Offices: Omens are mixed

The global economic slowdown has halted recruitment and often caused layoffs in financial services, telecoms, the media and even accountancy. Unfortunately for landlords this slowdown has occurred at a moment when many cities are seeing a spate of new construction on a speculative basis. As a result, office vacancy rates have doubled in the last 18 months virtually everywhere (except in central Brussels), and in many locations, especially out of town, they have trebled. In the worst affected locations – south Amsterdam or the London’s M4 corridor west of Heathrow – vacancy rates are now around 25 per cent.

Tenants’ market

All this means that there are some great deals to had by tenants. Not only have asking rents fallen, but rent-free periods have often doubled or trebled, landlords will offer fitting out, capped rent reviews – anything almost to secure a letting. Not since the early 1990s have the leasing cards been so heavily stacked in favour of the tenant.

Landlords warn the present position cannot last. The cranes have gone and new construction will be close to non-existent for the next three years. Vacancy rates are starting to stabilise and rental values are expected to do the same in 2004. How fast vacancy falls depends on the speed at which new office jobs are created. So the omens are mixed, with the US employment numbers giving few clues to how fast this economic recovery will reduce unemployment.

So is this a good moment for investors to be buying office property investments? Surely the bottom of the market cannot be far away and there must be some investment bargains around.

Well, no. Strange though it must seem, unless your fancy is an empty building, bargains are few and far between, despite falling rental values. Investors, led by the German open-ended property funds and US-backed venture capital groups, have been very active buyers of office buildings and portfolios of office investments across Europe in the last 12 months.

Buying frenzy

Further down the food chain smaller pension funds and private investors have also been keen buyers. The latter’s spending power has been fanned by the availability of cheap finance offered on high loan to value ratios. There have been plenty of sellers – life assurance companies and property companies, as well as major owner occupiers seeking to raise capital through sale and leaseback deals.

The two camps each see the market position differently. The sellers see the glass as half empty and have spotted what they believe is a golden chance to reduce their weightings to a property type that has become more cyclical than they realised and which has a much higher level of obsolescence than retail and warehouse property. They notice that while rental value may have fallen 20 per cent to 30 per cent, capital values are down only 5 per cent to 15 per cent. Many of the buildings they are selling could not be re-let for the rent that is currently being paid, so if the future income from the building is be maintained after the lease expires, rents must grow again and soon.

The buyers see the glass half full. They have a golden opportunity to invest significant sums at initial yields well above prevailing long bond returns and to gear with cheap fixed rate finance at below the income return from the property. Tenant covenants are, for the most part, sturdy, and the buildings will generally be modern or fully refurbished. They believe rental values will soon by rising again as the European economy recovers and the rental values will quickly recover they former levels.

Who will prove to have been the shrewder? The enormous growth in the European service sector over the past 20 years may have run its course and if it has, many European cities may have nearly as much office space as they will need in the coming decade. Rental values will grow again, the important question is how fast. My bet is that in five years hence those buying retail and logistics property today will have a higher return than those investors piling into offices.

Chris Turner is group fund manager of TR Property Investment Trust at Henderson Global Investors

‘Not since the early 1990s have the leasing cards been so heavily stacked in favour of the tenant’

Chris Turner, Henderson