‘Is the office sector losing touch with reality?’ Steve Jude’s thought leadership article in Property News08/09/2014
According to the Federation of Small Business (FSB), last year SMEs accounted for 99.9 per cent of all private sector businesses in the UK (1), employed over 14.4 million people and had a combined turnover of £1,600 billion, with small businesses alone accounting for 33.1 per cent of private sector turnover.
The economy is being revolutionised by SMEs and entrepreneurs, yet the office sector has been slow to acknowledge the change, continuing to build new blocks with larger occupiers in mind. These blocks, with restrictive tenancy contracts, are also pushing smaller, yet growing, businesses away.
Looking at how lease trends have developed over the past couple of years since coming towards the end of the recession and, indeed, moving out of it, it is clear that there is a real trend for the majority of businesses opting to minimise their commitment periods. In 2004 the average office lease length was almost 12 years, in 2013 it was down to little over eight. More poignant, though, is that of new leases signed last year, around half were for between one and five years. It is no coincidence that this mirrors the rising presence of small businesses and start-ups (2).
While larger, established corporations can afford to opt in to long agreements with landlords, the markets that SMEs tend to operate in, change quickly and therefore it is difficult for them to forecast where their business will be in five or ten years, let alone one year. In order to run efficiently, SMEs need to respond to their markets quickly, expanding or decreasing when necessary, and will therefore demand greater flexibility and freedom from their working space.
Whereas big players are in the fortunate position that means if and when they grow they can take on another lease elsewhere – often combining the two sites at a later date – SMEs and entrepreneurs simply can’t afford these fixed costs and will therefore be looking for 12-18 month terms. So if the demand is there, why are many landlords reluctant to offer shorter leases?
In fact, ‘reluctance’ is probably under playing it. When you look at the fact that in the same period that the lengths of new leases have declined; the length of rent free periods that landlords are using to incentivise longer commitments has grown. The average rent free period for the office market in 2013 was 16 months, up from 10 months in 2006. The truth is that many investors actively try to discourage shorter leases and are seemingly willing to sacrifice valuable short term income, in return for long term contracts.
With a few notable exceptions, many institutional landlords would also rather allow their office assets to sit vacant, waiting to secure traditional long-term leases.
To most businessmen this approach seems illogical. However, the reason is simple and it comes down to a landlords’ priority to protect the long term value of a building, rather than generate cash flow. The reliance on the ‘investment method’ of valuation for commercial property places a huge emphasis on the predicted long term rental income that a property could generate for the owner to calculate the yield. If a space is unoccupied, the value will be derived from the last lease, so if a long term tenant moves out of 20,000 sq ft of space at the end of their 15-year lease, it is more valuable for the landlord to leave the space empty than fill it with a multitude of smaller businesses on shorter terms.
The problem is, the statistics show that the new big occupier is not waiting around the corner. Instead there is an abundance of small businesses looking for suitable space. It is all very well for landlords to try the waiting game, but the long term occupier is unlikely to materialise, which is increasingly the case in this changed world of business.
In adopting this valuation method, lenders and landlords are missing a great business opportunity to tailor their under-utilised, second-hand office space and lease terms to the different requirements of start-ups and SMEs, subsequently allowing them to maintain a presence in the burgeoning business hubs of many of our towns and cities.
More thought also needs to be given to the actual design of existing offices. As larger corporations vacate, landlords should seek to adapt the space for the next wave of occupiers. Traditional open-plan set ups suit large corporates, whereas the rising number of start-ups and SMEs require more flexible floor plates. Offices must provide different layouts, different size meeting rooms and communal break-out areas, which will encourage smaller companies to take on leases and therefore trigger the cash flow for landlords.
The world of work has changed forever and we need to take heed of our business community’s demands and offer under-utilised office space at more affordable prices and with shorter, more flexible terms. This will provide the foundation for the future of British business and support SMEs to grow and prosper at their own rate.
2 IPD Lease Events Report November 2013
About the author
Steve Jude is CEO of Citibase.