Pressures Facing The Office Sector Will Create A Very Different Definition Of Prime

Relationships between landlords and tenants are under extreme pressure. Although office tenants have paid more rent during the coronavirus pandemic than tenants in many other sectors, there is an inevitable market tension growing regarding who should be bearing the brunt of the crisis as occupiers reassess their future needs.

And there is more tension to come, Gowling WLG partner Dan Gwilliam said. The pandemic is forcing changes on two aspects of the office sector for investors in particular: the leasing structure and office design. And in both cases, there is uncertainty around who will ultimately foot the lion's share of the cost of physical and structural market changes that will unfold over the next few years.

“First, we’re now more likely to move away from the world of traditional statutory framework leases with fixed terms and space — should they be more flexible at a higher price?” Gwilliam said. “Second, if spaces are redesigned to accommodate new ways of working and social distancing, who should pay for which elements? The landlord or the occupier? This is the time when the evolution of the traditional office product may accelerate to become more operational in nature in some markets than ever predicted before.”

The End Of Statutory Lease Frameworks

For the last few years, occupiers have been putting pressure on landlords to have more flexible leases. Lease lengths have been falling, a trend that has accelerated during the pandemic. The average commercial lease length in the UK was 27.4 months in June 2020 compared to 48 months in January 2019, according to CREDIA, the Commercial Real Estate index by Re-Leased.

However, the greatest changes are yet to come, Gwilliam said. Office vacancy rates are set to increase in the years post-COVID and midterm lease negotiations are ahead.

“There will be a time lag,” Gwilliam said. “Many businesses are tied into office leases for another few years before expiry or a break event, but large occupiers in particular will start making very different decisions counter to pre-pandemic expectations when they can. Landlords might not feel the impact for a while and their biggest challenge is to insulate themselves against a downturn in demand and plan now for their product to retain its attraction for occupier requirements.”

Gwilliam predicted that many occupiers will request more break clauses, as well as shorter leases, due to uncertainty created by the pandemic.

“This has to be quid quo pro on pricing however,” he said. “Investors and funds’ business cases are rooted on basics of secure income from 10-year leases, which they may find harder to secure outside prime locations. There has to be a middle ground where security overpricing is balanced against flexibility. Occupiers will need to accept that within the benefits of leasehold ownership there are limits to what can be underwritten by a property company with shareholders, or funds with investors, expecting sensible returns.”

There could be opportunities for landlords to make changes in their favour. Last year the government announced that it will be reviewing the Landlord and Tenant Act 1954.

“Its age tells a story,” he said. “Lease structures haven’t changed in generations and a review of the statutory right to review is long overdue. It was written in an era when landlords ruled the roost in order to protect tenants and longer leases were normal. Now there’s a lot of frustration for landlords and tenants, and market pressures suggest the statutory framework we operate in simply doesn't reflect the probable post-COVID market conditions. There will also be a new balance to be found in respect of tenant responsibilities at lease expiry in respect of reinstatement and dilapidations that reflect the new office products received.”

A New Office Design

The design of offices is the second aspect of office leasing that is causing tension between landlords and occupiers. Offices full of desks might become a rarity as businesses need to accommodate both social distancing and new ways of working that focus more on human interaction. The UK is amid a national lockdown, however, and it is not yet clear what the new design will be.

“Everyone is talking about flex space, but what does it look like?” Gwilliam said. “Space that can be used for just one day a week or four? Or that can change overnight to become a conference space? Or no office space at all — just meeting space as people want human interaction again? The smart office landlords will increasingly start looking at the nature of their occupiers’ businesses to see what services they will want and need, and by occupier type, to suit buildings they own in different geographical markets they operate in.”

As offices gradually move toward offering the level of design flexibility that office occupiers are looking for, Gwilliam predicted we will see an escalation of landlords offering a serviced office offering with their buildings.

“Landlords could start to increasingly offer a hybrid solution and treat assets as having more limited fixed income,” he said. “Organisations such as British Land and Landsec that already have serviced office products could have an advantage in that they may be well placed to offer hybrid models and have their own experts who understand how to make that sector work well. I can envisage new partnerships forming between funds and serviced office providers to work up hybrid solutions.”

Another solution could be for landlords to create more Cat A+ space to let out — space that is fitted out by a landlord ready for an occupier to move in immediately. This could facilitate a quick move-in for a tenant, who could be up and running immediately. It begs the question about who will pay, however. Previously, a landlord might have charged a premium for this space. In a market where landlords are competing for tenants, it could become a differentiator rather than a money maker.

Gwilliam highlighted other pressures on landlords, such as the increasing need to boost sustainability, all of which are adding to the uncertainty facing the office sector. Amid all these changes, however, eventually a new set of norms will emerge that could ease relationships between landlords and tenants.

This article was produced in collaboration between Gowling WLG and Studio B. Bisnow news staff was not involved in the production of this content.

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