16 November 2020
With central office rents down, and the very future of work spaces in jeopardy, Vincent Huck looks at what is in the balance for European insurers' €87bn of investments in the asset class.
Most professionals used to have a five-days-a-week office lifestyle. That all changed with COVID-19 and, from posing the question, "when will I go back to the office?" people have been asking "will I go back to the office" and then "when I go back to the office will it be in the same way and frequency I used to?"
Economists, sociologists, behavioural scientists have expounded on the topic and their theories have been widely reported across the media landscape.
A consensus seems to have emerged that whilst offices are not dead, office life as we knew it will not prevail.
Ash Belur, a director in Willis Towers Watson's insurance investment team, summarises: "[When we get to] the end of 2021, [and] things have smoothed out, there is a vaccine, [will employers] have to ask everybody to come back to work five days a week and take a one hour commute every day, each way? [They] probably don't. Some things in cities will change no doubt."
That change will have significant repercussions for European insurance investors who, at the end of Q2 2020, held €87bn in office and commercial real estate allocations—a sub-asset class which accounted for 57% of EEA insurers' investment in property.
French and German insurers tend to have more exposure to real estate than UK rivals—however, individually, UK firms tend to be the bigger spenders, according to research by Insurance Asset Risk.
As employers ponder what to do with their office leases, and employees voice their desire for more flexible arrangements, insurance chief investment officers have to think carefully of what to do with current holdings, and, perhaps more importantly, what to do with future allocation into real estate.
Lessons from the COVID-19
The pandemic has proven that technology works and allows staff to continue being productive from home. If anything, the experience of the last eight months has taken away the stigma of working from home, according to M&G Real Estate head of investment strategy, Jose Pellicer.
"This pandemic has proven that working from home only decreases productivity over the long-term. Over time it makes the sense of belonging to an organisation, the relationship with your clients, suppliers, far more challenging," he says. "After 10 months of lockdown and remote working, you can keep the lights on, but everybody that I know and talk to has a craving desire to go back to the office in one form or another. And this proves that the need for collaboration spaces in offices hasn't gone away."
Investors, for their part, have been in a wait-and-see mode from a structural point of view, Pellicer says.
But from a cyclical point of view, offices are suffering the same fate as in any other recession, he adds.
At Aviva Investors, Jonathan Bayfield, head of UK real estate research, shares the same analysis admitting that a number of clients have asked the question "does this mean we are never going to use an office again?".
It is important to differentiate between structural and cyclical trends, Bayfield warns. The current trend to home or remote working and the move by businesses to cut cost by giving back office space is purely cyclical for him.
"Over the next five-years we see positive returns in our market forecast, but we do see some economic fallout in the short-term," Bayfield explains. "[Office] rents are down about 5% in central London, and that is going to persist as long as we are in the crisis without a vaccine."
Aviva Investors is advising its clients to take the long view over a 5 to 10-year period where it still sees resilience in the best locations: city centers with good connectivity and amenities and in the best product that "bring people together to collaborate and build trust with each other".
"We think insurers as investors should be looking at the 10-year period and not worry too much about the short-term volatility over the next 9 months or so," says Bayfield.
It is a sentiment echoed by DWS's global co-head of real estate research and strategy Simone Wallace, who says that despite "some anxiety about the office market [...] the best quality assets with good tenants and long-leases have continued to attract high levels of investor interest".
Things are not as bleak as people think or say, Willis Tower Watson's Belur addss: "We are not witnessing the death of cities."
Taking the example of the UK, Belur argues that the country simply can't afford central London real estate offices to go down by 30%. "[The UK] will have to find a way to make it work – such as running the tube with more trains to achieve lower density and more capacity. They have put too much investment in London that you can't just take out."
Where are the opportunities then?
If things are not so bad, surely investment professionals are seeing opportunities in the market?
Aviva Investors is keeping an eye out for a number of mandates for acquisition at the moment, Bayfield acknowledges.
For him, in the short term, some secondary cities will get a boost until a vaccine is found. Aviva Investors is particularly upbeat about prospects in Manchester and Birmingham, which are two of the largest cities in the UK after London, and have established clusters of industries as well as a pool of talented professionals.
Cambridge is also on Aviva's affiliated manager list. Bayfield says that although it is a small city, it still retains "around 50% of Cambridge within the city either within the university or within organisation associated with the university or relevant companies".
Pellicer is more doubtful about secondary cities. He describes himself as a big believer of the big city and a big believer in concentration.
"Because the central business district is where you can connect to your colleagues, clients and suppliers and anything that is not that will always be sub-par," he says. "Your productivity will suffer if you are not in a central business district."
However Pellicer notes that it also depends on what is understood by 'secondary cities'. Although smaller than London and Paris, places like Manchester, Birmingham, Lyon, have their own business environment, he argues.
"I don't think that cities that are already established as office districts with a lot of economic activity will lose [that activity]," he says. "There is sufficient business activity in Madrid and Amsterdam to remain [business hub with office demand], I don't think London or Paris will steal activity from them."
"But, if you look at Spain, I don't think that cities like Valencia or Saragossa are going to gain business from the key centres of Madrid or Barcelona," he adds.
For him there is currently no opportunity in terms of prime offices in central business district locations which have maintained their prices due to high demand from cautious investors who have been in risk off mode since the crisis.
The opportunities are in the riskier assets, Pellicer says, like building sites, old unoccupied central buildings, or assets like business parks where there are sufficient differences in opinion about the viability of the asset to give rise to investment opportunity.
Wallace at DWS argues that while central London property may be overvalued relative to other real estate it is still attractive compared to the alternatives and, indeed, will grow in attractiveness as the economic recovery gains momentum.
"The central London office market has the potential to be one of the top performing locations in Europe over the coming years," he says. "While COVID and Brexit are short-term risks, current pricing in London is relatively attractive when compared to both fixed income products and other European office markets."
When will the waiting game end?
Assessing the timeline for investment is the question that plagues every investor, and it is no different with the property markets. Most are optimistic that the COVID-19 downturn is merely cyclical and that offices will rebound once this phase is done.
Once the cyclical downturn finishes there will be a cyclical rebound of offices, Pellicer says. "That is the point where an investor can think about how to position their office portfolio as the markets offers an opportunity to sell without necessarily taking a loss."
Like with retail investment post 2008 crisis, which saw investors getting read off their weaker assets and consolidate their position in the stronger one, Pellicer believes the same will happen with offices investments.
However, this time around, the stronger assets will be those with environmental, social and governance characteristics. Ultimately, over the long term, "there will be offices that are sustainable and offices that will become stranded because they are not net zero carbon, they can't become net zero and they need to be torn down and rebuilt."