Repositioning the RE fund towards London Office

@helicalplc, @BritishLandPlc, @WorkspaceGroup

During 2023 I repositioned the fund's primary investments towards London office properties, with a particular emphasis on exposure to development and flex offices. The daily liquidity afforded by investing in listed real estate allowed the fund to realign its core holdings in 2023 towards assets that I perceive to have greater potential for appreciation. Consequently, over 50% of the fund is now allocated to UK office properties, with a particular focus on London.

The immediate future of office real estate may appear uncertain. Despite being currently overlooked due to the work-from-home revolution, along with relatively high vacancy rates and a subdued macroeconomic outlook, it might seem tempting to adopt a pessimistic stance. Three structural factors are poised to shape the office markets in the medium term: shorter leases, a growing embrace of flexible offices, and increased demand for environmentally friendly office spaces. These drivers are expected to lead to a rise in lease expirations and drive a shift towards newer office spaces. However, the availability of such spaces is limited, setting the stage for potential challenges in meeting future demand.

The rise in interest rates prompted a repricing of office assets across the UK throughout 2023. Prime yields in all office markets monitored by CBRE ended the year higher than in 2022, with an average yield expansion of 75 basis points across the UK office markets. CBRE forecasts that the Bank of England base rate has likely peaked and will remain steady at 5.25% throughout the first half of 2024. However, they believe there is a tangible possibility of rate cuts in the latter half of the year, with base rates projected to end around 4.75%. Transitioning from an environment of anticipated rate hikes to one of expected rate reductions will impact the cost of debt. The full cost of debt for prime stabilized office assets is forecasted to decrease from 6.9% in Q3 2023 to 6.2% by the end of 2024. As interest rates decline, UK office yields are expected to stabilize throughout 2024 and begin to compress in most UK office markets from the second half of the year onwards.

Following significant growth in 2023, UK office-based employment expansion is anticipated to stall in 2024 due to the repercussions of interest rate hikes on the economy. Despite this, uptake in the the office market is projected to rise in 2024 compared to the levels observed in 2023, driven by a reduction in macroeconomic volatility.

Vacancy across the greenest properties was 0.8% in London. The growth of London office space has been slowing, and only a small percentage of development under construction is still available for letting. According to JPM, only a third of the developments delivered until 2026 are still available. This should benefit the developers with an active development pipeline.

Leases are getting shorter

According to JPM, an average lease tenure shortened in the last 15 years from 10 to 6 years, a trend that will probably not revert, benefiting the capable operators of flexible space. Shorter leases will help shift tenants into modern and green buildings.

Flexible space

The shift to more flexible office space is obvious in the market. Operators in the London office sector have been incorporating flexible workspace options into their portfolios for quite some time now. British Land and Storey have already established a presence across 296,000 square feet, while Landsec has launched Myo. Additionally, Great Portland is aiming to nearly double it from 15% of its portfolio to 26% by 2027. Worksapce Group's, the flexible office provider, occupancy is at pre-pandemic levels, with strong rent growth.

Shift to quality/Green building

Starting from April 1st, 2023, all existing commercial leases in England and Wales, must comply with Minimum Energy Efficiency Standards of E or above on an Energy Performance Certificate. As of February 2023, it was estimated that nearly a quarter of the inner London commercial stock might become ineligible for leasing from April 2023 due to non-compliance with this regulation. As a result, there was a continuous shift towards quality in 2023, with a surge in demand for top-tier, well-positioned, and environmentally sustainable buildings surpassing available supply. This trend partly stems from occupiers leveraging their office spaces to attract employees in a hybrid working environment. The heightened demand for premium spaces has led to a depletion in the development pipeline. As the development pipeline continues to shrink, competition for top-quality buildings will intensify, resulting in rent increases in the upper part of the market. markets witnessed new record headline rents in 2023, a trend likely to persist in 2024.

Creative space

London is a hub for creative industries. The creative industries, particularly those with US headquarters, have exhibited a slower return to office post-pandemic compared to other sectors. Consequently, demand for new space from this sector has significantly declined from its pre-COVID levels. Since the lifting of lockdown measures, the share of UK office market take-up attributed to the creative industries has steadily decreased. In the 12 months leading up to the end of Q3 2023, it accounted for 13% of the market, nearly half of the pre-2020 average. However, several factors indicate that 2024 could mark a turning point in demand from the creative and tech sectors. Creative firms, while retreating from traditional office spaces, have increasingly turned to flexible spaces. In 2023, the creative industries represented 45% of all flex deals transacted by CBRE. Although the outlook for flex space demand remains positive in 2024, many creative occupiers are expected to seek more permanent solutions. Towards the latter part of 2023, several major US tech companies implemented stringent return-to-office policies, positively impacting office occupancy in their UK premises. Some of these tech giants will need to acquire new space in 2024 to accommodate the significant net increase in staff relative to pre-pandemic levels. US-based boards, previously skeptical about office spaces, are realizing that the challenges faced by the office sector in the US are not mirrored in Europe. Consequently, they are more inclined to engage in office leasing transactions in 2024 than at any point since the onset of the pandemic.

Work From Home

Prior to 2020, remote working was relatively uncommon, with only a small fraction of the workforce primarily operating from home. Despite a gradual increase over the years, remote work remained the exception rather than the rule, with the majority of employees commuting to their workplaces for an average of 3.8 days a week. However, the onset of the COVID-19 pandemic in 2020 abruptly changed the landscape of remote work. Lockdown measures forced businesses to quickly adapt to remote work setups, leading to a staggering 46.6% of employed individuals engaging in some form of remote work by April 2020. Yet, the shift to remote work was not uniform across all sectors and demographics, with the creative industries showing a slower return to office spaces post-pandemic, primarily due to changes in work culture. Despite challenges such as isolation and blurred work-life boundaries, many employees found the flexibility and autonomy of remote work appealing, with surveys indicating improvements in work-life balance for 78% of respondents. As the world emerges from the pandemic, discussions about the future of remote work are ongoing, with a growing consensus on the benefits of hybrid working - a blend of remote and in-office work. However, opinions vary on its long-term viability and productivity, and both employers and employees are grappling with questions about the sustainability of remote work, the necessity of physical office spaces, and the impact of remote work on organizational culture and employee well-being.

According to British Land, during the pandemic, employees demonstrated their ability to work from home effectively, and going forward, many expect to work more flexibly, raising questions about the role of the office. However, British Land believes companies believe that the office plays a vitally important role in shaping the brand and culture of their business, by supporting recruitment and training and fostering innovation and collaboration. Successful office space will likely be high-quality, modern, and sustainable, offer a mix of collaborative and private space, provide high-tech solutions to complement more flexible working patterns, and be well-located for transport hubs, retail, and leisure. This trend will accelerate polarization in offices. Space not meeting these criteria will become increasingly hard to let, negatively impacting rents those office rental values.

I believe that successful operators and developers in the prime London offices sector which provides for green, modern, and flexible space will emerge as winners when interest rates start to normalize.

The elevator pitch for Helical

Helical owns 6 modern prime office assets in central London and one smaller single-tenant listed property.

• Decent rent yield with upside from letting vacant space - The company is trading at a capital value per sq ft of £730 for its investment assets, with a large discount (50%) to EPRA Net Tangible Asset of 409p. Current low rent yield of 5.7% due to WeWork default and planned refurbishments. Full occupancy rent yield of 10.6% on prime London offices.

• Sustainable properties – Flight to quality – Tenants want the highest quality assets for their employees, and B-type offices are not enough to encourage employees to go back to the office

• Development upside – Pipeline of development: a 194,000 sq ft refurbishment centrally located which will be refurbished commencing 2024. Signed a JV with Transportation For London to develop 3 new developments totaling 600,000 sq ft.

• EPC – High Energy efficiency buildings A and B, meeting future regulations.

• Yield compression – Fully let portfolio at current share price reflects unleveraged 10.6% yield. Once let and stabilized properties will be recycled into future developments, crystalizing capital gains.

• Track record – Long and successful track record of project development

• Dividend –currently at 6.0%.

• Cost of debt – 3.3% fixed with an average duration of 2.5 years (as of Sep 2023)

The elevator pitch for Workspace Group

The company is trading at a low capital value per sq ft (£440) and at a large discount to NAV. EPRA NAT 832 vs. 500.

• The trend for shorter leases - It should benefit from companies’ reluctance to bind themselves for long-term leases. 

• Alternative usage - Properties should have good alternative usage providing a floor on valuation. 

• Capital recycling - Selling non-core assets acquired in 2022 as part of an M&A transaction (McKay) releasing capital for debt repayment and capex.

• Development pipeline -The company has a pipeline of properties to redevelop and increase top-line rent. 

• Occupancy - Occupancy is at a pre-pandemic level, allowing for rent uplifts, as evidenced in the last few quarters. 

• Low leverage - 35%

• Flight to quality – Tenants want the best assets for their employees, and second-tier type offices are not enough to encourage employees to go back to the office

• Dividend - Currently 5.15%

• Cost of debt - 4.1% and 76% fixed @4.1 yr average duration