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Bank Stress Means London Office Discounts May Not Be Deep Enough Yet

Even before the recent turmoil in the banking sector, the value of a big chunk of the London office market was falling fast.

The last three weeks have done nothing but help those assets become increasingly unloved.

“In the market, we’re seeing some big discounts, but that doesn’t reflect how deep the discount will have to be on some secondary stock,” Art-Invest Senior Investment Manager Jenny Harbord told the audience earlier this week at Bisnow’s Future London Office Investment and Development event. 

Colorminium's William Rabey, Core Five's Jon Spencer-Hall, GPE's Alexa Baden-Powell, Castleforge's Michael Kovacs, Art-Invest's Jenny Harbord and Hiris Capital's Laure Duhort.

Held at Quadrant and Oaktree’s YY building in Canary Wharf, a redevelopment of the famous Thompson Reuters office, Credit Suisse’s 540K SF London office building was visible behind the panellists at the event

With Credit Suisse needing to be rescued by UBS earlier this month, the backdrop was a physical manifestation of how uncertainty about the stability of banking is likely to further hit a sector wrestling with its own big questions — including how much office space companies will want in future and what type of buildings can provide that space. 

“I was at Expo [the property conference in Munich], and a lot of the bankers you talked to were already saying last October that they weren’t going to write any business for the rest of 2022,” Harbord said.

While it is too early to definitively say what the impact of U.S. and European bank failures will be, the consensus was that it will not encourage more lending. 

The lack of available finance coupled with uncertainty around pricing means investors that use debt are essentially out of the market right now, the audience heard. And that is weighing on prices.

“Value-add investors are on the sideline right now,” Hiris Capital Director Laure Duhort said, adding that has created an opportunity to start development now and deliver new buildings in a few years' time into an undersupplied market.

Duhort said the withdrawal of banks created an opportunity for debt funds to lend into the London office market to find the kind of returns normally reaped from equity, but from lower-risk debt. 

The fourth quarter of 2022 was the worst in two decades for the London office investment market, with just £365M of assets trading hands, data from CoStar showed. The first quarter has already seen several assets sell for sums rivaling or larger than the entirety of Q4 sales, including the £395M St Katharine Docks and the £350M One New Street Square, both bought by Asian investors. 

But there is the perception that values will have to fall further to tempt buyers to take the plunge, Harbord said, especially on poorer-quality assets.

MSCI estimated that values would need to fall 29% from October 2022 prices in London to bring deal volumes back to historical average levels, based on the difference between the prices buyers were offering and sellers were asking. London office values fell 12% in the second half of 2022, MSCI said, with City office values falling 14% and West End values falling 9%. 

Panellists reported that some vendors were accepting reality and offering assets at prices reflecting market demand, but only on the quiet.

“We’re seeing more stock off-market at the right price point, and we’re restocking our development pipeline,” GPE Investment Manager Alexa Baden-Powell said. “For the last few years, when it comes to development stock, we’ve been outpriced, but we’ve seen prices come down a lot.”

As always, whether something has been accurately priced depends on the quality of the building and, in major gateway markets, the quality of the building it can be turned into. 

Quadrant and Oaktree's YY building in Canary Wharf

A vast swathe of London’s offices needs to be upgraded to meet incoming UK government Minimum Energy Efficiency Standards and provide the kind of modern work environments corporate occupiers are increasingly demanding. 

That is creating a bifurcation in the market between assets that can be made fit for purpose and those that can’t. Current owners of London offices all think their building is going to be a winner. But not all of them can be.

“It’s akin to what happened in the retail market six or seven years ago. People in retail couldn’t see it at the time, but now they can see it with the benefit of perfect hindsight,” Castleforge founding partner Michael Kovacs said.

With average London office lease lengths dropping from 17 years in the 1990s to less than seven years today, the business model of office needs to change in much the same way the retail property business model has evolved, Kovacs said. 

Owners need to create high-quality HQ-style office buildings that attract bigger companies to sign long leases, he said. In the case of smaller buildings, owners must create assets that are multi-let to lots of smaller tenants on shorter leases, be fitted out by the landlord rather than the tenant, and be managed much like a flexible office operator. 

“The 40K SF building split across six floors in a semi-off-pitch location — if you try and manage that like you used to, you’re in trouble,” Kovacs said.

Castleforge is in talks to buy the soon-to-be-vacant Winchester House, the 317K SF former London HQ of Deutsche Bank in the City of London, for around £240M from the China Investment Corporation. Castleforge would undertake a refurbishment of the building and try to re-let it. 

There are still buyers out there for top-quality new assets. GPE’s Baden-Powell pointed to the company's sale of 50 Finsbury Square in the City, with the £190M price representing a yield of 3.85%. 

And while prices for some assets requiring refurbishment need to fall further, Castleforge's Kovacs said, for others, the economics look good. 

“Vacant possession values in the City were £1K per SF, and now you can buy at £700 per SF," he said. "Rents have gone up [for the best assets], and building prices have fallen.”