Five years ago, we were stonewalled on our ‘sell retail’ theme, but after intu’s collapse and Hammerson’s £525m rights issue, it’s now a trade the shoeshine boy knows about.
Now, we are meeting the same resistance to our ‘buy London offices’ thesis, but we don’t think Zoom will do to offices what Amazon did to shops.
If tempted by prime shopping centres, ask yourself if Amazon has stopped growing. Intu’s Trafford Centre appears unlikely to attract bids now that banks are working through non-performing loans and rebasing valuations to clearing prices.
Covid-19 has moved e-tailing ahead by a decade so book your home delivery slots now as they’ll be gold dust in December.
Despite people working from home and London office rents falling, £3bn of the £6bn offices up for sale have traded at 4% cap-rates and within 5% of pre-Covid valuations.
This is all grade-A, ‘Covid-durable’ stock. The problem is older buildings with chugger lifts and air recycling, which need expensive retrofitting and are heading for distress.
Of the 12m sq ft of London offices under construction, 60% is taken, so scarcity is emerging and the pre-letting market is expected to be brisk. Modern offices we classify as Covid-durable make up around 40% of stock. The best estimates of working from home office market shrinkage seem to be 5% to 12%, so there won’t be enough room at the inn even on pessimistic estimates.
Flex offices account for 8% of the market and this is a solvent piece of pie on the assumption that WeWork is profitable next year.
The wild card is under-demand, as tenants shrink and act as ‘accidental landlords’ by putting surplus space on the market.
Negative net absorption, where offices have literally emptied out, has led to a rise in ‘grey space’ levels but it is lower than during the 2008 financial crisis and less than half the early 2000s peak, when London rents fell around 25%.
Our REIT memorandum ‘Make do and mend’ analyses the way trends in life science are now augmenting tech as the prime driver of growth, following Merck announcing a £1bn research hub and Google reportedly buying its £800m HQ in King’s Cross.
In San Francisco, where many of the tech giants originated, there is 1m sq ft of life science demand for every 100,000 sq ft of tech.
While private real estate funds are seeing inflows, public funds are not. This suggests that investors are voting against REITs’ management because execs lack meaningful ‘skin in the game’. Hammerson is now run by APG and Lighthouse and RDI by Starwood, which are forcing degearing as their returns are aligned with the equity, not high salaries.
Wised up and cashed up
Winston Churchill said: “Never let a good crisis go to waste” and the UK public real estate market’s over-arching problem is that it adopted the REIT tax-free status but not the REIT model.
It is a simple, cheap and flexible regime, but has been too heavily costed and is carrying too much debt and development. The problem is the driver not the car, but the drivers are changing.
However, after their ‘carry on regardless’ attitude in the global financial crisis, REITs have this time wised up and cashed up. Credit lines have been drawn down, and dividends and developments suspended.
We believe most can tough it out until 2021, when interest cover covenant waivers expire, with Hammerson papering over the cracks by offering more shares instead of a dividend.
Of the 12m sq ft of London offices under construction, 60% is taken, so scarcity is emerging
Property valuations are still a compromised view of reality, but RICS is grasping the nettle with a new committee to modernise the Red Book. Only sectors with structural demand – what we call ‘breads, beds, meds and sheds’ – have reliable net asset values.
As leases have shortened, with less rent to net present value, real estate returns are increasingly sensitive to sale values.
Perhaps only REIT non-execs should see valuations and not the execs whose compensation is linked to asset performance?
REITs experimented with high dividend distributions to buy yield support for their share prices, but that left the cupboard bare of cash to maintain buildings.
REITs are returning to capital plays, with dividends being rebased then paid at the minimum required by REIT legislation.
The tail doesn’t wag the dog any longer by holding obsolete retail assets for income in a losing battle of the dividends.
Mike Prew is managing director at Jefferies