Can auctions save the office sector?

16th June 2023

Published by EG on 17/06/23

‘Distressed loan books will put major tranches of offices within reach of entrepreneurial property owners’

In recent weeks, the portentous verdict that ‘Offices could be the next Retail’ has gained currency as concerns have grown about the potential future obsolescence of huge rafts of workplace accommodation.

The label of being the ‘next Retail’ draws parallels between offices and the millions of square feet of shopping space which has for several years now faced an uncertain future – unless it can be repurposed.

In the same way that shifts in shopping patterns and the growth of online retailing clouded the future of retail, hybrid working patterns and new regulations around energy efficiency and sustainability are mounting challenges to the office sector.

There is still strong demand for new, Grade A office space as occupiers seek to ‘bake in’ sustainability and ESG credentials whilst also making their workplaces attractive in the ‘war for talent’.

It’s secondary and tertiary office space which is the most problematic and the primary option for this is either retrofitting or repurposing. Retrofitting to make a building compliant with sustainability requirements and the long-term pathway to net zero is only viable when the rents which the offices could command on completion makes the necessary capital expenditure financially worthwhile. Where this scenario applies, the big UK institutions are already assiduously retrofitting office stock – a move which increases the longevity of the assets, reinforces rents and also improves the owners’ ESG credentials.

However, for a large proportion of this country’s aging offices that is not an option and the only way forward is demolition or repurposing. The latter route requires substantial repricing from its current notional value as an office asset and that usually entails a change of ownership. This is where auctions come into the equation and their ability to facilitate this type of transition.

In fact, the collision between energy efficiency and value is not without precedent. Following the global financial crisis, there was a significant reduction in rents for secondary and tertiary offices. At this time, it was the capital expenditure required to replace obsolete mechanical & electrical building infrastructure services which was unviable and meant that many owners faced the same sort of problems that they do today. The situation back then was exacerbated as lease lengths shortened and asset management became more intensive. As a consequence, many UK institutions began to offload office assets whose values and management requirements meant they no longer fitted with the strategic objectives of funds.

This value shift also led to the proliferation of distressed loan books. In the period from around 2013 to 2016, we advised on the prices that could be achieved in the market for hundreds of granular assets on which ‘underwater’ lending was secured. This advice also took into account the uplift in prices that could be expected if asset management was carried out prior to a sale; the depth of prevailing buyer demand; and the probability of sale at different pricing levels.

And since the Government actively promoted Permitted Development Rights from 2015 onwards, there was a huge rush of redundant regional office properties that came into our auctions on the basis that they could be sold for residential conversion.

As a consequence of these trends, during the past decade, we have sold more than 6m sq ft of office assets. Whilst many of these were bought as standing investments, significant numbers were bought with a view to repurposing.

Since 2020, the volume of office sales by auction has halved as landlords concentrated on rent collection and lease renewals during the pandemic. Also, the upper size limit for PDR office-to-residential conversions was reduced to 16,000 sq ft in 2021. This will have limited the scope for some repurposing but, in the light of such dire prognostications for the office sector, it will be interesting to see if this is relaxed in due course.

During the past three years, lenders have tended to work with office asset borrowers rather than enforce loan covenants. However, we are now entering a phase where the long-term realities of hybrid working and the rigours of new energy and sustainability regulation will begin to bite. And it seems inevitable that a growing number of distressed loan books will once again put major tranches of office assets within the reach of a new breed of entrepreneurial property owners.

These transitions are a sometimes brutal but necessary factor in reshaping property markets and auctions play a unique role in bringing swift resolutions which capture best price in the market. New entrants to a sector – who have less existing exposure to it – bring fresh ideas and the level of their initial buy-in investment enables the kind of financial elbow room that makes implementing those ideas possible.

So, auctions can’t ‘save’ redundant offices but – as they continue to do across the retail sector – they will be able to make the sector more fit-for-purpose as a whole and generate new opportunities for investors along the way.