A perfect storm is brewing in the office market. A correction is happening, but it is only the beginning for the UK and Europe. Office valuations are falling far quicker than expected and sub-£10m sales have been happening quietly in the market. When lenders acknowledge the true value of assets that they have loans against, and borrowers are not interested in resolving the issues, what must owners/ borrowers, lenders and prospective buyers consider as part of their asset management strategy?

As well as valuation issues, lenders need to assess additional factors such as fire safety, change of use, refurbishment costs, energy improvement measures, Energy Performance Certificate (EPC) compliance, insurance reinstatement costs (with the cost of inflation being near to 20% to 30% over the last couple of years) and development feasibility angles (where increasing height and rights-to-light issues might impede adding on floors). RICS guidance states that valuers must understand the costs of environmental, social and governance (ESG) improvements and very few valuers have the in-house knowledge or expertise.

This comes in the context of more loans maturing over the next year or two and the refinancing gap across the UK and Europe being in the region of £50bn. Borrowers may struggle in time to service their loans. When lenders offer the opportunity to extend a loan facility, they are also expecting assets to be improved particularly with green loans and those where questions about climate resilience, ESG strategy, Sustainable Finance Disclosure Regulation and EU taxonomy and their associated costs are required. With a downturn in the market coinciding with a cycle of refinancing, it is not looking easy for borrowers and, as we have seen, the US handing back the keys may be the best cure.

Another aspect of the office market is that a ‘wall of leases’ is about to expire. This year and next will be the most momentous time for leases expiring and breaks occurring. Coupled with this, there are plenty of occupiers that simply do not need as much space anymore. In the post-Covid world, many have taken stock and are making decisions with issues around lower profits and cashflow now starting to bite their business. The shift in working patterns the pandemic brought on has remained, depending on the company. Alternatively, companies might have had to make redundancies in their business and simply have a lower headcount particularly within the services industry.

Another trend we are seeing is towards higher-quality space to help attract and retain staff with best-in-class offices. As a result, higher vacancy rates might be seen in secondary markets and London’s older stock. Towards the end of the year, more buildings are predicted to be coming to this challenging economic market. Sellers want to get a fair price but will also be required to meet ESG criteria and buyers only want to pay what it costs to build the building – and we are not at the inflection point where transactions are happening. A story for the new year, perhaps?

Refurbishment costs

In addition, questions remain over what standards they need to meet if they hope to sell in five or seven years. Aiming for greater efficiency can cost more, but a basic, cheaper refurb could affect whether there will be a market for that type of building. A lot of capital will require a quicker return, so longer-term refurbishments might be less common until the market returns to normal.

For existing office owners, the net zero push – even though prime minister Rishi Sunak has rowed back on some of the targets – is adding to the pressure. Some owners are weighing up the cost difference between refurbishing to EPC ‘B’ or ‘A’, deciding if they are willing to gamble on the extra cost or on the occupier demanding a higher standard. Increasingly, corporate occupiers require a more energy-efficient building because it aligns with their own ESG principles.

Office refurbishment projects can face additional challenges as assets such as boilers might not yet have reached the end of their life. It might not be the right decision to remove and install heat pumps particularly when looking at reusing existing elements of the building and reducing embodied carbon. Asset Managers are increasingly aware of these factors and how they affect a building’s rating.

However, EPCs are not the only measure being considered, as occupiers are also often tracking energy usage within offices. Although energy usage meters can produce significant data, this information is not currently readily shared between stakeholders. EPCs are not universally accepted as fi t for purpose so energy usage figures might become more important in a more dynamic market where science plays a greater role. The use of more real data looking at energy usage intensity and requirements with embodied carbon is becoming increasingly commonplace as part of planning.

Other standards include BREEAM and NABERS, with some lenders pushing for the more expensive BREEAM standard. NABERS is gaining momentum, but it is more on the new-build side, making the building more efficient so occupiers pay less. Embodied carbon is another factor to consider.

Planning requirements often ask about the embodied carbon usage and could lead to more refurbishment rather than demolishing a building to keep embedded carbon lower. Finally, buyers may consider looking at alternative uses for buildings. Office premises can be changed to residential or self-storage. This is particularly relevant for out-of-town offices where stock with a lower EPC could be used for storage.

Of all our transactions at Hollis, what we have seen from the last two quarters is that approximately 40% of the market are getting assets ready for sale. Early advice is required for the borrower or the lender and caution is needed by the buyer. For those buying now, it is important to look at every scenario, taking a holistic view and a comprehensive approach to your bidding and acquisition, valuations and overall cost of buying the asset, from feasibility right through to ESG, fire safety and more.

The office market is facing many issues on many fronts and both buyers and occupiers have much to consider. There is a correction on its way, and it is still to fully emerge, so this will be an interesting space to watch for some time to come.