The UK office real estate market has been heavily impacted over recent years, both by the impact of COVID-19 on the dynamics of working life and by the changing economic environment for tenants and landlords pushing up the costs of borrowing, building and renting office space
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Yet, further pressures are also looking likely to increase the pressure on office stock going forward, following the minimum energy performance regulatory requirements coming into effect in the spring of 2023. With an array of potential roadblocks for property investors and management companies it is likely that we will see a transition within the office space, to adapt to trends and provide more services to remain attractive to new and retained businesses throughout the transition of ‘flight to quality’ within the office market.
Looking forward to 2023, one of the biggest potential headwinds is the Minimum Energy Efficiency Standards (MEES) regulations, which are a key part of the strategic approach of the UK government to significantly reduce carbon emissions, of which commercial property are some of the biggest emitters of CO2. Current MEES regulation has been in place since 2018 and requires buildings with new tenancies to achieve a minimum EPC rating of E before they can be let to new tenants; from April 2023 the same rule will apply to existing tenants.
The issue here is that almost 10% of London’s office stock currently has an EPC rating of F or G, meaning that as of April 2023 landlords will not be able to let new leases if the property doesn’t meet the required standards. This is likely to have an impact on investors due to the capital spend needed to improve rating levels to an E or better. Further regulatory tightening is yet to be had, with new minimum requirements stating an EPC rating of B or C by 2030. However, around 80% of London’s office buildings are below this minimum standard and will need to be upgraded by 2030, an equivalent of 15m sq ft per annum.
With much of the market likely to face strong headwinds over the next seven years, A grade office space looks to be well positioned within the market going forward. Following a focus in ‘flight to quality’ buildings over recent years, premium office space has become some of the most sought-after property across the UK.
Much of the demand comes as a result of high-quality, tailored fit-outs, allowing companies to lease space that aligns with company culture and provides an attractive, modern and exciting place to work, while promoting collectivism through group work areas. A further selling point are the additional services provided, such as concierge, security, corporate discounts to businesses within the surrounding areas, and other benefits.
Finally, properties that hold strong EPC ratings, which A grade offices do, are likely to yield lower energy bills, a smaller need for renovations and thus less disruption to tenants, longer lease life for tenants as they remain happy with the high-quality characteristics of the property and, finally, often a greater alignment to tenants’ environmental goals in reducing their carbon emissions. Because of this, A grade properties are able to command greater rents and tend to attract premier tenants, with limited default risk of rental payments.
Further market conditions within the space suggests that due to a supply and demand imbalance, grade A properties are likely to see an uptick in pre-let agreements, with 35% of space under construction being pre-let, and this is expected to increase as the year progresses.
At the other end of the spectrum, lower quality property such as Class B and C stock could possibly see a slowdown in leasing due to the poor quality and undesirable characteristics of these properties. Furthermore, depending on the EPC rating of these properties, a large amount of capital will likely have to be spent on not only improving standards of the properties, but also the attractiveness for future tenants given the competitiveness of the market. Following recent data, expectations for the average length of unoccupancy within the second-hand market is expected to increase in 2023 as demand looks weak against current supply levels for the lower quality property.
A further focus point for the year ahead from an investor standpoint will be prime yields, which is the annual return from property investments. In 2022, most UK office markets experienced an outward shift in prime yields, partly because of continued growth in prime rents drawing from the disparity within supply and demand and also from increased property upgrades allowing property managers to warrant an increase in rent due to greater quality office space. Despite positive uplifts in yields, capital values declined by 12.1% in 2022 following an unfavourable economic environment for property markets and rising borrowing costs as implemented by the Bank of England, following the rise in interest rates.
Therefore, given the level of market uncertainty over 2022, it has been estimated that approximately, only 30% of total potential investments in office real estate will transact within the current market conditions, with capital investment volumes expected to be 20% down year-on-year in 2023. If we are to see a recovery within the commercial office space in 2023, it is likely that we will also need to see interest rates reduce with inflation, office upgrades and increased EPC quality, continued demand for high quality stock and improved investor sentiment in order to see valuations increase and market growth to push forward.
Historically, office real estate has been an attractive opportunity for strategic investors to diversify a portfolio and capture healthy returns from their strong underlying fundamentals and long-term lease agreements. But, with valuations falling off considerably last year, it will be interesting to see how the office space fares over the next year, particularly in terms of yield movements, property valuations, and investor sentiment. If the UK economic environment settles and interest rates look to turn the other way, it could be quite possible to see a recovery across the industry as confidence levels rise, property prices gain stability and investment volumes return more positively.
This article was taken from the Winter 2023 issue of 1875. To subscribe to our investment publications, please visit
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