While flexible working arrangements could reduce office demand by 15-20% over the longer term, office space will still be required. Larger corporations will need time to comprehensively assess their office footprint requirements. How we use office space in the future will be different, though. There will be more collaborative space rather than work stations, and occupiers will demand higher wellness standards.

FACTS-fit?

We use the FACTS – flexibility, amenity, connectivity, technology and sustainability – framework to evaluate how future-fit an office will be. The framework is also used to assess how any proposed value-add work can enhance an asset’s FACTS score in a holistic manner. This will ensure its competitiveness over the longer term. Ideally, investors would want to target a well-balanced building that scores well in all five categories, but that may not always be possible, given pricing and refurbishment considerations. Knowing what to prioritise is key. Targeting non-core assets in core locations may help, since the location itself will likely enable the asset to tick many of the right boxes under ‘amenity’ and ‘connectivity’.

Meeting sustainability targets

Apart from enhancing occupier experience, a FACTS-driven, value-add strategy would also address the rising demand for sustainability (the ‘S’ in FACTS) targets. According to JLL, nearly 70% of respondents in its 2020 investor survey selected sustainability and climate change as the long-term trend that will have the greatest impact on UK real estate. This compares with just 7% of respondents in the 2019 survey.

Sustainability targets could be raised further through regulatory changes as we move closer to 2030, and this could hasten the unsuitability of existing stock. In the UK, for instance, a building cannot be occupied by 2023 if it has an EPC (Energy Performance Certificate) rating of below E, but this could be tightened further. It is estimated that 80-90% of London’s commercial buildings are EPC rated C or below, which puts the majority of buildings at risk.

Even the best-in-class buildings today are unlikely to meet the sustainability demands of tomorrow. But a thoughtful and comprehensive value-add strategy will position the asset ahead of the curve in terms of meeting sustainability targets.

Rent premiums will increase

The bulk of future office demand will be focused on FACTS-fit offices. We expect the rental premium that FACTS-fit offices could command over core offices will increase from an initial 10% to 22% by 2030, which will justify the refurbishment costs. The rental premium and the savings on ongoing capital expenditure will also translate into higher valuations.

We also expect the additional cashflow to translate into a yield increase of around 10 basis points (bp) a year. By 2025, we expect FACTS-fit offices to command a yield premium of 30bp; by 2030, we expect this to increase to 80bp. Based on our estimated cost of a FACTS refurbishment (around 24% of the initial purchase price), our estimates suggest the return on income could be more than 25% over an investment period of seven years.

In addition, government grants and subsidies could be made available for projects that meet certain sustainability targets. And lower-cost ‘green’ financing options may become available.

Future-proofing assets

Leasing demand will focus on future-fit offices after the pandemic, while less competitive assets will struggle. This will result in an uneven recovery and possibly a two-tiered market. Enhancing occupier experiences and being ahead of the curve in meeting sustainability targets will be key. A value-add strategy will therefore need to have a greater emphasis on future-proofing assets by targeting a FACTS score of at least 75%.

Considering core office yields have remained relatively stable, or even fallen in some instances despite the pandemic, there is an opportunity for investors to move up the risk-curve in order to generate better risk-adjusted returns. The good news is that value-add opportunities appear to be surfacing in selective markets. More opportunities are likely to emerge over the next 12-24 months as vacancy risks increase.

This is the second in a series of papers where we look at the future of offices.