Deep Dive: Offices face a new era of change

The pandemic has changed how and where we work. But what does that mean for offices and how they will be financed?

The office sector is in limbo. Across Europe’s cities, employers are coaxing staff back to their desks after 18 months of covid-induced home working. Many companies are embarking on a hybrid experiment. As they do, they are pushing the white-collar world into uncharted territory.

A survey of lawyers, C-suite executives and human resources professionals carried out in May by employment law practice Littler found that only 4 percent believed employees who can work remotely would want to return to the office full-time. More than half of respondents were busy planning a blend of office and remote working.

Such planning creates huge uncertainty for office owners around the future strength of tenant demand and the impact on asset value. However, among those that finance offices, there is a belief that, with conditions attached, the asset class will remain bankable.

Real Estate Capital spoke to several property lenders to gauge their appetites for the challenged sector. The message was clear: offices will prevail if they adapt and improve. Covid-19, most agreed, is the accelerant of a long-overdue office sector upgrade.


Lenders unsurprisingly dismiss talk of the office’s demise. Data from the Business School at City, University of London, shows that many are exposed to the sector, at least in the UK. Of the country’s outstanding real estate debt at the end of 2020, 29 percent related to offices – the highest level of exposure – followed by residential at 20 percent.

This does not spell an immediate-term crisis, insists Nicole Lux, senior research fellow at the Business School and the report’s lead author. “Lenders are generally in at around 55-60 percent loan-to-value, so they will be covered even if asset values were to fall because of a drop in tenancy,” she says. “Even if rental income were to reduce by half, most lenders would be OK, because most loans have 2.5x interest coverage.”

Sharon Quinlan, head of real estate finance at banking group HSBC UK, says borrowers have continued to service their loans. “Rent collection has been very strong during covid, and leverage is low relative to previous crises,” she says. “So on that basis, I have no concerns about them right now, in the sense that they are all perfectly viable loans. But I feel the office sector has quite an uncertain outlook.”

Most of HSBC UK’s property loans have a weighted average lease profile beyond the loan term, Quinlan explains: “The real issue comes when you get those corporate occupiers that might have five or seven years left on their leases, but when there is a break option or expiry clause, they might consider whether they need so much space in certain locations. So, the concern is not right now. The challenge comes two to three years out.”

“The concern is not right now. The challenge comes two to three years out”

Sharon Quinlan

Cushman & Wakefield recorded a 35 percent increase, year-on-year, in Q2 2021 office take-up across the European cities it monitors. However, another consultancy, JLL, says the European Q2 vacancy rate this year – 7.5 percent – was the highest since 2017. In June, rating agency Fitch warned that hybrid working could hit prices and volumes for London offices over the medium term, as the city becomes a “renters’ market”.

Peter Cosmetatos, chief executive of the Commercial Real Estate Finance Council Europe, believes it is too early to estimate the scale of covid’s impact on offices. “It is at least another year, possibly more, before we are ‘post-pandemic’,” he says. “It is only from that point you can start the clock on another two-to-four years during which new norms around how people work are likely to settle. Today, no-one knows what the office occupational footprint and configuration requirement of businesses generally will be after the pandemic is well and truly over.”

In the near term, Cosmetatos says the industry body’s members should weather the storm because of diversified exposure and conservative underwriting in the current cycle. However, he adds that a slow-burning crisis may be seen in parts of the market over the medium term. “While newer, well-located buildings should have a bright future, a growing divergence between ‘the best and the rest’ is likely,” he says. “Many office buildings in less economically dynamic locations will struggle to attract the capital required to avoid obsolescence.”

For Alexander Oswatitsch, head of real estate debt for Europe at Frankfurt-based asset manager DWS, the future of the office is uncertain. “Everybody gets the logistics story,” he says. “But on offices, peoples’ views range from doomsday scenarios to those who believe there will be no substantial change. We believe the office will remain a key asset class because it is a place where people come together to re-establish the core of their companies.

“We always look at the worst-case scenario, so we are taking that even further. Mezzanine office loans have been more difficult to underwrite because we have had to review so many more scenarios.”

Office market conditions remain uncertain, agrees Jérôme Gatipon-Bachette, co-head of real estate finance at French investment bank Société Générale. “A significant number of tenants have been in waiting mode since the beginning of covid as it may have had an impact on their own business,” he says. “They need a period to assess that impact before making any decisions. So, the question for me is, will their conclusions lead to an adjustment of the way they configure their office space?

“We are reviewing situation by situation, thinking about ‘what ifs’. Our analysis relates to the potential for the future evolution of an asset – and how can we identify or be sure an asset proposed to us will be sustainable.”

Office 2.0

Lenders believe office financing will become far more selective, as occupier and investor demand focuses on quality, sustainable buildings.

“One of the things that we have seen and continue to see is a bifurcation in the market,” says Alexandra Lanni, head of investments, credit strategies, for manager CBRE Global Investors. “There is no ignoring the fact that the ESG [environmental, social and governance] credentials of investments for investors, and of space for tenants, is something which is very front and centre in terms of peoples’ agenda, particularly for the kind of product we aim to lend on – as close to institutional as possible.”

Germany’s DekaBank lends against prime offices and Chris Bennett, head of its London branch, says scrutiny of assets’ ESG credentials is essential. “Covid is clearly an accelerator for the discussion around how people will use space in future,” he says. “But if you think about all the other relevant factors that are materially influencing the office sector, one of the biggest is sustainability. The impact of meeting current and likely future sustainability criteria is a factor that, as a lender with a typical five-year-plus time horizon, you should have been thinking about anyway.”

To stay relevant as the world emerges from the pandemic, lenders believe landlords need to undertake capital expenditure to bring their properties to the standards of sustainability and wellbeing that occupiers will demand. Offices as long-term assets are no longer a passive investment, Bennett says.

“If you are financing a building where the primary motivation to lend is based on the income stream from the day one lease, then I would suggest that is a dangerous strategy, because you might find there is more volatility in the value of that investment than you would think,” he says. “If you are financing, or you own a building which is and which will be relevant from an occupational perspective, including meeting sustainability criteria, then it is fine.”

CREFC Europe’s Cosmetatos says that, amid the uncertainty ahead, the only certainty will be the importance of ESG: “What we know is that over the next decade and beyond, there is an enormous amount of climate-related retrofitting that needs to be done to office buildings on top of other adaptation costs required to attract occupiers. The big question is: are investors and lenders budgeting for substantial capex requirements between now and 2030?”

It is a question that is becoming fundamental in modern office underwriting. For some, it means baking financial incentives into loan deals, to encourage occupiers to see capex plans through. For example, the commercial real estate lending division of asset manager Aberdeen Standard Investments plans to offer margin discounts to all sponsors, pegged against upgrade targets for properties.

Martin Barnewell, investment director with the team, says: “If you look at a grade B, second-hand office in the City of London, where vacancy is up, unless that landlord has a real plan for how to transform that asset, to make it more environmentally friendly, then in three or four years’ time, when the loan is maturing, that is the single biggest risk to a lender.”

Underwriting is taking longer, he adds: “We always ask ourselves, ‘Is this going to be a stranded asset?’ So, when we talk to borrowers, the first question we ask is, ‘What is your plan for this asset?’ I don’t care if it is let for six years to a good covenant. What is it going to look like in five years’ time, when there is one year left on the lease?”

“When we talk to borrowers, the first question we ask is, ‘What is your plan for this asset?’”

Martin Barnewell
Aberdeen Standard Investments

Applied to office property, the broad term ‘sustainability’ can be difficult to classify. But some argue the term is a catch-all for properties that are set to meet upcoming environmental standards, that  are located where long-term demand is likely to be focused, and that have the amenities occupiers will require to attract staff. If an office property ticks those boxes, lenders argue, it should be defensive loan collateral in the years to come.

What about the rest?

If lender purviews narrow to the office market’s ‘best’ and most sustainable stock, will owners of ‘the rest’ struggle to source finance?

The Business School’s Lux has seen lending margins for UK secondary stock increase to reflect enhanced risk, with average pricing at 343 basis points for secondary offices by the end of 2020, up 30bps from the end of 2019. “It is not just about margins and LTVs at the moment,” she says. “There are lots of covenants, a lot of extra escrow accounts to cover capex and all the other cash that needs to be put into an account and not spent elsewhere.”

Across Europe, lenders are considering the strength of non-core office markets. German bank LBBW operates a prime strategy, and its global head of real estate, Patrick Walcher, says financing offices in Germany’s ‘B’ or ‘C’ cities would be a tough call for any lender now. “Ongoing discussions about home office and digitalisation make it very difficult to predict future demand in these locations,” he says. “If I were an equity investor right now, I would be cautious about new investments in B and C locations.”

However, Walcher adds that the movement of people out of major European cities to more suburban or regional locations may bolster the case for secondary offices: “It is too early to tell. But it could influence the long-term demand for B and C locations.”

The fact remains that there are many small-to-medium-sized companies across Europe that cannot afford, or do not want, the cutting-edge office space offered by major landlords. Will lenders’ focus on ‘the best’ leave the owners of the kinds of offices those businesses occupy financially adrift?

Not necessarily. Lanni says there is a case for financing smaller, regional offices, as long as they meet environmental standards and demand in their specific locations.

“There will be stock in the office market which, historically, you might have taken comfort from the fact it has a low break-even rent position, and it is cheap affordable space – there is still a place for that,” she says. “But it comes back to how resilient that building is in the longer term as more and more stock is improved and as the bar for quality stock gets higher, even for that affordable space.”

Lanni says the supply of good office space is constrained in some of the regional UK cities that CBRE GI lends in: “It comes down to micro-locations and understanding the delivery of product for a specific occupational market. For example, we have funded offices in listed buildings in Birmingham, where the intention is to deliver smaller floorplates because there is demand for them. Quality does not always need to mean a big, shiny office building. It just needs to be the most appropriate space for its market.

“Quality does not always need to mean a big, shiny office building”

Alexandra Lanni
CBRE Global Investors

“Where I get more worried is where more of an everyday affordable product is being delivered and it is not sufficiently differentiated for people to want to occupy it. I’m not saying we wouldn’t fund ‘the rest’. But we would need to understand how the rest is making itself as close to the best as possible.”

Gatipon-Bachette agrees secondary offices could be more difficult to finance. “That is where we will be more selective, and there may be some offices that are difficult to finance,” he says. “Overall, offices will become more capital-intensive to adjust to higher environmental standards, higher technological needs and a higher focus on sanitation. The big question is: will all sponsors have the resources to do the necessary investment?”

In a July report, Savills said that with limited grade A supply across Europe, available office space is likely to be concentrated in secondary stock that does not meet current occupier requirements in areas such as space and air quality. This, the consultancy suggested, will lead to more redevelopment projects in the coming years.

Some argue the increase in such value-add projects will create lending opportunities for the more risk-embracing lenders, such as debt funds. However, building owners are unlikely to find any lender that will not insist on a sustainable future for their collateral.

Still keen

Lenders Real Estate Capital spoke to insist that, despite a more selective approach, they will continue to finance offices. The shift towards ‘beds and sheds’, as the residential and industrial sectors are known, was underway pre-covid, but offices are still a mainstay of investment and lending portfolios.

However, owners of Europe’s poorer-quality office space are likely to face more limited financing options in the years to come. If such assets meet with lukewarm demand from occupiers, investors and financiers, repositioning plans are likely to be drawn up to find new uses for them – perhaps as homes, thereby gradually eroding Europe’s supply of secondary and tertiary stock.

For prime offices, sources in the advisory part of the market insist that lender appetite remains strong. Zoe Maurer, a real estate finance partner with law firm Addleshaw Goddard, says deals are being done, albeit on more defensive terms.

“There is a lot of focus around cash,” she explains. “For an investment loan, that means lenders are looking at lease events on the horizon that might have an impact on financial covenants. Lenders are very focused on projected interest cover and whether there will be income for the life of the loan.”

But Maurer says she is optimistic about the supply of debt. “If we were talking about a change to the office sector 15 years ago, when there was a narrow capital base in the lending market, I would be concerned. But because of the broad mix of alternative and traditional lenders, and the ability for lenders to invest from senior debt to preferred equity and go up the risk curve, I am hopeful there will be debt at every step of the way.”

Representing one of the newer lenders to the market, Imo Skrzypczyk, portfolio manager of European real estate for debt fund manager Tyrus Capital, says offices will feature in its strategy. “We will be more selective, with a focus on income-producing assets,” he says. “And for development, we would insist on there being pre-lets. But we will finance transitional properties, if there is a baseline of income to service the debt.”

The proof will be in sector origination volumes over the next few years. One London-based debt adviser, Jonathan Jay of Conduit Real Estate, reports significant investment activity in the London office sector, with lenders vying to finance investments: “On the transactional side, a number of very large clients are currently buying landmark offices. They all say the deals represent good value but need a bit of re-engineering.”

Jay goes on to say that the appetite to deploy debt against offices is stronger than the appetite to deploy equity for some real estate organisations: “One firm, which is both an equity and debt investor told us, ‘We are not quite ready to deploy equity in the office sector yet. But we are happy to lend.’”

DWS’s Oswatitsch says debt liquidity for offices has held up so far during the pandemic, far more so than for hotels or retail. He noted an increase in senior loan margins in the order of 25-50bps immediately after lockdowns were imposed, but says they have since fallen back largely to pre-pandemic levels for prime stock. Junior loan pricing, he adds, has been more volatile and remains higher than before the pandemic.

Theory of evolution

Société Générale’s Gatipon-Bachette believes that, while the case for some offices may need attention now given the uncertainties, the market will evolve and adapt. It has happened before, on a market-level basis, he says: “In Amsterdam, vacancy was very high after the 2007-08 financial crisis. But the municipality pushed for the conversion of assets into residential, and so Amsterdam is now a much stronger office market than it was.

“Conversion of offices into different purpose buildings could be a natural regulator of office space.”

A reckoning is due in offices. Some assets will pass out of favour and require repositioning. Owners will also be required to invest in their products to ensure they appeal to tenants, investors and lenders. But if office properties do hit the standard expected, lenders insist they will be there to finance them.

Bennett says DekaBank has a long-term commitment and belief in the sector, but it will be more careful about underwriting offices to ensure ongoing occupational relevance. Ultimately, he says the onus is on office owners, which can no longer sit back and expect their properties to attract steady income. “You do need to understand and to have properly underwritten your asset,” he says. “The market will no longer bail you out.”

More flexible leases

In recent years, office leases have got shorter, partly due to the rise of flexible workspace operators. Some believe covid will create a renters’ market, with more flexibility. But lenders argue they are prepared.

“Years ago, we could have expected to write 25-year, FRI [full repairing and insuring] leases, but that has not been the case for a long time,” explains HSBC’s Sharon Quinlan. “The change had already started before covid. Banks have already adjusted to less security of tenure.”

CBREGI’s Alexandra Lanni agrees: “There is no ignoring that there is an element of flex in the terms of lease durations, but that just keeps all parties focused on ensuring the landlord and tenant relationship is strong. As a lender, just because a lease has a two-year duration does not necessarily make it difficult to finance. You can look back and see how many times the tenant has renewed to get a sense of whether they got a good service from the landlord.”

Re-letting risk underpins any office financing, argues DWS’s Alexander Oswatitsch: “Continental European markets typically have shorter leases than the UK, so it is down to the lender looking at the specific assets, including supply and demand in the immediate market, to manage micro-risk.”