Steve’s blog – Thoughts on valuation12/02/2015
The world of work has changed. A combination of technology and globalisation has forced most businesses to become more agile in order to compete for customers. In the commercial office sector, although the welcome benefits of cyclical recovery apply to some metrics, the requirement for flexible real estate is a structural change in the behaviour of occupiers which pre-dates the financial crash. In 1991, the average length of a lease was over 20 years. In 2013, the average length of a lease was less than 5 years. This decline in the initial guaranteed value of office leases has been slow and steady, and represents a quiet revolution in the economics of offices. This structural change in occupier behaviour has implications for the valuation of offices. Of course, the traditional valuation models continue to work well for those parts of the market which value certainty of tenure over flexibility. The rising headline rents for Grade A space in Zone 1 indicate that there is more demand than supply. In this niche market, the traditional model of valuation works well and underpins the current high levels of investment. However, the majority of the UK commercial office occupiers are not in the market for long-term leases in Grade A space in London. Most businesses in the UK are in a constant cycle of driving down operating costs, increasing the quality of their products and services and matching their fixed costs with their guaranteed income. The traditional long-term lease does not provide sufficient flexibility for these businesses, so they have done what all customers do in all sectors and have voted with their feet. The inexorable decline in the length of leases has been matched by the explosive growth in the serviced office sector and flexible working patterns. As the ‘Facebook Generation’ assume decision-making roles in business and as mobile technology continues to force change into the workplace, it is inconceivable that the commercial office market will do anything but become even more flexible. Indeed, in a recent survey of small business commissioned by Citibase, we discovered that 60% of small businesses would not take a lease for more than three years and 100% would not take a lease for more than 5 years. So what are the implications for office valuation? Short term leases create a very high level of friction costs. On agreeing a new lease, the costs of marketing, agency fees, and legal fees all have to be spread over a very short-term of guaranteed income. This short-term means that dilapidations and rent reviews are difficult to impose on occupiers. Should the occupiers move out, then the costs of voids between short-term lettings become large relative to the guaranteed income. In this environment, some of our valuation colleagues have argued that an empty building with the promise of a long term lease carries a higher valuation than a building full of cost-conscious small businesses with flexible terms of occupation. In this environment, owners of secondary offices may be dissuaded from matching their offering to the needs of the occupier market as it could devalue their asset and possibly threaten banking covenants. Consequently, office buildings remain under-utilised and the serviced office sector continues to grow. Ultimately, all businesses, including property businesses, only have value if there is demand for their product from customers. If a business does not provide the products and services required by its customers, then the customers will vote with their feet. The majority of commercial office occupiers require a level of flexibility which puts pressure on the traditional model of valuation. Accommodating the mega-trend for flexibility within a valuation model which does not destroy value, will become one of the most challenging aspects of the next few years.