Among the hundred or more office developers and investors gathered in a Mayfair hotel in early February, it was possible to detect a sense of optimism that has been absent since Covid-19 first swept the UK in March 2020.
Conversations over breakfast flitted between the amount of cash targeting London workplaces to the record-high rents companies were willing to pay, and the difficulty in securing deals amid stiff competition. From the stage, hosts from estate agency Knight Frank posed a question: “are offices more in demand than ever?”
To anyone who has recently worked in an office surrounded by a sea of empty desks, it is easy to dismiss this as property salesmen’s characteristic braggadocio.
But, as governments in the UK prepare to end pandemic restrictions, reality is beginning to catch up with the confidence. Employers are signing up to costly new leases; investors are pouring billions of pounds into office blocks.
The activity is most pronounced in central London. In the West End, Google announced in February it was buying offices in which it is already a tenant close to Tottenham Court Road for $1bn. In the City of London, an £820mn sale was agreed this week for The Scalpel tower, which first went on the market in October 2020.
And in Canary Wharf, in what was widely seen as a vote of confidence in the future of the office by a major employer, Citigroup announced plans to give its iconic skyscraper there a £100mn, three-year refurbishment.
The trend is not limited to the capital, however. The £8.9bn spent on offices outside central London last year was the third-highest annual total ever recorded, according to estate agency JLL.
In December, NatWest paid £292mn for a block in Spinningfields, Manchester — the largest single UK office deal ever outside of London. In Glasgow, Edinburgh and Leeds, the recovery has been slower, but still discernible.
Yet all this activity amounts to an enormous, costly gamble that, post-pandemic, workers will still want to travel into city centres to do their work in lofty glass towers. In fact, what employees want — and are prepared to do — remains a mystery, almost two years into the pandemic.
“The reality is there is no evidence — the return to work has been too disrupted by Omicron,” said Zachary Gauge, head of European real estate strategy and research at Swiss bank UBS.
Even though the requirement to work from home was lifted in England and Scotland in January, the country is nowhere near being fully back to the office. During February, offices were on average less than 25 per cent full, compared with average levels pre-pandemic of between 55 and 60 per cent. One-third of UK workers say they haven’t been into the office since March 2020, according to a study by global risk management and insurance brokerage Gallagher.
This appears to be a particular problem for high-end central London. New FT data reveals that sales by retailers in the City of London were down by 55 per cent on pre-pandemic levels in January 2022. The area around Canary Wharf was down 45 per cent – a significantly weaker performance than business districts in other British cities.
More than one in ten roles advertised on jobs website Indeed last month were for entirely remote roles, an increase on December’s figures, according to accountancy firm Hazlewoods. Millions more jobs will, at least for the short-term, offer the option to work from home. In the US, a Pew poll found that 60 per cent of workers with jobs that can be performed at home said they would prefer to do that all or most of the time post-pandemic.
In the UK, the shift to hybrid or agile working has already slashed space requirements for some companies. Mat Oakley, head of European commercial property research at estate agency Savills, estimates that agile working will result in a 7-14 per cent reduction in gross office space need.
Real estate developers and salesmen who have weathered financial crises and 9/11 are outwardly confident. In private, though, there are signs of disquiet. One senior employee at a property group said they had been into the office every day this year, “because we have to pretend there’s a need for offices”. He bemoaned the relentless public optimism of his colleagues about the future of the office: “It’s astonishing quite how delusional some of them are about it,” he said.
But standing still and doing nothing also carries risks. Companies who decline to upgrade substandard offices risk losing talent to those who have made improvements, while landlords face being caught out by environmental regulation.
“The people who haven’t done anything for the last two years have missed the boat,” said Katrina Kostic Samen, head of design studio KKS Savills. “If it stays a bland office with rows of desks no one will come back.”
And if the property industry loses its wager, and vacancy rates spike then the repercussions will be profound — especially at the lower tiers of the office market, where occupiers have tried in vain to sublet millions of square feet at a discount during the pandemic.
Place your bets
In the hope of ensuring its gamble pays off, parts of the UK property industry are spending lavishly to rethink what an office can and should be — and, in the process, to lure staff back from their kitchen tables.
Developers and landlords are focused on three things they anticipate will give them the edge in a post-pandemic employment market; remodelling offices to better suit flexible working, thinking about how to design them in a way that promotes staff wellbeing, and lowering their carbon footprints.
Landlords at the top of the market, such as British Land, Great Portland Estates, Derwent London and Canary Wharf Group, are rejigging their portfolios in anticipation of a spike in demand for shorter-term, more easily reconfigured space from companies who don’t yet know where their staff will end up working in the future.
Shobi Khan, Canary Wharf Group’s chief executive, said the company would convert more of its buildings into flexible offices over the next few years in response to demand from occupiers, with an upper limit of 20 per cent of its estate.
Developers are also focusing on building working environments in which people are happy. “Very simply, when people come back the space should have been shaken up. People are asking for more colour, more freedom, collaboration booths or a doggy booth in the corner,” said Kostic Samen.
The highest-spec offices completed during the pandemic are replete with features intended to improve the lives of tenants. British Land’s newest development, 100 Liverpool Street, has a cavernous “interactive social lobby” and layers of outdoor terraces; 22 Bishopsgate, the City’s tallest tower, will have a climbing wall affixed to a 25th-floor window. AXA IM Real Assets, the building’s owner, describes it not as an office but as a “vertical village.”
“We’re working to make our offices more of a destination . . . As a result of feedback from staff, we’ve got more outdoor space,” said Ian Elliott, chief people officer at Big Four accountancy firm PwC. At the company’s newest office, Merchant Square in Belfast, “half a floor is devoted to wellbeing space where staff can go and get a massage or get their nails done,” he added.
For tenants, the first priority is very often green offices. While greater flexibility and a consideration of wellbeing are a concession to employees, companies with a public profile are under pressure from investors, customers and regulators as well as their own staff to improve environmental performance. “All new buildings will be sustainable; that’s table stakes. Every company is looking at that now, and if you can’t address that, you are in real trouble,” said Khan.
The overwhelming majority of London offices do not currently meet the energy performance standards that will be required by regulators in 2030. Those that do are in high demand, while those that don’t will require significant capital expenditure. As a result, environmental performance is increasingly being priced into office values.
“I’m company X and I’ve committed to be carbon neutral by 2040, so I’ll likely strike off my list the properties that don’t meet sustainability criteria. Let’s say five out of 10. Then I look at the best locations and specifications for attracting and retaining talent,” is how James Seppala, head of real estate in Europe for Blackstone, explains the new hierarchy of corporate priorities.
“Sustainability and competition for talent: those two priorities tend to be more important to many corporate occupiers today than the CFO’s aim to find the most cost-effective offices possible,” he added.
That process of elimination leaves a small selection of suitable offices. Companies can justify paying high rents if the office provides an edge in the war for talent because office costs are a fraction of wage bills — roughly 15 per cent and 55 per cent of total costs, respectively, according to a 2016 analysis by the British Council for Offices.
For some companies, having a good space and hoping staff use it might still make more sense than cutting back. Oakley, at Savills, describes touring the London offices of a global technology company earlier this year. Just one in ten staff were in the office, he was told, but there were no plans to downsize or downgrade. “They didn’t care — as long as people are happy coming into the office,” he said.
If the gamble fails
Those companies that are piling cash into mostly-empty offices to bring back staff are doing so more in hope than in expectation. There’s little evidence yet to suggest that newer buildings are performing any better in drawing people back to work. The Gallagher survey found that 32 per cent of business leaders in the UK reported resistance from workers towards returning to the workplace even part-time.
Developers forking out for upgrades today might also find they are superfluous in the future. “At what price point do occupiers say ‘we don’t need a yoga room and a scented candle’? There is a view that spending a lot of money means you will get the tenants. They might like it, but will they pay 10 per cent more?” said Gauge.
Experts say the landlords of older buildings, who either don’t have or can’t afford to make upgrades, are especially at risk. “If you haven’t got what occupiers want or an adaptable building, your building is reverting to dirt”, meaning its value will only reflect the price of the land it sits on, said Tony Gibbon, founder of commercial property agency BH2.
Older blocks in the hands of smaller landlords face a triple threat: falling demand from occupiers, rising costs to meet regulations and competition from flexible working companies such as WeWork or IWG. Combined, those factors could trigger massive value destruction.
“Let’s say we’re optimistic and occupancy goes to 50 per cent. That’s still lower than it ever was. That implies less need than there was. If there’s less need then someone’s space goes obsolete,” said Oakley.
Additionally, the cost of bringing offices up to acceptable emissions standards is only just being grasped by landlords and investors, but few doubt that the ultimate price tag will be huge.
In central London, with high rents and relatively modern buildings, those costs can be borne by well-capitalised developers and tenants. But in cheaper regional cities, the outlay to make a building green could dwarf annual rental income.
Inflation, which has already pushed up materials and labour costs dramatically and could do so further if there is a rush for environmentally-friendly products and specialist tradespeople, will make that burden harder to bear.
“Obsolescence has been underestimated in real estate generally . . . what’s happening in relation to the environment is exacerbating that,” said Daniel McHugh, chief investment officer at Aviva Investors’ real assets fund.
Even well-located, relatively modern buildings are at risk from falling space demands and rising costs. With investors looking for stable, secure income, a building like 30 St Mary Axe, opened in 2004 and better known as the Gherkin, might struggle to sell, said one real estate investment banker. “It’s an old building. Unless you get a trophy hunter its hard to sell . . . Institutional investors are not going to run into a burning building.”
Increasingly, commercial property owners say that the additional pressures of falling occupancy and higher environmental standards will cleave the market in two.
For investors, the challenge is judging where the axe will fall. Valuers have not meaningfully repriced older office stock during the pandemic, in part because there has been a lack of transactional evidence and tenants have carried on paying rent.
“When values are flat it’s not because they are not changing, it’s because there’s no evidence. Valuers are not factoring in high enough capex costs [to meet green targets], longer void periods and lower rents,” said Gauge. “We saw the same thing with retail before it started to fall down: a stabilisation while everyone in the market knew there were assets that were worth much less,” he added.
Working from home is not likely to hit office values as severely as the rise in ecommerce has hammered shops, he said, but the industry is underestimating quite how much it could bite later this year — at both ends of the market.
“My view is that the reason people aren’t going back in is not to do with the building, it’s the commute and the comfort of working from home,” Gauge added. “You can put as many climbing walls as you want in the building and it won’t change those fundamentals.”
Additional reporting by Michael O’Dwyer and Chris Cook in London