A new report from Bloomberg Intelligence (BI) has found that prime offices in London and Paris may acutely feel the pain from remote work, as a mix of falling values and widespread vacancy destroys the city networking vibe and leaves high-quality buildings empty.
REIT defences, such as inspiring green buildings and services, coupled with low leverage, might not be enough to defend the sector's credentials. Clusters of ownership where landlords can create destinations -- such as British Land's London campuses -- look most resilient.
Sue Munden, real estate analyst at BI, said: 'European office values are declining, and there's considerable uncertainty as to where they may settle. Views expressed by REITs that high-quality space may prove more resilient are backed up by strong leasing activity and low vacancy in those premises as second-hand buildings empty.
'But with economic growth weak and continued popularity of remote working, it's possible that secondary space distress may spill into prime offices. A worry is that even in dense office districts designed to encourage networking, vacant space defeats that purpose and can trigger a knock-on negative effect for rents and demand.
'For now, migration to prime or serviced space is shoring up REITs, but waning spending on development and entrenched hybrid work that inevitably reduces the quality and quantity of offices is a trend to watch.'
Green buildings have better prospects
Net-zero carbon buildings are prized, making them a good defence against vacancy and declining values, according to the report. Office REITs have made significant progress in ensuring their portfolios will comply with a goal of being net-zero carbon by 2030 and the percentage of buildings already complying with 2030 requirements is well ahead of the average for European office stock.
As many occupiers are keen to brand themselves as environmentally friendly, properties that don't comply are already finding leasing activity compromised, while buildings that are net-carbon zero achieve premium rents of as much as 20%. Other attributes, such as service provision, shorter leases and pre-fitted space are also popular as occupiers seek flexibility.
Quality factors
European office REITs aspire to deliver top-class space with net-zero carbon credentials, yet this may not be sufficient to attract tenants to offices unless networking can be encouraged. British Land's strategy to build campuses for tenants in specific sectors, and Workspace's business centres are good examples of how control of a district can drive demand.
Landsec's Victoria estate and Derwent's Old Street and Baker Street ownerships are less cohesive, yet the REITs can still influence the quality of the area and facilitate tenants' changing space requirements within the estate.
Strategies that involve isolated buildings are more at risk of vacancy contagion and REITs may sell these "noncore" buildings to focus on key localities.
Low leverage is another survival strategy, and REITs such as Gecina, Landsec, GPE and Covivio have been increasing asset sales since the pandemic to cut leverage so they are capable of shouldering a 40-60% slump in property values before breaching 60% LTV covenants.
Better liquidity has also been put in place, learning from the effect of low rent payments during the pandemic, while interest cover is 4-6x, compared with a 1.25x covenant. Yet office transactions have dried up, making future disposals more difficult to execute.
REITs may have an advantage over owners of single buildings or privately held portfolios where leverage is more commonly closer to the 60% tolerance. REITs see this as an opportunity to acquire financially distressed offices that complement their portfolios over the next couple of years, the report concluded.
