Obsolescence is the biggest threat to the European office market but it will also create opportunities, say Bill Page and Benoit du Passage
Obsolescence will accelerate and become one of the biggest issues for the office sector across Europe. It is being driven by three factors that in themselves are undergoing profound change: sustainability legislation, workplace technology and corporate office requirements. According to Jones Lang LaSalle's Offices 2020 research, this will change the industry irrevocably.
The majority of office buildings are old. In Germany, 59% of non-domestic building stock dates to between the 1950s and 1990s.(1) Similarly, in the UK, 22% of commercial building stock dates from before 1960.(2) In Paris, two-thirds of office stock is over 20 years old.(3) The rate of office-building replacement is critically low across Europe.
Obsolescence and depreciation are nothing new for real estate. Depreciation is accepted as "the rate of decline in rental (capital) value of an asset (or group of assets) over time relative to the asset (or group of assets) valued as new with contemporary specification"(4) and obsolescence generally describes property that is no longer practical or desirable to the end user. The two terms are, to some extent, interchangeable.
Obsolescence affects offices more than any other commercial sector: The physical structure of office real estate has a greater interrelationship with its occupier. For instance, in unit shops fit-out and location drive attractiveness but the former is something relatively easy to address. In logistics the nature of the real estate is simpler, by design. But changing corporate preferences as well as changing legislation provide regular challenges to the office investor. Staying ‘ahead of the game' is a perennial issue, especially when you consider the risks of owning or leasing obsolete property.
The extra depreciation is arguably caused by increased obsolescence.
In the UK the Investment Property Forum commissioned various studies (2005, 2010 and 2011) proving that depreciation hits the office sector hard. Although they acknowledge some data verification issues, there is a compelling and consistent message: annual depreciation rates for IPD standard retail, office and industrial segments were 0.3%, 0.8% and 0.5% respectively over 1993-2009 (see figure 2). This order compares exactly with the 2005 study which tracked the 10 years to 2003. Capital expenditure analysis also measures ‘managed depreciation'. While expenditure rates can be higher outside offices, capital outlay has not been far from sufficient to arrest sector decline.
In the European study published in 2010, London, Frankfurt and Dublin exhibited the most rental depreciation over time. There were data issues again but intuitively much of this distribution will derive from differences in lease length and repairing obligations. Consider the difference between an investor holding a new single-let 15-year full, repairing and insuring lease in the UK and one holding five years in Germany or three years in Singapore, for instance. The UK investor can be relatively relaxed for the majority of the lease profile (breaks aside) knowing that the occupier will be financially responsible for the upkeep of the building and significant expenditure will not be required until the end of the lease term. The investor in Germany or Singapore, however, will be incentivised to keep the property at a high standard as there is more regular void risk. Property is more frequently brought up to the standard prevailing requirements demand until, eventually, the underlying real estate is no longer suitable for further change.
While longer leases with less onerous repairing obligations are understandably attractive to investors, they are storing up obsolescence and will accentuate this issue, not to mention curtail early investment in energy efficiency improvements by the investor.
Factors behind obsolescence
Each of the three drivers of obsolescence is undergoing significant change. There will therefore be acceleration in risk, particularly for secondary assets.
• Sustainability legislation: There are many new environmental laws driven by the EU and the most proactive nations but also a lack of visibility of what might be in the pipeline. As we have seen with the UK government's procrastination on mandatory carbon reporting, governments are also failing to provide sufficient certainty to investors about implementation timescales. What is certain is that green imperatives will increase as legislation becomes more stringent. For instance the EU requires that by 2020 all new buildings will be "nearly zero energy". In the UK, the Energy Act 2011 will make it unlawful to lease a property from 2018 below a minimum energy rating which is currently expected to be EPC ratings of F and G. According to the UK's Department of Energy and Climate Change (DECC) around 18% of non-domestic properties with EPCs have a rating of F and G. This is likely to increase as the decade progresses as finance for capital expenditure will remain challenging. New voluntary certifications governing improved green performance of existing offices are already under way in France: ‘Haute Qualité Environnementale (HQE) Exploitation' and ‘HQE Rénovation'. Strict legislation under the Environmental law package, called ‘Grenelle Environnement', also obligates investors and corporate owners to undertake energy performance retrofits of all existing commercial real estate by 2020, decreasing energy consumption by at least 25%.(5)
• Workplace technologies: We predict that five technological changes will shape the office sector over the next 10 years: the provision and delivery of electricity, cloud computing, collaborative technology, mobile technology and sustainable technologies. Inflexible stock will become more obsolete. New build is naturally more ‘future proof' than older stock, but there are exceptions: provided the underlying real estate is good and well located, more strategic refurbishments can be expected, especially as the requirements for cabling in occupation diminish.
• Occupier preference: Corporate occupiers have stronger internal real estate teams, more sophisticated requirements and increasingly see real estate as fundamental for recruitment, retention, productivity, collaboration and - increasingly - branding. This is not necessarily a logo on the side of a building but a dedicated entrance, a workspace that can be identifiable as part of their ‘corporate brand' and a building that helps meet corporate social responsibility (CSR) requirements. For the larger user, buildings that fail to enable these evolving preferences will become obsolete.
And, of course, occupiers themselves are driving changes in sustainability and will increasingly do so as voluntary and non-voluntary ‘in-use' measures become more commonplace. Studies have shown that despite global economic uncertainty sustainability is increasing in importance to occupiers. ‘Prime' will increasingly be synonymous with ‘sustainable', and made visible via green building certification schemes (BREEAM, LEED etc.) or Energy performance labels (Energy Star, etc.)
In France, the Grenelle environmental laws, which were introduced in 2009, are expected to further decouple prime and secondary valuations. These stringent laws impose more obligations and cost on investors - and occupiers - and the logical consequence will be value erosion on property where more expenditure is required - in absolute and relative value terms.
France has also seen additional obsolescence risk from occupier requirements. Large corporate requirements for offices across France demand the same standards in Paris as they do in second-tier cities. These demands cover green building certificates, branding, technology and space efficiency. This is creating real challenges and a stock base at greater risk of obsolescence.
Implications for investors
With bank finance restricted, capital expenditure will be challenging. This will have a greater effect on secondary product, which requires more expenditure, than prime with lending to ‘risk' structurally different. The volume of distressed assets held by banks also suggests greater depreciation risk (banks are unlikely to inject capital to protect value while controlling loans). Add to that the obsolescence risk presented by new technologies and evolving requirements and a huge problem is developing. We expect inevitable value depreciation in secondary product further polarising markets across Europe. This represents a massive structural risk to investors holding relatively poor assets - and among the biggest such owners are, of course, banks. Further value erosion will exacerbate technical loan breaches, enforcing more disposals in a damaging circular trend. Investors are still waiting for this inevitable further correction in secondary assets as a key buying/refurbishing opportunity.
There is proof from global markets that sustainable buildings can achieve capital value and rental premia.(6) The US has shown rental premiums between 3% and 17% for LEED and 2.5% and 9% for Energy Star offices. The same studies also show capital value premiums up to 3%, as well as a positive relationship between occupancy levels and Energy Star ratings. In Australia, studies show NABERS ratings leading to capital value premia of between 2% and 9%. Evidence is improving for Europe, particularly concerning extra depreciation risk,(7) although proof for premiums remains relatively absent.
We would argue that proving a premium is increasingly irrelevant as reduced depreciation of a sustainable building relative to a non-sustainable one is intuitive and provable. Poorer-quality product will exhibit:
• Longer void risk on expiry;
• Reduced rental growth (increased rental depreciation);
• Longer rent frees on renewal;
• Higher exit yield;
• Lower liquidity (saleability);
• Require more capital expenditure
All these factors will significantly alter value under discounted cash flow and Jones Lang LaSalle has developed models to assess the potential impacts on value.
We are increasingly seeing instances of institutional funds targeting sustainability criteria to meet both their own CSR requirements and the demands of retail investors, as well as mitigating depreciation risk. More banks will demand sustainable development (where pre-let) for similar reasons. These are self-reinforcing trends.
In future, outperformance will logically derive from high-quality sustainable assets but also from the refurbishment and upgrading of suitable stock. Active asset management will be required more than ever. ‘Average' buildings with limited refurbishment potential and inflexible floorplates do not have a compelling story and will increase the trend towards full obsolescence followed by change of use. A compelling statistical example has emerged from Birmingham in the UK: around 35,000 sq m was let in units over 1,000 sq m over 2011. But over the same period 50,000 sq m of office stock was allocated to alternative uses. Similar trends can be expected across European markets exhibiting high overall supply as values become increasingly polarised. In Amsterdam, take-up over 1,000 sq m totalled 160,000 sq m in 2011. This compares with over 93,000 sq m of office space allocated to alternative uses.(8)
Implications for occupiers
Critics maintain that the extra cost of developing sustainable buildings will have to be passed on to the occupier, resulting in higher rents and encouraging occupiers to find value from poorer office space. But investors and occupiers will move towards an overall cost-per-head measure of value rather than headline rent per sq.m. New or refurbished product that offers lower energy costs and enables more flexible occupation can be cheaper in use than unsustainable, inflexible office space, and green buildings are rapidly becoming the standard in core markets.
There are also risks to occupiers. Like investors, occupiers need an ‘exit strategy' should they wish to sell an owner-occupied asset or sub-let or assign leasehold liabilities. This flexibility is vital for managing portfolios. Obsolescence and legal restrictions on energy use will severely restrict this flexibility. We can expect more refurbishment in situ and partnership approaches between investors and occupiers to alleviate risks for both parties, despite inevitable upheaval.
Value depreciation on secondary stock will enable savvy investors to access problematic, but appropriate, stock cheaply and refurbish.
With replacement rates so low - average rates of 1-2% per year are commonly quoted there is great potential across Europe for refurbishment. Speculative bank finance will be limited for at least the medium term but partnerships with occupiers will open up pre-let funding and alternative sources of equity offer huge potential. Replacement rates will have to increase. There are competitive advantages to be had for those landlords who move first, in terms of satisfied tenants and reduced voids. In addition there will be investable opportunities for those with the right skills as values inevitably fall for compromised stock.
In conclusion, while the offices sector is currently focused on economic risk and lack of finance, obsolescence and depreciation are slowly rising. They will become structurally more acute in time, driven by sustainability legislation, workplace technology and occupier preference, each of which is undergoing significant change. More evidence will emerge from more progressive countries and we will monitor value changes in France closely. New valuation techniques are being developed. There is risk but also compelling opportunity.
Footnotes: 1 Zeitschrift für Immobilienökonomie, special edition 2009; Jones Lang LaSalle 2011; 2 Tyndall Centre, 2006; 3 Jones Lang LaSalle, 2012; 4 Law, V (2004) The Definition and Measurement of Rental Depreciation in Investment Property, unpublished PhD dissertation, University of Reading/IPF, 2005, 2010, 2011; 5 "Recommandations relatives à la rédaction du décret organisant l'obligation de travaux de rénovation énergétique dans le parc tertiaire entre 2012 et 2020, Rapport final", November 2011; 6 Various studies, see McAllister, 2011 for useful summary; 7 The Impact of Energy Labels and Accessibility on Office Rents, Kok & Jennen, The Netherlands, 2012, for instance; 8 Jones Lang LaSalle, 2012
Bill Page is head of EMEA offices research; Benoit du Passage is MD France & Southern Europe at Jones Land LaSalle