Long leases — or, at least, the security of the tenant — come at a premium. That premium is for a depreciating component because, as markets return to normal, the lease length will shorten and risk aversion will reduce.
At that time the premium pricing will, we believe, switch from being dependent on tenant quality and lease length to location and building quality.
But, in the short term, voids remain the most significant risk.
The question is how to manage that risk. One solution is to defer that risk for about three years by undertaking speculative property development.
This may sound like a higher risk than investing in a property that has an income-paying tenant — and, indeed, the prospective developer’s profit would suggest it is. But this downturn is very different. The balance sheets of businesses — and potential tenants — are in remarkably good shape.
Occupiers typically have the ability to expand or relocate to more efficient premises, they just often lack the willingness, given the economic risks and business uncertainties.
Committing to a development is predicated on the idea that the market will have improved in, say, three years’ time, when the risk will be lower.
There is never an obviously “good” time to start a development. Indeed, the replacement cost of a building — a measure so beloved by “defensive” investors — is above the market value for most of the cycle.
That simple measure tells us that, by some estimates, the window of opportunity to start a development and gain a profit commensurate with the risks can sometimes be no more than six months.
Start too early and you face the prospect of insufficient tenant demand to achieve the required rent. Start too late and you run into competition from completing schemes that force up incentives and reduce the rent achievable.
It is a risk at which most non-property businesses would baulk. But the rewards are high: IRRs (internal rates of return) for successful schemes typically exceed 20%, and frequently more than 25%.
Perhaps the best example of office development potential is the City of London, but other dominant European cities also offer opportunities, provided they have the following characteristics:
That may appear counterintuitive and is certainly not what an investor would necessarily seek. But a strong cycle provides an entry point when rental values are low — likewise the costs of the development site — and the potential for a very significant uplift during construction.
Such businesses naturally want to locate in centres with agglomeration and profile benefits, such as access to skilled workforces. The City is of interest because, although prime rental values have recovered by more than 20% from their trough in September 2009, they are still 20% below their peak.
A reasonably cautious development appraisal might take today’s rental value and yield (£55/sq ft and 5.25%), although a well architecturally designed building should be able to beat the “average prime”. A more aggressive approach would be to take into account growth between current values and what would be expected when the building is completed.
That would not be an unreasonable perspective, given there re an estimated 8.7m sq ft of active requirements in central London. Admittedly, calling this figure “active” might be stretching the use of the word as, although it is real demand, commitments are still being deferred until the economic and business climate becomes more conducive.
But it is a very significant accumulated demand. Buttressed by upcoming long-lease expiries of older buildings, this demand will be unleashed when conditions start to get better.
The occupiers will face difficulties. Although there is nearly 3m sq ft of new supply available to lease, there is only just more than 2m sq ft of speculative office space due to be completed in 2012 in central London. Net new demand from the financial and banking sectors will be weak this year, but we believe demand from elsewhere will be sufficient to absorb this new supply.
From the tenants’ perspective, the choice of available stock will not improve in 2013 and 2014, and a maximum total of only 5m sq ft of new offices is expected to be completed in those years.
The cumulative speculative supply of space under construction between 2012 and 2014 will amount to just more than 7m sq ft, which is short of the active requirement volumes.
There is still time for new schemes to be initiated for completing in 2015, and this would make up the difference in supply. Those should be relatively safe. But after that, there will be an increasing risk of oversupply and we would be wary of developments completing in 2016 or later.
Anne Kavanagh is global head of asset management at Axa Real Estate