Mass construction leaves NYC office landlords in a less promising position.
The rise in remote work due to the COVID-19 pandemic might have indicated office buildings would eventually become obsolete. Investors don’t appear to be too concerned, however, mainly due to construction, or lack of it depending on the city, The Wall Street Journal reports.
For example, the London commercial real estate office market looks to be especially promising because not too many new offices were built there recently. The lack of new construction should help CRE landlords in London bounce back quickly from the pandemic. Real estate investment trusts British Land, Great Portland Estates and Landsec both own office portfolios in London said their lease signings have increased during the prior three months through September. Additionally, the firms noted that their portfolios increased between 1.6% and 2.8% over six months.
Overall, office leasing in London was about 12% below average quarterly levels during the third quarter, according to real estate broker Knight Frank, The Wall Street Journal reports. However, tenants that were initially hesitant to add space while their employees worked from home are now beginning to sign new leases. Facebook recently signed of the biggest deals during that time as it took space in London’s West End.
Due to limited building supply, London landlords won’t have much trouble leasing space. CRE owners with more modern, energy efficient buildings that are in central locations will have the easiest time attracting tenants, however. Approximately 60% of London leases signed since the pandemic started have been for new or recently renovated office buildings, according to Knight Frank. Less than 4 and 10 were as successful prior to pandemic.
London’s current overall vacancy rate is 9.1%, per British Land, but it’s only 3.5% for newer, “prime” buildings. The top-notch office buildings only comprise 10% to 20% of London’s total portfolio and the city’s high-profile landlords own a majority of them, along with older buildings that can be renovated.
Prime building CRE owners can expect a lot of interest from tenants due to there being a limited supply. Construction slowed in 2016 because developers wanted to see how the U.K.’s “Brexit” vote would impact the city, according to The Wall Street Journal. The result of the construction slowdown is only 8 million square feet of new offices will be built between now and 2025. It’s projected that 4.7 million square feet will be leased annually.
Oversaturation hurts New York City office market
Meanwhile, New York has prime real estate like London, but unfortunately, too much of it. Office building construction has held steady in the Big Apple—25 million square feet of new office construction or major renovations are expected to occur in the Manhattan market, according to Franklin Wallach, a director at real estate firm Colliers.
The issue isn’t a lack of tenant interest. Manhattan-based corporate clients want to lease space in the more modern and sustainable offices. Landlords just can’t capitalize on the demand because there’s so much supply. Almost 17% of Manhattan prewar office space was available to rent. More than 18% of office buildings built since 2015 is available, according to Colliers data.
Majority of London CRE office owners need to update their buildings
London’s office building market looks promising for now, but the optimistic outlook could quickly sour if CRE owners don’t get their properties to meet upcoming government sustainability regulations, Bisnow reports. Currently just 4% of London offices have an Energy Performance Certificate that meets the energy use regulations that will go into effect in the United Kingdom in 2030. The requirements are part of the reason building owners have pushed to make their properties more eco-friendly—it’s not just about making them more appealing to tenants.
This isn’t some technical requirement — it gets to the heart of an existential overhaul currently ongoing in the London office market, precipitated by the need to radically cut the carbon society produces.
“On most property-related stats, like rental levels or vacancy rates, if you asked me to guess, I’d normally get within about 10%,” Patrizia Head of Transactions for the UK and Ireland Phil Irons told Bisnow. “When I was asked what percentage of London office stock would currently be obsolete by 2030, I said about 30 to 40%. When you find out that figure is 96% you just go, my God.”
Being forced to upgrade their buildings has led current CRE owners and buyers to ask how much they’re willing to pay for office space. Creating a “greener” office has financial benefits, but CRE owners have to weigh those benefits against the possibility of people not returning to the office post-COVID.
London’s energy use regulations explained
The UK’s current building rating system is called an EPC, which grades a property’s energy efficiency from “A” to “G” with “A” being the best, Bisnow reports. The new Minimum Energy Efficiency Standard legislation requires that all commercial buildings have an EPC by 2025. Buildings that don’t have at least a “C” rating by 2027 will be prohibited by law from being leased. A “B” grade will be required by 2030.
Right now, only 4% of London buildings that have an EPC had a “B” rating or better. Just 22% had a “C” or “E” rating, while 32% received a “D.” The remaining 21% had an “F” or “G” rating, meaning it’s illegal to lease them now. JLL’s analysis revealed that 90% of U.K. office buildings will need to be upgraded in order to meet government requirements as well as tenants’ and institutional investors’ demands.
The cost of a building upgrade
Investors are already thinking about office buildings due to the uncertainty that the COVID-19 pandemic caused, as well as how much upgrading offices will cost, Irons told Bisnow. The concern about upgrade costs stems from the price tag already exceeding other assets classes. A basic upgrade to make a building ESG compliant could cost approximately 100 pounds ($132.69 USD) per square foot, according to Irons. A more significant upgrade could cost more than 150 pounds ($199.03 USD) per square foot. At that rate, a 100,000 square foot building would cost almost $20 million (USD) to upgrade.
“The question is, do secondary offices go the way of secondary shopping centers?” Irons told Bisnow. “We’ve had painful experience of the value destruction that has happened in secondary shopping centers, where the decline from the peak is 80%. If you’d asked people that owned those centers five years, would they see an 80% drop, they’d have said no.”
CRE owners appear to have no choice but to upgrade
It’s not just government regulations forcing CRE owners’ hand to make their buildings more sustainable. Tenant demand is pushing the issue, too. While making these upgrades might be expensive and time consuming, they have a good chance to pay off in the long run. According to JLL data from 2019, London’s most sustainable office buildings have a rental premium between 6% and 11%. That premium is likely to increase as ESG becomes more of a priority for tenants as the pandemic subsides.
While the premium increase applies to the best new buildings, current buildings should also see a rental boost once they are upgraded and made more sustainable. If successful, real estate professionals and investors might see carbon emissions in a new light and prevent secondary offices’ from becoming obsolete. These current buildings have to be well built to begin with in order to survive, however.
“The greenest buildings are going to be the ones where you can reuse the embodied carbon (carbon emitted during a building’s construction and demolition),” Cushman Chairman for the UK and Ireland Digby Flower told Bisnow. “Embodied carbon could be the saving grace of secondary offices.”
In the past, when investors and tenants examined a building’s carbon footprint, they looked at emissions during its operation. Today, they’re also paying attention to what emissions are being created during construction. Renovating an existing building creates less emissions than building a new one since less steel and cement need to be created.
“People will take good buildings from the ’80s and early ’90s, buildings that have good bones, that can incorporate modern amenities and sustainable technology, and refurbish them,” Flower told Bisnow. “Those are going to be the most sustainable buildings, because they reuse the existing concrete, cement and steel. They are going to be the winners.”
Office buildings that aren’t in as good of shape might not be as fortunate, however. It’s hard to convert them into other uses and they’d be subject to the same environmental regulations anyway. If a property can’t be made into a sustainable office building, it’s unlikely it can be transformed into any type of sustainable building, according to JLL Head of UK Offices Research Elaine Rossall.
“There will still be a need to provide energy-efficient homes as well as offices, and there is the added cost of conversion to residential,” Rossall said.
Rossall also noted that the efforts to make office buildings more sustainable might be easier if it became more cost effective for smaller companies who happen to own a lot of the city’s office buildings but lack the capital to make the required improvements.
“The government need to think about ways it can bring smaller investors along,” she told Bisnow. “There needs to be a carrot as well as a stick, which might be making green finance available to smaller owners. The policy needs to be thought out to bring everyone on the journey.”