What are the most important considerations when assessing office repositioning opportunities?

The key for me is the supply/demand dynamics of the city. Micro location within the city is important but, in cities with low supply and limited pipeline, peripheral buildings which can be properly repurposed to provide a USP in terms of ESG/Wellness and physical environment may work.

Physical constraints and building adaptability are also crucial. The asset must have the capability of providing what the market (occupational and investor) is looking for. Slab to slab height for increased mechanical ventilation, plant space to enable the change from fossil fuel to electric, adequate space for wellness, collaborative space, outdoor space and end of journey facilities must be capable of being provided, otherwise the building cannot be fully re-positioned. Whilst in low supply environments, occupiers in need of space may not manage to tick all requirements, investors in this space are more sophisticated and require a full suite of ESG credentials. Catering for this underwrites the exit and is crucial to development success.

We have witnessed a value correction in the office sector over the last 9 months. In your opinion, is this sufficient to make repositioning opportunities attractive, or do values have to fall further?

I don’t believe the “correction” has gone far enough, and I think Q4 2022 valuations should have been hit harder. In my opinion, secondary office values need to fall much further generally to reflect post pandemic demand and cap ex required to re-position. As ever, each asset should be assessed on individual merit, however there is already a 2 – tier market. Prime, well-let, new builds with strong specifications together with ESG and wellness credentials will trade well – absolute value being dictated by building quality, location, leasing profile and market dynamics. Even buildings delivered over, say, 5 years ago are over-priced (especially at valuation level), as they do not offer sufficient ESG credentials (e.g. they still use gas) and pricing does not sufficiently reflect the cap ex requirement, especially against the background of construction price inflation. There is a hope that, when inflation subsides we will see a drop in prices, but that “deflation” has rarely happened in recent history, except when there was sufficient distress in the construction market e.g. post the GFC. Lack of competition in the Scottish construction market doesn’t help!

Whilst appraising, everyone is attempting to “future proof” buildings which comes at a price, however, the speed of technological advancement will also provide a challenge! What is certain, is that the days of “light touch” refurbishment are “no more”. Many assets which are not capable of providing modern, occupier-led space will be subject to change of use. Smaller businesses occupying small floorplates still need space but most occupiers are now aware that they need to be in the most energy efficient space they can find.

We anticipate further polarisation in this market which will lead to a more pronounced pricing differential.

When looking at repositioning rather than ground up development, what ESG credentials are most important and what benchmarks are you targeting?

We would always look to target best in class credentials. With my aforementioned views on further polarisation, developers must be able to demonstrate market leading attributes. We look to EPC, Nabers, BREEAM/BREEAM (in-use), Wired Score, Air Score, “WELL” accreditation (accreditation is hugely expensive and “WELL” ready/compliant tends to be sufficient) and UK GBC Green Building Standards as benchmarks. Re-positioning existing structures utilising embodied carbon, may be the preferred route of many from a sustainability perspective, but comes with a “health warning” in terms of physical constraints and cost.

Given the evolving occupier market and move to more flexible working, do you think there is greater need for inclusion of flex space in larger office buildings and how do you appraise for this on exit?

Historically, flex space was an “afterthought”, down the pecking order from a traditional leasing offer, but also offered a solution for more compromised space, or for lower floors within existing buildings delivering increased “activation” on ground floors. However, larger buildings with an element of flex provision are now likely to appeal directly to building occupiers and help make tenants more “sticky” as they can readily flex up/down more easily, using the provision to grow or contract within the same building. 

In terms of pricing, a small percentage of flex space shouldn’t impact – there are other factors to consider whilst appraising such as lease duration, covenant, fit out etc but, overall, I am of the opinion this now forms part of a building’s overall flexible leasing strategy/re-positioning and should be looked at favourably.

When underwriting, which modelling variable is the hardest to be accurate on at the present time? 

Ha! Good question. Until the market settles – most require careful consideration – however, if I had to choose two, exit yield and construction costs. Leasing assumptions are more straightforward as these are dictated by the relevant demand/supply dynamics.

Construction costs still require margin for error, or suitable contingency, and exit yields remain relatively fluid. Rents are arguably one of the easiest inputs – we would only focus on cities with strong supply/demand dynamics, and are confident that larger occupiers are happy to pay for best-in-class product that can achieve a quality working environment with strong ESG and “wellness” credentials. This is essential for businesses to attract and retain talent going forward.

How are you finding appetite from capital partners and lenders for office re-positioning opportunities?

We work with a number of partners who are actively seeking office stock of this nature. We envisage this continuing in the short to medium term. Returns can be attractive for product offering genuine potential but, as ever, you need to choose your battles. Some stock is better suited to alternative use – in the case of vibrant cities with constrained city centres and low supply levels, conversion to alternative use only adds to the rationale for office repositioning, but the strategy has to be carefully thought through in order to create an end product that will perform. General appetite for office repositioning is certainly improving but demand is currently led by prime new builds, and a flight to quality for the best refurbishments in prime locations ie “the best and the rest!”. 

The lending market remains challenging, mainly due to the cost of debt relative to entry pricing and a negative cashflow while works are ongoing. Lenders are very focused on the sponsor behind the transaction, the business plan and, increasingly, proposed improvements to ESG credentials – both to ensure the end-product is “fit for purpose”, and to satisfy their own corporate agendas.

There is a drive to take repositioning and ESG credentials as far as economically possible to maximise and protect the exit position. Technological advancement means that a project planned now may easily be superseded during the business plan period. Intelligent use of capital is critical.