UK Office Real Estate: Faith, hope and clarity

A lot has been written about offices over the last five years. Many predictions have come true while others have been quietly shelved. 

Broadly, the market seems to be behaving in an intuitive way. There is bifurcation in occupier demand and rental performance and investors seem, in our observations, generally happy with a narrative that the good offices in good locations will do well, so buying these - or those which can become good - seems like a good strategy. We’ve seen few entertaining risks around B-grade properties in B-grade locations, unless there is a compelling change of use underwrite. Perhaps the main surprise, at least for us, was that rental growth has been OK. On MSCI, average office rents grew 3.0% over the 12 months to December 2024[1]. Although slower than the All Property average, that is not a collapse; we had expected poor offices to have been a bigger drag on this average.

We have previously written that we believed office yields were – on average – at about the right level to compensate investors for old and new ‘post-covid’ risks, including slower long-term growth and elevated depreciation as well as less empirically provable risks like weaker liquidity and transparency. We are still convictional on this, but it is worth getting under the skin of what such yields represent.

An initial yield tells you what an investor would pay for the current income stream less some non-recoverable costs incurred over a limited period. A reversionary yield tells you what they would pay for a fully market-let income stream. The equivalent yield (which commands most attention from institutional investors) is effectively a discount rate which describes the path from initial to reversionary. Less well used is the Net Operating Income Yield (NOIY). This deserves more airtime, in our view, as it is the ‘true’ income, after voids and other risks incurred, that investors have actually received; no assumptions are required. By way of example, an investor might think, based on recent experience, that they will receive £10 a year, from day one, on a value of £100 (10% initial) but be advised that that £10 has a market value of £20 (20% reversionary). The equivalent may be around 15% describing the journey between the two and the timings of uplifts. The NOIY will be a factual ‘this is what has been received after costs’ and may be more like £8/£100 or 8%. There has always been a big gap between the NOIY and equivalent yields at the all-property level and this gap moves around with the cycles, as the graph below shows.

The next graph shows the gap between yields at the sector level, and how this compares to ranges experienced over the same 20-year horizon.

Offices clearly stand out. What does this mean? Well, if we take a view that NOIY yields are ‘factually correct’, by definition it suggests there is a lot of ‘hope’ built into equivalent yields. In other words, one could argue that the apparent compensation – fair value - suggested by higher yields since the pandemic may be more illusory than previously thought.

But current market dynamics suggest nuance. Expanding on the first paragraph: rental growth has been good for high-quality offices. Indeed, PMA expect 3.1% p.a. for prime UK offices over the next five years[2], outperforming all property. And, because they are good offices, depreciation and cap-ex risks will likely be lower. We could also argue that, because they are good, they are probably being managed well and are less likely to experience void. So, if this holds, all important income leakage will be relatively stable and will probably not increase. The opposite remains true for that proportion of the market that is neither good quality or well located – and that will be where the ‘hope’ value in yields is greatest.

In other words, we still feel comfortable with our office market narrative. But what the gap between different yields does show is that we should not be complacent; there will be buildings that are fairly valued and sensibly underwritten and others which are relying on binary bets coming good that may end up disappointing.

For investors, we maintain a view that new targeted acquisitions populating an office portfolio that may be shrinking overall makes sense. But with two sides to every deal, investors should make sure the assets they are buying do not rely on faith that things get better, or hope that income growth meets expectations - and instead are underwritten on factual clarity. Let the other side do the hoping.

 
[1] MSCI Quarterly Digest, Q4 2024
[2] PMA UK Prime Forecasts, January 2025