In this episode of the Market Lens Podcast, Tom Wallace, CEO of Re-Leased, and Andrew Knight, Global Data & Tech Lead at RICS, look at how some commercial landlords are adopting innovative approaches to ensure demand for spaces while others are being left behind. They also discuss the impact of shortening lease lengths in the UK office sector on valuations and how to approach adaptive reuse.
Listen to the full episode here:
Here are some key insights from their conversation:
Data from Re-Leased has revealed that from Q1 2019 to Q1 2023 there has been a substantial 34% decrease in office lease lengths in the UK.
Moreover, leases spanning over ten years are down 70%, while shorter leases, defined as 12 months or less, now account for 48% of all office leases. This indicates a notable shift towards shorter and more flexible lease arrangements.
This is not solely a result of the pandemic but rather an ongoing trend. Factors such as the rise of startups and firms seeking to avoid long-term commitments, uncertainty surrounding hybrid work models, and a preference for higher-quality locations with superior ESG ratings have contributed to this change.
The implications of these trends are far-reaching. From a valuation standpoint, shorter lease terms introduce uncertainty into income flows for income-producing assets, making accurate property assessments more challenging. Additionally, determining real effective rents becomes more intricate, as rent-free periods and fit-out premiums have a more significant impact on the value of shorter leases.
Landlords and asset managers have recognized the need for active management to maintain properties' attractiveness to potential tenants. This includes addressing ESG compliance and reinvesting a portion of rental income to ensure the asset's success. Landlords have a vested interest in actively managing their properties to retain tenants beyond lease periods, so that they avoid lease breaks, and can negotiate higher rents during rent reviews.
The flight to quality and the growing demand for ESG-compliant spaces have given rise to new market entrants, such as WeWork. Surprisingly, traditional landlords have been quick to respond, offering higher-quality and more flexible spaces to cater to evolving tenant needs. Contrary to expectations, many traditional landlords, such as Great Portland Estates, have successfully embraced flexibility in leasing options.
Investors and valuers must now consider various indicators beyond guaranteed lease tenure, such as tenant satisfaction and renewal rates, to ensure stable rental income. Property valuers also rely on comparable evidence to assess properties with shorter lease terms, such as the market performance of similar, to make judgments about the property's value.
Additionally, the trend has opened opportunities for the conversion and adaptive reuse of heritage buildings, which can still retain their historical facades while undergoing significant refurbishment to meet modern demands.
The future of commercial real estate will involve evolution and adaptation, similar to how physical retail has had to coexist and work alongside e-commerce. High-quality office spaces in attractive locations with mixed-use elements are likely to thrive, and physical experiences will continue to be valued and play a significant role in the industry.
