The Great Office Myth

Ovation is currently considering an office move and I am looking around at what the market offers. It’s got me pondering – what next for commercial property as an investment?

Property (I’m thinking mainly office and retail here) has traditionally been a great part of any investment portfolio, especially funds which actually own physical buildings. Ongoing rental yields, increasing values, and people do love bricks and mortar.

The value of such property is in the income stream. The value of an empty building is very different to a building with the Govt as tenant on a 15 year upwardly only lease.

A stockbroker friend of mine had a few words to say on this recently. What’s happening (he said) is that managing agents are quoting the same rental yields (price per square foot) as they always have. But there are deals to be had. He quoted one client who had a 5 year lease with a 2 year rent free period.

Hang on (says I), why not just quote two fifths of the rent? It’s the same income over 5 years, and after all it’s income that matters with property.

But no (says my friend). The value of the building is rent per square foot multiplied by size of building. The agents are paid based on value of the building. The owner of the building doesn’t want to lose money on the value of the building. The value of the fund (if it’s owned by a fund) is dependant on the value of the building. The values of all the other buildings in the area/fund are established by reference to the value of this building.

Which is why there are so many empty offices/shops. If one landlord admits that the real rent isn’t, for example, £20 per square foot but £10 per square foot, the value of his building will halve. And other buildings will follow suit. And fund values will dive. Better to have an empty office on the market at the current rent than let it out at a lower value.

Of course, it’s entirely possible that my friend’s cynicism is unfounded, and that in 10 years time (say) the economy will be much more buoyant, offices will be occupied, and values quoted will be real values once again. No-one will have realised that underlying values plummeted during that period but were kept high by creative rental deals.

And yet it doesn’t seem quite right to me. I don’t think a retail investment product would get away with this kind of pricing, for example.

I’d love to hear comments and thoughts of others on this sector.

 

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6 thoughts on “The Great Office Myth

  • Great article Chris – I can imagine people adding “must check asset allocations and model portfolios to look at my exposure to commercial property” to their “To Do List” on the back of this. I know that many supposed low risk funds including with-profits have lots of exposure to commercial property.

    Reply
  • I am only speculating here, but I’m surprised that the ACD isn’t forced to get the properties re-valued every 3 years or so by RICS. Surely this is just another Arch Cru waiting to happen if the valuations on the underlying assets are spurious.

    Reply
    • I don’t think the owners, agents and everyone involved would agree that they are spurious – although I (genuinely) hope one of them posts a comment to explain why not. But…

      A friend of mine went to an agent who had a property on the market at £20 per sq ft. He offered them £5 on a lease which meant the landlord could kick him out with one months notice.

      The logic, he put to the agent, was that rather than the property being empty for, say, 6 months, they would get some money in. They could carry on marketing the property at £20 and would have complete flexibility if someone wanted a lease. He was, in effect, taking a gamble on how long the property would take to rent at £20, at no risk to the landlord.

      He was turned down. Why? Because of the effect on the market and valuations. They would rather have an empty building at £20 than a full one at £5, even on a flexible lease.

      Reply
  • I am only speculating here, but I’m surprised that the ACD isn’t forced to get the properties re-valued every 3 years or so by RICS. Surely this is just another Arch Cru waiting to happen if the valuations on the underlying assets are spurious.

    Reply
    • I don’t think the owners, agents and everyone involved would agree that they are spurious – although I (genuinely) hope one of them posts a comment to explain why not. But…

      A friend of mine went to an agent who had a property on the market at £20 per sq ft. He offered them £5 on a lease which meant the landlord could kick him out with one months notice.

      The logic, he put to the agent, was that rather than the property being empty for, say, 6 months, they would get some money in. They could carry on marketing the property at £20 and would have complete flexibility if someone wanted a lease. He was, in effect, taking a gamble on how long the property would take to rent at £20, at no risk to the landlord.

      He was turned down. Why? Because of the effect on the market and valuations. They would rather have an empty building at £20 than a full one at £5, even on a flexible lease.

      Reply
  • Great article Chris – I can imagine people adding “must check asset allocations and model portfolios to look at my exposure to commercial property” to their “To Do List” on the back of this. I know that many supposed low risk funds including with-profits have lots of exposure to commercial property.

    Reply

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