Obsolescence or Opportunity?
The combination of changing work patterns, tightening regulation, and a greater corporate focus on ESG creates risk and opportunity for office assets. These pressures add conflict and complexity to the office's position and purpose. This tension has led to uncertainty and obsolescence entering the narrative with more vigour. So how did we get here?
4 minutes to read
From a functional standpoint, the rapid onset of hybrid working during and after the Covid pandemic has shifted the employer and employee mindset. Results, recruitment and retention dominate the demands placed on real estate, whilst attendance as a performance measure has all but disappeared. Offices are considered more in the context of a company's social, educational and collaboration objectives; thus, spaces that emphasise experience, support learning and well-being, and offer high levels of amenity are keenly sought-after.
The narrowing of the occupier lens comes at a time when physical obsolescence is also challenging market supply.
The Minimum Energy Efficiency Standards (MEES) stipulation will reduce office stock in the South East. From the 1st of April 2023, the scope of MEES extended to existing tenancies of most commercial property, restricting a landlord's ability to continue to let a property with an F or G rating. Whilst the impact on the office market in the South East was limited – around 6% of office space - its implementation fires a starting gun to enforcing a minimum EPC rating of C by 2027 and an EPC rating of B by 2030 in England and Wales.
The 2027 and 2030 milestones will potentially have a more significant impact on the market dynamics.
Analysis conducted in April 2023 indicates that 54% of office space in the South East fell short of the 2027 MEES requirement of an EPC rating of C or above. When considered against the 2030 requirement of an EPC rating of B or better, 80% of office space in the South East did not comply. Whilst these dates are some way off, both fall into the typical lease length for an occupier or hold period for an investor. Consequently, both occupier and investor interests may favour the compliant, much smaller part of the market, driving up rent and value.
Non-mandatory certification has entered the criteria.
While we acknowledge the minimum planning requirement is for buildings to achieve BREEAM New Construction of an Excellent rating, we have yet to see NABERS Design for Performance, the NABERS Energy for Offices rating scheme and BREEAM In-Use become mandatory. Interestingly, the existence of these certification types is increasingly featured in investor criteria.
Consequently, remedial or upgrade work examples will rise as the milestones approach and market pressures grow.
The focus on carbon reduction will mean that retrofitting over new development may grow as a preferred route to market for developers, thus limiting the environmental cost. A recent study comparing new build, conversion, and refurbishment found that embodied carbon emissions from refurbishment were at 2.1%, conversion at 10.3% and new build at 27.9% - 31.3%, illustrating the significant difference between adaptive reuse and new development. A good example of the preference for redevelopment is the Here & Now development on Thames Valley Park, one of the UK's first redevelopments targeting net zero for operational and embodied carbon. This ambition is set to be achieved through repurposing existing materials and using 100% renewable energy, among other initiatives, and has provided 145,650 sq ft of best-in-class space.
Economic factors may prove prohibitive. As of March 2023, the BCIS General Building Cost Index forecast is up 7.1% compared to the same juncture in 2022, while materials costs are up 8.1% over the same period. Both sets of costs are forecast to stabilise in the near term; however, the cost of labour will most likely continue to rise in the coming months and years to 2028.
Given the breadth of current and future drivers and the speed at which ESG is developing in real estate, it is clear that all markets must adapt. Investor and occupier focus is sharpening on ESG within real estate, with mindsets transcending any market turbulence. Supply chain issues, delays, and government regulation will not prevent the sector from pursuing an ESG-driven agenda, primarily due to strong market demand balanced with converging occupier requirements.
Rising obsolescence comes from a negative standpoint, but this could be considered an opportunity.
A few obsolete offices are strong candidates for conversion to residential, mixed-use or other kinds of space. In the South East, 41,020 additional net dwellings were added to housing stock across the region in the 12 months to March 2023, representing a 5.6% increase on the pandemic-affected previous year. Although a step in the right direction, this remains lower than the requirement for more than 50,000 homes per annum, using the Government Standard Method of calculating housing needs. Office conversion is tricky despite the shortfall, and examples are limited.
The best use of office space is as an office. Demand for high-quality space that supports the ambitions of the occupier is strong. The evolution to align market products to today's criteria will tighten office supply in the South East, presenting an opportunity. As conformity towards minimum standards becomes a reality, particularly in the case of EPCs and MEES, landlords might consider key environmental credentials as a point of differentiation. Only the oldest office buildings, and those least suited for the modern age of hybrid work schedules, will suffer the full fate of obsolescence. Newer or improved properties with amenities will continue to be profitable as office spaces.