pay for the re-vamping that will make it "real" office.

At a presentation he gave at the London Business School in April, Harry Platt, chairman of Workspace in London gave an indication of how the transition can work. The firm earmarks 25% as subject to change of use over a five-year period and 20% over 10 years. Workspace, he said, was "to be treated as equivalent to affordable housing".

Restructuring existing buildings isn't the only option, of course. London-based Stonemartin, for instance, specialises in purpose-built serviced office. But this mixed-use element is a significant component of, for instance, Igloo, the UK's first regeneration fund.

The £2.5bn (€3.7bn) fund, managed by Morley, invests in live-work property complexes, largely serving the UK's creative industries. Fund manager Hoon Wey Woon cites "urban lifestyle" as a factor.  The residential he sells on; the commercial the fund continues to manage, generating value from rental.

Kingshott likewise sees serviced office in terms of "new communities" - with residential and commercial in proximity.

It would be easy to overstate just what impact regeneration has had, or is likely to have, on property investment trends. Across the UK market, there has been no shortage of attempts to lure investors to would-be enterprise hubs as part of regional regeneration efforts. With some exceptions, they haven't worked.

"Serviced office has been around for longer than people realise - around 25 years - but it isn't as visible or acceptable as other areas," says Kingshott.  "Now we're seeing a kind of re-urbanisation, with an emphasis on major conurbations. There was a great surge of regeneration initiatives in the north [of England], but businesses wanted to stay in the south."

Despite its brownfield credentials, Igloo is resolutely urban. It acquires mixed-use assets in "edge of city-core" locations in 20 UK centres, including Cardiff, Leeds and Leicester.

As part of a diversification strategy, serviced office has its limits. In the UK, at least, the problem is that investible shared office is limited in geographic scope.  Matthew James, research manager with Workspace, in June pointed out that nowhere else in the UK do you find the scale and mix of business that you do in the capital. More businesses launch and close in London than anywhere else in the UK.
"Regeneration is now a mainstream investment product," says Woon. 
At least the fund he manages is, not least because a strong SRI bias makes it a relatively natural choice for pension funds. In May, the West Midlands Pension Fund invested £20m and the South Yorkshire Pension Fund £10m in the fund. Other investors in the fund include the Environment Agency Active pension fund and Derbyshire County pension fund.

But is Woon right? Alastair Adair, head of the School of the Built Environment at the University of Ulster, suggests that putative demand for serviced office needs to be balanced against continuing investor caution towards regeneration real estate products.

"Most regeneration companies are SMEs, so serviced offices to meet demand in the sector would probably work," he says. But he points out that regeneration attracts relatively little institutional investment into property - "possibly of the order of less than 20% of total investment".

The obstacles, he says, are the mis-perception that it delivers below-target returns and, perhaps more significantly, a paucity of investment expertise.

The London-based Business Centre Association was reported to be working with DTZ to "educate" investors via ongoing research, although DTZ proved reluctant to comment on the sector, suggesting that its last major research was already several years old. Despite relatively few regeneration funds (Igloo and Blueprint) and developers (Quintain and Argent), opportunities are relatively scarce.

"Yield compression is already taking place in regeneration areas, hence the search for new regeneration opportunities in cities across the UK," says Adair.
What's surprising about serviced office is how shamefaced its investors are.
Even fund managers - usually more willing than pension funds to tout their investment decisions - proved cagey about investments in serviced office.
Not only the Executive Office Group but also its parent, Morgan Stanley, emerged as reluctant to comment on the sector. 

A spokesman for Arlington (now rebranded as Goodman), the Macquarie-owned real estate business, told IPE Real Estate: "It is not an area we focus on too much." Meanwhile it created a third company with Regus, the serviced office specialist to construct serviced offices in Goodman-linked business parks.
Pension funds that invest in serviced office are notably cagey about their investment - perhaps not least because serviced office development projects, like any other, can go wrong.

Hermes declined to comment on the British Telecom trustees fund it manages, which recently decided to sell its stake in Stonemartin, the listed serviced office group. The decision followed delays in the completion of projects in Birmingham and Reading. The company's managers suggested that they saw completion as an indicator of the market's investibility.

Yet investors still need to be convinced about the pricing and profitability of companies active in the sector. It seems everyone's waiting for serviced office to take off - but no-one wants to be the pilot.

Even so, the market is maturing. Witness, for instance, London-based property firm Kenmore's acquisition in March of Avanta, the UK serviced office group. Morgan Stanley Real Estate, which owns Executive Offices Group, is understood to be circling Stonemartin, until recently held by Britel Trustees. Merchant bank Close Brothers has been active in the sector both via its subsidiary, Business Centre Properties, and through its high income fund.

Another potential suppressant to investor appetite for serviced office comprises the obstacles to cross-border investment. "It does operate cross-border and will," says Kingshott.

"It's another issue whether cross-border strategies will be successful."
An exception to a largely domestic focus is Paris-based NCI, a serviced office specialist with operations in France, Luxembourg and Belgium.

"We operate with a European mentality but we face local law and adapt to local regulations," says NCI director of operations Edouard Lagourge. 

In France, he points out, the building lease contract may extend for three, six, nine or 12 years. In Belgium, term contracts are more complex and, he suggests, skewed against operators. "From the customer's point of view, there is no change," he says. "They all operate via a service contract. There is no flexible contract for the owner."
The company plans to launch operations in the UK. "It's bit early for us but it will come - for sure," says Lagourge.

Longer term, there is another major potential threat to serviced office as a sub-sector: that pension funds will abandon niche to concentrate on, for instance, geographic diversification. 

Even if that's the case, niche will have had a good run. In April, Arlington Securities urged pension funds to target real estate alternatives in order to maximise returns within clear risk limits.

Currently, pension funds faced with a shortage of opportunities love their niche sub-sectors.

Student accommodation, nursing homes and motorway service stations have all attracted investor interest. In June 3E Car Park Investors said it had attracted €50m from three unnamed European institutions for a Luxembourg-domiciled fund dedicated to global carparks.

Although launched funds are no guarantee of pension fund interest, they do indicate investment trends - and the trend is from niche to nichier.

But there are a few early signs of what might be the beginning of a backlash - or at least pension fund scepticism about what does and does not count as a credible investment.

A case in point is the recent response from pension funds to a Dutch proposal touting government-controlled roads as a potentially investible infrastructure sub-sector.
But there is one curiosity of this niche sector worth noting. It isn't necessarily what it seems to be. It is a target for opportunistic value-adding investors, but as likely to be purpose built. It's office, and yet also, in the regeneration context, mixed-use.
In fact, suggests Lagourge, serviced office is closer to hospitality - that is, hotels - than to mainstream commercial.

"[Companies are] looking for comfort - for the office equivalent of a hotel," he says. "If you look at Regus, they're operating the same model. They provide phone links, secretaries and meeting rooms. You just turn up for work."