The office market has changed. What will determine performance going forward?

This is the last in a series of four blogs which explore the implications for institutional investors of the recent evolution of the office market. The first is on the challenges facing the UK market, the second is on the global context and the third is on fair value.

The earlier blogs in this series offered a constructive view on offices, explored what fair value looks like, and considered the categories of offices we see as best placed to deliver performance. We’ll summarise our thoughts below, but first let’s address a conundrum many investors are facing.

A polarised market

Even if we are more constructive on office returns after 2024, capital is finite, and it has a choice between sectors. The conviction behind industrial and residential, for example, is clear and embraced by the consensus. Office investment will have to compete for this capital, and this is likely to remain a challenge for the medium term – even when pricing looks ‘cheap’.

We therefore expect institutional investor allocations to offices to continue drifting lower as they dispose of poor-quality offices and increase their allocations to other convictional sectors. But this does not rule out more focused investment in the portions of a polarised office market that could be more likely to deliver returns.

Key elements that may determine returns include:

1. Age: High-quality offices are likely to command a greater share of available occupier demand than before. We think there will be a proportion of stock that offers upgrade potential if entry pricing is appropriate, but a significant amount of space in the ‘wrong’ locations may have a more troubling future. Given development cost increases, it may not be economical to refurbish poorly located offices, which may necessitate a change of use if the asset is not to be ‘stranded’.
2. Weights: Over the medium term, we think institutional investors are likely to reduce office weightings relative to other sectors.
3. City centre: In our view, an increasing majority of occupiers will prefer stronger (economically and amenity-rich) city or town centre locations. This could increase value risk for suburban and out-of-town offices, and for some third-tier towns. This has been borne out by leasing activity since COVID-19.
4. Income length: Long income with inflation protection will remain possible, in our view, especially in off-plan pre-lets and for government occupiers. However, the majority of the market has experienced shortening leases and a higher probability of breaking leases. MSCI measured the average propensity to exercise a break option in the office market at 51% of leases in 2021, compared with a long-term average of 41%.¹
5. Diversification: Offices have long been a high-beta sector and are generally more sensitive to economic stimulus. This relationship may weaken post-COVID-19 as performance becomes more sector-specific.
6. Forecasting: The MSCI average disguises a range of risks and outcomes. We advise breaking MSCI into quartiles of risk and creating a weighted forecast where required.
7. Management economies: Strong management and occupier engagement could further differentiate owners and support returns, ahead of pre-pandemic trends. We think larger investors will have an advantage in recycling occupiers through portfolios and could enjoy economies of scale in management. For fund managers, this will require seamless coordination between funds.
8. Overshoot potential: Yield expansion may overshoot fair value into ‘cheap’ territory, and this could happen in 2024.
9. Lending: Appetite for new lending to the sector will be constrained, or much more specific, for at least the medium term, especially from banks. Similarly, the cost and availability of corporate debt for office majors may be constrained, or more expensive over the medium term. This favours equity purchasers.

We would therefore advise fresh investment is either focused on the top 10% by specification in strong locations where asset pricing has adjusted to within the upper range of our valuation estimates, or on assets priced to enable them to become top 10% via refurbishment.

We would define these high-quality offices as offering top-rated sustainability and wellness criteria, generous reception space and flexible open floors. They could have generous bicycle provision and showers, be recently refurbished or developed in a vibrant economically robust town or city with ample public transportation options.

Beyond the big six

Investors should be aware of ‘moving goalposts’ in seeking an underweight position to offices. We think more emphasis should be placed on the right assets within holdings rather than the proportion of holdings compared with peers. It may also be wise to avoid concentrating on just the ‘big six’ markets, and instead identify a limited number of locations with long-term attributes for growth. Being strict with location could also support residual value.

We think fully fitted, short income and managed options will continue to grow, complementing a dependable and quality service offering on traditional leases. Investors should ensure they are comfortable with a shorter and more volatile income profile in their cash flow assumptions.

Given the opportunities to capture more upside under management agreements, which generally carry a lower risk of binary default, risk-adjusted returns may be enhanced relative to traditional leasing. That said, we acknowledge that this will not appeal to many investors who may prefer to allocate capital to other sectors and less-intensive structures.

LGIM Real Assets was underweight offices at the start of this period, and we expect to remain so. There may be an apparent contradiction in highlighting opportunities for certain styles of offices while expecting investors to reduce overall weightings, but this is consistent with expected polarisation.

Those with a clear plan for when values become ‘fair’ and then ‘cheap’ will be well placed to extract performance from what is likely to be a very different asset class going forward.

Sources

1. MSCI Lease Events Review, 2022 (latest data)