Over the past few years, the flight to quality among investors and corporate blue-chip occupiers has seen many moving their capital away from riskier commercial real estate investments to safer ones – which usually include strongly targeted ESG credentials.
Even despite the current economic backdrop, tenants and investors are still demanding more sustainable office spaces, and landlords are future-proofing their assets to achieve the best-in-class buildings, which in turn has widened rental premiums even further.
This focus on high-end office space may well lead to the market becoming even more polarised, with premium and new-build commercial offices continuing to generate an increasing proportion of transactional activity, at the expense of inferior specified space.
Looking at the South East, evidence from the 2021 office transaction data reinforces this trend. Of the 3.2m sq ft transacted in 2021, 69% was of grade-A quality accommodation, and the figures from 2022 match this data. This compares to a figure of just over 50% in 2020, pointing to the fact that premium offices are continuing to see growing demand.
Developers are clearly picking up on this trend. As an illustration, the redevelopment of 150,000 sq ft grade II-listed Mountbatten House in Basingstoke has recently been agreed, with funding secured from Puma Property Finance, which will create a modern and sustainable workspace on the M3 corridor targeting an EPC A rating.
The ESG market is not slowing down and those buildings with eco credentials will outperform those without them. Sustainability was a ‘tick box’ but now it is a mindset for all stakeholders. There is still a long way to go but the flight to quality will provide new opportunities for buildings across towns and cities throughout the UK, perhaps even bringing some of the more secondary markets into the limelight through refurbishments and a smart rethink of how we approach ESG within our sector.
Developers have not been slow to pick up on the flight to quality in the office market. As a development lender, those projects that can deliver high sustainability credentials are particularly attractive. This is a result both of the environmental / moral case, but also crucially for sound commercial reasons as well.
New legislation is set to require most existing commercial leases based in England or Wales, let on a new or renewed lease, to meet the Minimum Energy Efficiency Standard (MEES) of an Energy Performance Certificate above F. By April 2030, these requirements will be tightened to an EPC rating of B.
Many offices are struggling to meet these criteria, meaning huge numbers of buildings across the UK are requiring refurbishing or repurposing. Indeed, 80% of London office space will need to upgrade to meet the new EPC requirements set to come into force in 2030. If commercial landlords do not future-proof their assets, they will face their property being deemed unlettable, with local authorities able to take enforcement action against unlawful tenancies. This has huge implications for valuations.
In many cases, it is uneconomic or practically impossible to refurbish ageing stock, meaning a choice between obsolescence or knocking down and rebuilding. In the meantime, developers who have land-banked well can produce high-quality ESG buildings and steal a march on landlords holding problematic older property.
In the long run, there is a direct correlation between sustainability credentials and cost efficiency in owning and operating commercial real estate, further reinforcing the fundamentals behind the flight to quality.
Willem Janssen is director of national offices for the South East at Colliers, and Paul Frost is managing director of Puma Property Finance
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