On 25 July, BNP Paribas Real Estate’s UK chief executive called the top of the market for London offices.

Commenting on the sharp slowdown in investment transactions as the firm published its Q2 Central London data, Etienne Prongué pinpointed the end of 2021 as the moment the cycle turned. ‘The speed of the interest rate hike has caught the real estate market by surprise,’ he said. ‘As it stands, rising debt costs and the deteriorating economic outlook are impacting pricing discussions, causing some sellers to pause disposals and wait for improved sentiment.’

In the weeks since his comments appeared, little has happened to suggest that sentiment has changed or that those discussions have got any easier. Investors considering pressing the button on office investments in any European city have some serious calls to make.

If the sector was represented as a pair of scales, weighty reasons remain to come down in favour of going ahead and investing. Chief among them are that the office occupation market has bounced back surprisingly strongly after Covid and that investors have copious equity ready that they would dearly love to deploy. Landlords and agents say that tenants need higher quality space – in buildings which are greener, more attractive to their workforce, and flexible. These buildings are seeing rental growth, providing the inflation hedging that asset allocators crave at a time when inflation has raced away to 9.1% in the EU and 9.9% in the UK.

Weighing in heavily on the other side of the scales is the long list of risky scenarios: continuing high geopolitical tensions; the possibility of stagflation and recession with the fear of the negative impact on tenants; the persistence of hybrid working; rising debt costs. For those investors looking to buy offices in order to spend capital improving them, add the volatile costs of building materials and the challenges of meeting environmental regulations that they face.

Renegotiating prices
Prices are already softening: one capital markets agent says that ‘buyers are re-trading on price just before they close, because of the market conditions we’ve seen through the summer.’ Others have been public about falls they see coming. Prongué told the Financial Times that anyone trying to sell an office on the open market now was ‘chasing the market down’. DWS’s global head of real estate research told Bloomberg that depreciation for older, less energy-efficient buildings could be 20%.

LaSalle Investment Management’s Mid Year Investment Strategy Annual published on 5 August suggested ‘there is a growing range of older (office) stock which is likely to be stranded and should be sold at – or at times even below – current valuation before liquidity dries up.’

In the prime office sector, Andrew Hawkins, international partner in London capital markets at Cushman & Wakefield, believes there will be ‘a range of activity in the coming weeks across European cities which will give a degree of pricing discovery. It’s the €200 mln to €400 mln lot sizes which will prove a degree of confidence’.

He says: ‘In London, if you’re selling below £200 mln and it’s a super-prime deal, I think the yields have moved up about 25 bps. But the buyers of that stock more often tend to be UHNWs or family offices and they have their own reasons for allocating capital; they’re trying to find something which is a long-term hedge against inflation. If you’re into a deal that’s more than £200 mln, I think the debt component is beginning to have a bigger impact. And there yields might have shifted 50 bps, with the same true of Europe.

‘But it’s wrong to generalise about the market. The yields are very asset-, location- and leasing-specific.’

Transactions in Europe’s largest markets, Germany and the UK, started to slow dramatically in Q2 and slowed further in Q3 as sellers pulled buildings from the market where bids disappointed. MSCI Real Capital Analytics’ provisional figures for all European office investment deals in July and August (as at 5 September), were €5.7 bn and €3.4 bn respectively, compared with €9.6 bn and €10.7 bn in 2021.

So liquidity hasn’t completely dried up. Hawkins points out that ‘there is a lot of dry powder raised by private equity and there are petro-carbon-based sovereign wealth funds who clearly have more money than they did nine months ago because they are beneficiaries of the energy crisis we’ve seen.

‘It’s inevitable that activity will continue to be slower as prices adjust. But it is not like 2008 when the market did completely grind to a halt.’

One of the largest office transactions agreed in September was indeed by an oil sovereign wealth fund – Norges Bank Investment Management’s acquisition of two prime buildings, in Berlin and Paris, for a combined €674 mln in a joint venture with Swiss Life. Not long before announcing that acquisition, Norway’s SWF had decided to pause the £720 mln sale of Bank of America’s HQ in London.

Other trophy offices withdrawn from the market in London include MidCity Place in Holborn, which Oxford Properties and Singapore’s Temasek had been looking to sell.

Gerald Kaye, chief executive of London office developer Helical, says ‘best in class buildings will see a much smaller adjustment than the buildings of poor quality that need capex. The agents say yields are up a bit, 25 bps for prime, which is reasonable.’ The REIT’s September sale of the 90,000 ft² London office of TikTok for £158.5 mln to Hong Kong buyer ChinaChem Group reflects a net initial yield of 4.25%.

The tenant signed a 15-year lease in March 2021 at £86 per sq ft for the MidTown Kaleidoscope building over the new Elizabeth line station in Farringdon.

What will Q4 bring?
Kaye points out: ‘The first half of the year seemed very strong and Q3 is very often quieter, because people are away. Q4 is traditionally busy and it will be interesting to see what happens. ‘There is a recognition that buildings on the wrong side of the bifurcation between best-in-class and those that aren’t very appealing are potentially too expensive. But it’s still a competitive market, so it will be very interesting to see what happens to the pricing in the next few months.’

Helical hunts for central, well-located buildings ‘with good bones’ which it can extensively refurbish to create the appealing sustainable workplaces with high quality amenities. ‘Building costs have gone up quite considerably’, Kaye says, ‘and what you pay for something is a residual after you’ve paid all the other costs to get there. So you can see there’s going to be an adjustment in price but not necessarily in yield. If £400 per ft² is now £450 per ft² to build, then that’s £50 per ft² less that you can pay for the asset – it’s actually more than that, because you’ve got interest and fees and everything else.’

James Stevens, head of real estate investment at Aviva Investors, says the higher debt costs ‘have already driven out leveraged buyers who make up a large part of the market because debt is not accretive for a significant part of capital unless prices re-adjust.’

The rental growth story ‘will insulate some of the pricing movements for top quality offices’, he believes. ‘Others? If there’s a huge capex bill to transition to net zero and the building doesn’t meet what occupiers are looking for, then that’s going to shift pricing - it’s already happened and will no doubt continue happening through the next six to 12 months. We’ve got money to invest in the delivery of refurbishment plans...’

Norges and Swiss Life acquired their office asset in Berlin – the 30,000 m², newly-built, fully let VoltAir complex – from its developer, ABG Real Estate. Munich-based ABG, headed by Ulrich Höller, has worked through multiple property cycles and expects to be very active in 2023.

The firm lured Piotr Bienkowski to its management team from BNP Paribas Real Estate last year – Bienkowski is credited by many as the driving force who took BNPPRE’s German team to a dominant position in German capital markets, especially large office transactions. At ABG he leads a new investment management division with a manage-to-ESG office fund in the works.

Plenty of others also expect to see opportunities start coming to the market from less well-capitalised holders of office real estate than Norges or Oxford Properties. Valesco Group is just one. Founder Shiraz Jiwa sees ‘a situation emerging of immense pricing dislocation’. And none of them will be paying December 2021 prices.