Could Offices be the Best Commercial Property Opportunity over the Next 5 Years?
This article was first published in Property Investor News, February 2024
If you were to ask me to predict where the best opportunities in commercial real estate will be in the next five years, for SME investors, I would probably highlight the opportunities available in the secondary office market. On the face of it, of course, the office market is on a downward spiral, due to the ‘working from home revolution’. However, whenever there are problems in the real estate market, there are always potential solutions that present opportunities for those in the know. As prices fall and buildings lie empty, now is the time for investors to look at the potential to maximise on these opportunities.
The Office Market: A Changing Landscape
The demand for traditional office space has experienced a downturn since the onset of the COVID-19 pandemic. However, despite working practices changing, we haven’t yet seen a mass outflux of businesses from office space as many are bound by existing occupational leases. Businesses are finding leases difficult to exit from as alternative occupier demand is thin on the ground – landlords won’t take leases back, and potential assignees or sub-lessees are limited. This is a problem for many tenants, as with an increasingly flexible workforce the need for real estate flexibility has never been greater.
In addition, high inflation has created cost pressures for corporates, who are increasing their focus on productivity and cost reduction. This, together with the longer-term impacts of working from home, mean that being many businesses continue to reassess their usage of commercial property. Data from Remit Consulting in 2023, suggests that office occupancy rates are at circa 30%, and the three-day office week appears to have become the new normal. Indeed, the recent survey found that nearly 60% of employees would consider leaving if full-time attendance were to be mandated. Corporate real estate is the second highest cost after salaries for many businesses and as a result office requirements are continually being reassessed. On the flipside, however, the provision of high-quality space is still important for many businesses, to assist with recruitment, retention, and productivity as well as staff health and well-being.
There is also a much greater focus on buildings that are sustainable and energy efficient, as occupiers try to ramp up their ESG aspirations. The surveying firm, Carter Jonas, recently conducted some research that found only 31.6% of Britain’s office stock is EPC C or above. Occupier demand is largely focused on these Grade A type offices. EPC C is the proposed minimum standard from 2027 but office properties within EPC bands F and G account for circa 17.2% of all offices (Carter Jonas). This means that nearly a fifth of all office stock in the UK potentially became unlettable from the 1st of April 2023, unless remedial action has been taken. In reality, of course, this figure will be a lot lower as exemptions can be applied for – but it is also likely that the availability of exemptions will reduce over time.
All this means that there will be lower overall quantity of office stock going forwards, and it will be the highest quality buildings (that meet corporate and legal requirements) that will be lettable. These trends are being seen nationwide, even in prime office locations such as the City of London and Canary Wharf. Many secondary and tertiary offices in these locations are simply unlettable now as demand ebbs away.
The Challenge: A Chance to Think Differently
Within this challenge lies an opportunity for investors to rethink and repurpose existing office spaces and, as demand for traditional offices diminishes, creative solutions have the potential to salvage commercial values. It’s crucial for investors to have multiple exits up their sleeves to mitigate risk.
The Opportunity: Investigating Multiple Exits
1. Reletting as Offices
This option may seem a little odd, as I’ve already said that a huge proportion of the U.K.’s office stock will become obsolete over the next few years – and prices are decreasing substantially as a result. However, reconfiguring, extending, and re-arranging space in offices can change it from being unusable to being highly desirable.
An example of this is to create co-working accommodation in office buildings. As corporates change their way of working, there is little or no demand from businesses to take a secondary office building on a long lease. But there is often high demand from businesses who favour flexibility. Renting co-working space on flexible leases means that businesses keep a physical base but don’t have to pay the high overheads associated with being tied into a longer full repairing and insuring (FR&I) occupational lease.
There are two ways you can bring this type of tenant into your investment. One way is to lease the property to a specialist co-working operator. This will allow you to maintain your investment without getting involved in any of the hands-on operations. It will also be more straightforward to raise finance on this option, depending on the covenant of the operator. Alternatively, you can run the co-working operation yourself – which is a more hands-on approach.
Another way of retaining an office use is to divide the property into smaller office suites which are usually in high demand from SME businesses. This differs from co-working as the space used is less flexible, as are the leases. As more offices get converted to residential, office space is at a premium in some towns – and in these locations rightsizing the space according to local requirements can be a highly profitable strategy. In order to pursue this angle, it’s important to understand the supply and demand locally – knowledge on this can usually be obtained from local commercial agents who will understand their markets well, as well as running adverts with local business groups and on Gumtree and Facebook Marketplace.
2. Conversion to Other Uses
If there is thin office demand, then the most obvious route to investigate is conversion to alternative uses. The UK government has made that much easier in England by bringing in permitted development (PD) rights in order to make the planning process planning quicker and (usually) easier. In other locations a planning application will be needed.
Depending on location, the most obvious alternative use is residential. Class MA can be used in England to facilitate this in most areas (but not all). Up to 1500 sq. m can be converted from Class E under this PD right. The property must have been vacant for a period of three months prior to the application for prior approval. The local authority will assess the application against transport and highways, contamination, flood risk, noise, natural light to all habitable rooms and potentially request an impact assessment. Once granted, you have three years from the date of the prior approval to carry out the works. There are currently areas where you can’t carry out this type of conversion – such as in AONB, listed buildings and in areas where an Article 4 restriction applies. However, the government is currently in consultation to make changes to this permitted development right in order to allow a conversion of up to 3000 m², and to remove the three-month vacancy requirement, as well as extending its use into AONB and national parks.
Class G (converting units above Class E to flats) can also be used to convert office space – and the government is also out for consultation on widening the scope of this permitted development right.
3. Commercial to Commercial & Mixed Use
Of course, you often don’t need to convert office properties to residential to make money. It can often be equally profitable to convert to other, mixed, commercial uses. Examples of these could be health uses – such as doctors’ surgeries, dentist, chiropractors / physiotherapists, gyms, wellness clinics etc. You could also look at storage uses, aparthotels, hotels, even some retail may be suitable on the ground floor of some properties. There is also the potential to mix commercial uses with residential. Large office blocks may have a daylight / sunlight issue that can preclude conversion to residential in some parts of building, unless you build a lightwell – mixed commercial uses may work well in this scenario.
Permitted development rights (in England) have also made conversions to other commercial uses much easier, particularly within Class E which now includes a wide range of commercial uses. Uses outside Class E may require a planning application.
4. Airspace & Extensions
Classes AA and AB are the main permitted development rights in England which facilitate building up to two extra storeys above detached or terraced commercial buildings. There are also permitted development rights to permit sideways extensions to commercial buildings in England. Airspace applications are very complex, and I would strongly advise the use of the planning advisor.
Conclusion: Strategic Thinking for Future Success
As the office market reshapes itself, the investment values of secondary and tertiary office space are falling. This, in turn, is starting to make the repurposing of office buildings financially viable and presents a great opportunity for SME investors. Success in this strategy depends on buying the real estate at the right price (and not overpaying); having niched market knowledge and great relationships in your chosen market; and making sure that you model financeable multiple exits.
