Exploring how COVID-19 will impact the future of the Landlord/Tenant dynamic in the UK market
“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of light, it was the season of darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us.”
These famous words, as I am sure many readers will know, are from the opening of Charles Dickens’ A Tale of Two Cities set in London and Paris during the French Revolution. Despite being written over 170 years ago, these words seem apt today to describe the ‘tale of thousands of cities’ throughout the world over the past 12 months. What changed the future then was a revolution. So, are we today on the cusp of a revolution that could change the UK real estate market?
We have seen hundreds of articles discussing the impact of working from home on employees wanting greater choice of where and when they work when offices re-open. People talk about the option of working from home as if it is some radical new development in the way we work. This is not the case. I – and many people I know – have been working from home one to three days a week for at least 15 years. The majority of people who have historically been working from home were within non-core functions of the business. The fundamental difference now is that the core as well as non-core teams have clearly proved to senior leaders (many of whom were opposed to the idea of their staff working from home) that they can be just as efficient and even more productive than they would be in the office.
Does this mean the death of the office?
Clearly not, for all the reasons I’m sure you have read about or heard discussed on the hundreds of webinars held on this topic. However, what is clear is that the way the workspace is used will move further towards the activity-based model. For those who have already adopted agile working there may be a re-alignment of the ratio of space dedicated to collaboration v individual workstations. When it comes to the desk, sharing ratios are likely to be increased to as much as 1:5 or 1:6. Even taking into account social distancing measures (which I believe are here to stay), there will still be a need for less space.
How have landlords responded to occupiers increasing demand for flexibility?
The pandemic has highlighted more than ever occupiers’ need for flexibility. With the growth of the serviced office/co-working market over the past five to 10 years and the flexibility they offer in terms of contract commitment, capital expenditure and services provided, the percentage of an occupier’s portfolio in flex space has grown. I would estimate that this percentage is anywhere from 5-10%. This could double especially if corporates implement a hub and spoke model as has been suggested by many commentators. There will still be a desire to have dedicated office space but if leased (as opposed to owned) there will be an expectation that terms and fit out will be more in line with European/global markets.
So how will UK landlords, investors and developers respond? Even before the pandemic, many landlords had realised that while leasing to flex operators such as WeWork, Spaces, TOG and Hanna was an easy way to dispose of significant space, they were missing out on the margins these companies were making both from SMEs and enterprise clients. Therefore, developers such as HB Reavis, Skanska, British Land and many more set up their own subsidiary flex brands. Many landlords are now able to offer a flexible solution to occupiers alongside traditional office space.
This therefore leaves the issue of lease terms and fit out costs. When I first started working in real estate (when ‘dinosaurs’ still roamed the earth!) the standard institutional lease term was 25 years and you were lucky if you had a break option after the 15th year. Over time the length of lease has reduced where 10 – 15 years is now acceptable and in some cases with breaks in years 5 and 10.
The days of five-year or even three-year business plan have gone. With the pace of change the longest business plan these days is between one or two years. Therefore, making a commitment to lease an office for 10 years doesn’t work. If you add in re-organisations (I experienced five in eight years at AIG), M&A and divestments, any lease longer than three to five years is not suitable for most corporates today.
UK vs. EU and Global Markets
One question I have asked UK Investors for years is why can the UK market not operate in a similar way to European or global markets. Why are investors who have portfolios in the UK and Europe unwilling to accept short term leases such as 3+3+3 or 5+5 years in the UK but accept them elsewhere? Why can’t rents be linked to CPI/RPI and not have to be upward only? I’ve never received a convincing argument to either of these questions other than ‘because that’s the way it is’ which isn’t a good answer. It would require an adjustment in the yield when valuing to account for the additional risk (and you don’t when valuing in Europe?). Or is it because of our legal structure and, if so, where in law does it state that the review of rent must be upward only?
Then we have the issue of the fit out. In many European countries, it’s standard that the landlord provides a base level Cat B fit out. This includes the ceiling, lighting, carpet and base partitions. LandSec recently launched MYO, offering a choice of inclusive leases. From providing fully-fitted-out space, to supporting with day-to-day hurdles like IT problems. L&G have a similar product in their Capsule offering. These are seen as innovative approaches, disruptors to the market. To those of us working in global markets, this is the standard approach in many countries.
One change I have noticed, even prior to the pandemic, is the language used by landlords when referring to occupiers. They are now no longer tenants or occupiers’ but are customers or clients. While only a subtle difference, it demonstrates that landlords now recognise that without a happy tenant there is no investment and they can no longer just see them as an income stream. Provided that this terminology is not just lip service, then the landlord/customer relationship will hopefully be more harmonious.
So, revolution you say?
Do we need a revolution in the UK real estate market? My simple answer to that question is no, but only on the proviso that landlords recognise that they need to be more flexible in their approach to lease terms, provide alternative options in type of spaces available (flex, shell & core, CAT A and part CAT B etc) and treat their tenants as customers. I think we are already starting to see the convergence of the traditional and flexible offerings from landlords as demonstrated by the MYO and Capsule models.
I believe the approach for multi-tenanted buildings will need to be closer to hospitality, where the quality of the operator is as important as the asset, to guarantee high occupancy rates even if contracts are short. Landlords will need to provide more of a day-to-day service particularly for the small and medium-sized enterprises who don’t wish to carry even part-time resource for service support they only need periodically. Workers will increasingly be looking for an improved experience, including safety, from their workplace. Landlords need to rise to these challenges as competition between buildings, cities, etc. will only increase.
Many corporates are currently working on their workplace strategy for when they re-open their offices, a majority on the basis of lower occupancy levels. There will be more space coming to the market and less demand. Landlords who don’t meet the requirements outlined above will lose out.
A final proposal which I believe would give any landlord an advantage (and probably a heart attack) over their competition is to either replace upward-only rent reviews with CPI/RPI indexed linked or be willing to accept downward as well as upward reviews. Now that would be truly revolutionary!
About the author
Philip has over 30 years’ experience in the property industry, 23 years of which he has specialised in the corporate real estate (‘CRE’) sector. He has experience across many different commercial sectors including the Banking, Insurance, Technology, Automotive and Biotech industries having worked as an external consultant to as well as directly for a number of major corporates including Ford Motor Company, General Electric, AIG and Willis Towers Watson.
Philip has a proven track record of success in conceptualising creative cost-saving solutions to reduce operating and capital expenditure through implementing effective real estate strategies.
Philip has significant transformational change experience successfully leading projects across multiple geographies. He has an in-depth knowledge of the complete property lifecycle, from portfolio-wide strategies to major complex transactions encompassing the negotiation, design, construction through to delivery. Philip has a track record of being an agent for change, managing highly engaged teams that consistently deliver projects on time, below budget through periods of both high growth and major restructuring whilst successfully managing senior stakeholder relationships.