Value-add office investing in uncertain times

It is the best of times and the worst of times for value-add real estate investors. Runaway inflation, rising interest rates, eye-watering increases in construction costs, supply-chain issues and geopolitical uncertainty amount to the perfect storm for investors looking to create value by refurbishing tired office buildings.

Then there is the paradigm shift in the way people work and live, which may affect demand, not to mention the focus on net-zero targets and ESG, which will push up construction costs further. Adding together all these negatives, it is tempting to think it would be foolish to embark on an office renovation in the short to medium term.

The are many value-add specialists, however, who believe that the current late-cycle environment could throw up some interesting opportunities. The art is in identifying underperforming properties with favourable supply-demand dynamics held by capital-constrained or motivated sellers that can be acquired below replacement cost. This is no easy task.

Getting the price right is the first major hurdle. It is never an easy negotiation and in today’s market, it has got a whole lot harder.

Paul White, head of Hines’ European value fund series, says: “There is slightly reduced liquidity in the market and things have been moving very quickly from a geopolitical and macroeconomic perspective, and that has direct ramifications for the value-add space. 

“Rising interest rates have fed through to increases in the cost of debt financing and this has an implication for affordability. At the moment, the market is processing how quickly those events have moved, and that’s leading to a classic bid-ask spread. Buyers are worried that prices are moving, so they are building in a bunch of risk headroom – and this leaves a gap between where seller and buyer are willing to trade.”

The fact is, though, that there are huge swathes of substandard office space around the world, in all the leading cities. What may have been considered grade-A space five years ago, in a prime location, may be marked as obsolete now. 

White adds: “You can understand that it’s a tough call for the owners of this sort of property to be selling at a price that value-add operators want to pay.”

But it might be worth taking a risk and paying more for the best-located ‘obsolete’ office space. As a recent report from M&G Investments points out: “One of the largest industry shifts over the 2020s will be the focus on climate and achieving net-zero carbon and energy-efficiency targets. Evolving occupier sentiment towards energy use and worker health has also increased the incentive to improve assets to meet these targets.”

This means value-add operators that create offices with genuine ESG credentials and a focus on occupier wellbeing – with external accreditations such as LEED or BREEAM – are creating assets that will be worth more than even a premium acquisition price.

M&G’s researchers explain why: “Five to 10 years from now, most core investors will likely own portfolios that are skewed heavily towards greener buildings, thereby providing a deep investor pool in which to sell these upgraded assets.”

Mike Bessell, managing director and European investment strategist at Invesco Real Estate, makes another interesting observation that will help drive the value-add market. He says: “I think the fact that there is embodied carbon within existing office buildings means that we will see far fewer buildings demolished and rebuilt. So there will be more scope to refurbish and modernise buildings.”

As for getting the valuation right, Bessell says value-add buyers must always “focus on location, then work back from your exit and think about what risks you can control all the way through the project”.

Aviva Investors recently completed a major office refurbishment at Ealing Gateway, in West London. The project involved the acquisition in 2017 of a tired 84,000sqft building that has been transformed into a fully future-proofed asset.

To create value, aviva embarked on a visionary redevelopment to include post-pandemic occupier requirements such as breakout areas to encourage collaborative working, as well as occupier amenities including dedicated changing and shower facilities and secure storage for up to 80 bicycles, all of which are aimed at encouraging and accommodating more sustainable modes of transport.

Aviva also invested in upgrades to the building management system as part of its drive to reduce the carbon intensity of existing buildings within its £47bn (€54bn) real assets portfolio – with a target to reach net zero by 2040.

The building’s location, close to a thriving retail centre and leisure facilities, with excellent transport links including national rail services direct to London and Heathrow and the addition of the Elizabeth Line increasing connectivity, helped strengthen Aviva’s decision to invest.

James Stevens, head of real estate investment at Aviva Investors, says: “We believe our upgrade work will hugely improve the experience of occupiers and employees in the building. Underpinning this is a focus on energy efficiencies, which should ultimately benefit occupiers in avoided energy costs.”

Stevens believes that offices will continue to be an important part of Aviva’s investment portfolio, with a caveat. “Not all offices will be successful,” he says. “To be a successful part of our portfolio they have to become much more operational assets. So you have to invest in them on a continuous basis. You have to work with the occupiers, you have to appeal to a specific market and be able to show the benefits to their business and vice versa. If you can establish that type of relationship and deliver the right kind of buildings, taking into account that people live and work differently now, then we see the future performance of offices as valuable assets. But we don’t see that everywhere.”

Jason Oram, partner at Europa Capital, is also a proponent of collaboration between landlord and tenant, and the public and private sectors. He says: “One of the key challenges for these partnerships, is to know which sustainability options are the best ones to pursue and rapidly consolidate upon agreed methodology and metrics to secure success through a unified approach. The importance of green-lease clauses enables that partnership to flourish and the use of smart metering and proptech platforms allow collection of vital data to streamline reporting, as we seek to achieve net-zero carbon across our portfolio.” 

The use of green-lease clauses in value-add offices is becoming increasingly popular. Diann Hsueh, deputy portfolio manager at CBRE Global Investors, takes an open-minded approach, but is clear that alignment on energy saving and net-zero goals is essential.

She says: “We rely on alignment where the occupier is looking to get to net zero as part of their corporate strategy, and their physical occupancy of their real estate is probably the biggest single factor in getting to zero. And then you’re finding yourselves as developers and investors, that you are having an ongoing dialogue with the occupiers saying, ‘Okay, if you notice that your energy consumption is going up, or there are changes, we are happy to come back in and make those changes’. But we would never have done that in the past.”

It is clear that value-add investors are facing increased costs and need to be very careful about valuation and cost accounting. Yet, despite all the uncertainty, there is still plenty of enthusiasm within the sector.

As Oram concludes: “Uncertain economic and geopolitical environments are always a good time to seek value through acquisitions, regardless of risk-return profile. Limited availability of leverage in such an environment may favour value-add and core investment strategies.”

Economic and geopolitical uncertainty could result in a fall in capital values, although Oram believes the denominator effect is of more concern. He says: “Often of more impact to real estate sentiment is the denominator effect of rising yields within bond and equities markets, which can rapidly cause investors to become overallocated to real estate. In such a market, it is important the real estate industry continues to focus on long-term value for its investors through delivery of continued improvements to the built environment.”

This can certainly be achieved by taking a value-add approach, although, as Oram stresses, “experience will be required to appropriately assess value, implement the improvements to future-proof assets and identify the sectors where long-term value will be sustained”.