As Morticia Addams, the fictional 1930s cartoon character from The New Yorker, observed: “Normal is an illusion. What is normal for the spider is chaos for the fly.” You can’t self-isolate against climate change and behind the three ‘Rs’ of reflation, reopening and reoccupation, buildings are going green — fast.
For REITs that think building wellness and energy efficiency credentials are just a box-ticking exercise, it may already be too late. They risk seeing their equity in 20th century buildings playing in injury time, ultimately to be stretchered off the pitch in 21st century markets.
The ‘E numbers‘ of Energy Performance Certificates (EPC) and Environmental, Social, & Corporate Governance (ESG) mean these new wellness and energy credentials are redefining commercial and residential markets. Formerly prime shopping centres are gas guzzlers but face bigger issues of rightsizing and rent resets, as well as the triple whammy of ecommerce, mid-range fashion retrenchment and the pandemic.
Offices are the big issue and we started buying London REITs Landsec, British Land, Derwent London and Great Portland Estates a year ago, despite high and rising vacancy rates. We think doubts about the future of WeWork will dissipate with its impending flotation via a special purpose acquisition company. This should reduce risk for flexspace operators, which account for 7% of the London market.
The hook for us was that less than 40% of London offices fit our post-pandemic wellness criteria with regard to access (elevators) and air-conditioning.
This means there is a shortage of suitable prime buildings, which is being exacerbated by the government’s 2030 deadline for all offices to be EPC rated A or B. JLL estimates that more than 90% of London offices are rated C or worse. The Ds might get a cheap quick
fix of double glazing, solar panels and grey water management, but the Gs will probably need expensive retrofitting.
Working from home, a possible downside to our case for buying into office REITs, is losing traction. A slew of banks and financial institutions and now Google and Amazon are restoring “office-centric cultures” with little post-Brexit shifting of headcounts to Europe.
Well and green offices probably already command a 10% rent premium, but the investment market is seeing indiscriminate buying at 4% yields. Boutique developers such as Derwent London, Great Portland Estates and Helical can’t find cheap stock to upcycle. Our London rental forecast for green offices has been upgraded to a contrarian 5% in 2022, while ‘brown’ office stock could see a -5% rent correction.
Pricing discrimination
Pricing discrimination is already here. The sale and leaseback of BAT’s 192,000 sq ft Globe House London HQ (EPC rated E) was marketed at £300m (a 4% yield) but the tobacco connection was possibly seen as a negative factor.
Brookfield’s uber-prime 850,000 sq ft 100 Bishopsgate is reportedly for sale at £1.8bn, or £2,000/sq ft. This ticks all the ‘E’ boxes and compares with British Land’s Cheesegrater and Landsec’s Walkie Talkie sales, at £1,850/sq ft and £1,900/sq ft in 2017.
Occupational trends are also positive for the right office stock. Helical completed the 88,000 sq ft Kaleidoscope in EC1 in December 2019 and let it to TikTok at 5% ahead of ERV. British Land pre-let 134,000 sq ft to JLL at 1 Broadgate for 15 years and Latham & Watkins forward leased 200,000 sq ft at 1 Leadenhall Street at an estimated £85/sq ft for completion in 2026. Tenant demand is increasingly being funnelled into a narrow section of stock with EPC A and B ratings, so the pre-let market could accelerate in 2022.
The economy is expected to rebound with 7% growth then settle back to annual 1.5% to 2.0% growth.
Central bank policy is expected to stay locked into the ultra-low rates upon which the real estate universe depends. We think there will be a hump in inflation over the summer and while nominal bond yields have risen, real rates are expected to stay flat, which is key to our ‘buy’ case.
Our REIT report ‘How green is my value?’ shows real estate is an indifferent inflation hedge. A chart of interest rates versus REIT performance looks like a blunderbuss fired at a barn door with little or no correlation.
The problem for REITs is that most have little or no inflation protection. Only sectors with structural support, such as logistics and supermarkets, command long leases with in-built rent escalation, which is a hedge worth having.
Mike Prew is managing director at Jefferies
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