Riding the cycle

In spite of respectable investment and letting figures, the future of international office property markets is riddled with questions, if only due to geopolitical imponderables. The art of active asset management is more important than ever before.

Potsdamer Strasse isn’t one of Berlin’s top tourist attractions. But the street, located to the west of the city centre, has been experiencing a remarkable boom over the past few years. Prestigious design and clothing shops, along with popular restaurants, are attracting a new clientele to the previously rundown neighbourhood. And now a building ensemble that has seen better days is being refurbished: Pecan Development is giving a former Commerzbank location a facelift and adding new space as part of a development project funded by international investors. A total of 27,000 square metres of office space will be marketed under the name “Im Wirtschaftswunder”, a sly reference to Germany’s economic miracle.

By revitalising the office location, the project developer is providing one possible answer to the question currently niggling at every asset manager: in light of the very late stage of the market cycle and all the political and economic imponderables, how can they responsibly invest the money entrusted to them? It’s hard to answer that question because the signals are very different.

On the one hand, the European office property market enjoyed another outstanding year in 2018. Office rents all over Europe have been rising for eight quarters, as calculated by the Cushman & Wakefield consulting group. In spite of the macroeconomic risks, the Royal Institution of Chartered Surveyors believes the European real estate market is still on track for success. And the Real Estate Investor Survey of the auditing firm PwC shows that investors are still optimistic about the German real estate market.

Investors are increasingly concerned with the question of what will happen to their properties if the economy slows and the growth in rents weakens.
Sabine Barthauer, Member of the Board of Managing Directors at Deutsche Hypo

On the other hand, there are increasing signs that the boom may be coming to an end. The major stock indexes experienced considerable losses in late 2018, not least due to uncertainty about the impending Brexit. The OECD (Organisation for Economic Cooperation and Development) has reduced its growth forecast for the world economy and also for Germany. The German real estate climate index of Deutsche Hypo, which finances commercial real estate, accordingly ran out of steam in December 2018, falling to its lowest level in more than six years.

Add to that the uncertainty about interest rates. A rate increase seemed to be edging closer after the European Central Bank (ECB) announced it would allow its bond buying programme to end. But experts are no longer all that sure. For example, the German Economic Institute (IW Cologne) expects that, even if the ECB abandons its expansive monetary policy, interest rates will rise to just 1.3 percent by 2025.

Are we close to the zenith?

What does it all mean? “We are probably very close to the absolute zenith of the real estate cycle,” says Sabine Barthauer, Member of the Board of Managing Directors at Deutsche Hypo. She observes that investors “are increasingly concerned with the question of what will happen to their properties if the economy slows and the growth in rents weakens.” Where office buildings are concerned, says Barthauer, institutional investors are therefore increasingly focused on the primary German cities and largest secondary cities, where they expect to see rising or at least stable values.

A survey of investors operating in Germany by Engel & Völkers Investment Consulting paints a somewhat different picture. It found that only 38 percent of investors plan to invest more in the top seven cities. In contrast, 48 percent of investors plan to intensify their commitment to the larger secondary cities, while 52 percent have an eye on areas surrounding the major cities. Philip La Pierre, Head of Continental Europe at LaSalle Investment Management, is particularly interested in “locations around the classic central business districts (CBDs) which have good connections to public transport.” La Pierre believes there is room for upward movement by rents. “That’s why we prefer to invest a bit more there so we can generate much higher rents following refurbishment. A tear-down followed by new construction is also an option in locations of this kind.”

Opportunities offered by refurbishment

Many asset managers – not just at the “Im Wirtschaftswunder” project in Berlin – are following a bottom-up strategy of this kind. For example, Union Investment is considering construction work on the Le Président office building on Avenue Louise in Brussels. “It’s an older single-tenant building that is past its prime, 6,200 square metres in size, and its lease will probably expire in 2020,” says Volker Noack, Member of the Management Board  at Union Investment Real Estate GmbH. The plan is to do more than just modernise the existing space, and to also expand the lettable area by as much as 2,000 square metres. “This will considerably increase rent yields and therefore the value of the property,” says Noack, who stresses that “a project of this kind requires active, creative asset management” (see interview below).

38 %

of investors surveyed by E&V want to invest in Germany’s “Big Seven”

However, this will pay off only if there is sufficient demand by wealthy tenants seeking office space. The question that is often heard is therefore “What will the effect on rents be if we invest a specific amount of money?” For fund service provider Real I.S. the answer to this question turned out to be a positive one for the project in Rotterdam. It modernised an office building at Wilhelminakade 123 there, expanding it by 2,800 square metres. “Refurbishment has a very important role to play in active asset management and helps increase rental income,” says Brigitte Walter, Member of the Board of Management at Real I.S.

The increased importance of portfolio optimisation is also related to the trend on the land market. “Land has become so expensive that adding upper floors to buildings, building on open areas and refurbishment can all be used to tap the potential for rentals, thereby earning higher yields than by investing in new builds,” says Michael Schneider, Managing Director of Service-KVG Intreal.

52 %

of investors want to invest in the areas around major cities

In contrast, given the heavy demand for office space, the conversion of office buildings into residential buildings – as seen in the Bürostadt Niederrad project in Frankfurt am Main several years ago – is now less important. If there is to be a change in how an office building is used, says Sabine Barthauer, Member of the Board of Managing Directors at Deutsche Hypo, the end result tends to be halls of residence for students or a hotel.

Longer or shorter leases?

Overall conditions won’t change anytime soon, according to Matthias Pink, Head of Research Germany at the real estate consultancy Savills. “It doesn’t appear that office rents will decrease in 2019 and 2020,” he says. Marcus Lemli, Head of Investment Europe at Savills, also expects growing demand for high-quality office space. At the same time, Lemli and Pink warn that an economic downturn is possible. They consider the risk of a recession to be greater than the risk of an interest rate rebound, because market participants are better prepared for interest rates to change.

Long-term investors are also well aware of the potential hazards. “If the economy weakens, the shortage of office space may ease somewhat,” says Brigitte Walter of Real I.S. According to LaSalle Investment Management, “Europe still has some good years ahead of it. But at some point the market will turn. Therefore we have to do our best to orient our properties to a possible weakening.” It is thus important “to work on the yield side.”

What lease term will optimise yields? There’s no one answer to that question, says Brigitte Walter of Real I.S. At the office tower in Rotterdam, for example, Real I.S. extended the lease with KPN, a telephone company, by 20 years. “If the term of the lease had been any shorter, the major investments we made at the tenant’s request would not have paid off,” explains Brigitte Walter. Things are different “at locations offering the potential for rent increases. That’s where we prefer shorter leases.”

Other investors are following exactly the same strategy, although a survey of its fund partners by Service-KVG Intreal suggested that there has actually been a slight shift. Still, 27 percent of survey respondents stated that they buy only buildings with long-term leases. “That percentage would presumably have been much lower two years ago,” says Intreal Managing Director Michael Schneider. “Many market participants have become more cautious because they consider a downturn to be a possibility in coming years.”

“Looking at the actual asset”

There is considerable debate at present about how to view leases with coworking providers such as Wework, Spaces and Rent24, which have long been expanding. Currently, there is tremendous interest among investors in any event. In the EY Real Estate “Trendbarometer 2019”, 91 percent of real estate firms surveyed agreed that digitisation would lead to a greater focus on investment in coworking spaces in the future.

Refurbishment has a very important role to play in active asset management and helps increase rental income.
Brigitte Walter, Member of the Board of Management at Real I.S.

The background to this assumption is the fact that digitisation makes flexible forms of work easier. Coworking spaces also have the advantage of being available to companies that need space in the short term and would otherwise not be able to find it on the regular office market due to low vacancy rates. However, companies that let office space must also be aware of the risks involved, says John Kamphorst, Member of the Board at Engel & Völkers Investment Consulting. If demand at a location falls, it may no longer be profitable. Many owners are also critical of having coworking providers as the sole tenants of their properties.

Attractive additional services

Volker Noack of Union Investment points out another aspect: “Coworking operators earn higher per-metre rents than we do. So it’s worth thinking about what attractive additional services we can offer that will allow us to share in the higher income.” For that reason, Union Investment added conference rooms, a mobile Starbucks and a lounge to one floor of an office building in Chicago as requested by the tenant, in order to create a working and meeting environment that would enhance communication.

Asset managers must never forget that a property will be bought and also sold. It is precisely in the current market phase of high prices that people must “look very carefully when buying and closely examine factors such as location quality and the potential for use by third parties,” says Brigitte Walter, Member of the Board of Management at Real I.S. “In other words, you must always look at the actual asset.” Or, as Michael Schneider of Intreal puts it, “The role of the manager who knows how to handle real estate has become more important.”

By Christian Hunziker

Volker Noack, Member of the Management Board, is responsible for Real Estate Asset Management.
Union Investment/Urban Zintel

“Five-year leases help when the cycle comes to an end”

Volker Noack, Member of the Management Board at Union Investment Real Estate GmbH, discusses the best lease term for the current market phase and when refurbishments pay off

Mr Noack, you’re currently considering a complete refurbishment for an office building in Brussels. Does the possibility of creating additional rental space play a major role in that?

That’s only one of several aspects. Particularly in this market cycle, new space offers the opportunity to charge higher rents. But it depends on the individual case. Increasing the space was not the decisive factor for Emporio in Hamburg, which we completely modernised from 2009 to 2012. The main thing was to turn a structure from the 1960's into a green building oriented to the future. We believe that this orientation to sustainability, combined with a high level of quality, offers investors steadier earnings over the long term.

How important is the approach of turning a single-tenant property into a multi-tenant property?

When buying a building, we check whether it can also be let to multiple users. Emporio is also a good example of this, since our aim was to make ourselves independent of a single major tenant.

What effect do users’ changing requirements have?

That is the subject of heated debate at present. Tenants’ wishes for new worlds of work aren’t making themselves felt all that strongly, at least right here and right now. Still, companies’ intention to make themselves attractive to young, talented employees with high expectations is a major driver. It isn’t just IT-related companies that hope to recruit young talent and want to create the necessary ambience for that.

What are the barriers to remodelling?

The main thing to remember is the restrictions imposed by planning and monument protection laws. If you’re planning to remodel, you must always request a meeting with local representatives, although coordination of this kind isn’t always easy. Pollutants in older buildings can also be an issue. And if you’re working on only part of the building, it’s a challenge to keep tenants’ businesses up and running during construction work.

How long do you think a lease for an office building should be?

We have enough experience to know that the cycle may end abruptly when it does come to an end. We are trying to get five-year leases to smooth out any upcoming rough patches. Ten-year leases used to be fairly common, but now they’re used only for new builds or project development and tend to be an exception when renewing leases. In our opinion, the cycle for office properties will last for another one or two years. That’s why we’re not following the full risk curve and prefer to renew expiring leases – sometimes in advance – for longer terms when we can.

Has the time come to bid farewell to some properties in certain markets?

We’re a long-term portfolio holder and want to keep our properties for longer than one cycle. However, in the past few years we’ve taken the opportunity offered by advantageous market scenarios to sell buildings that we don’t want to keep in our portfolio over the long term. At 98 percent occupancy for our German office properties, all signs naturally point to “hold” at present.

How important is cooperation between asset managers and investment managers?

Decisions are taken in the investment-asset-fund management triangle, with the fund manager specifying the strategy for each of his properties. The goal of asset management is to do the best possible job of tailoring the length of leases to the timing of a sale as planned by fund management.

Interview by Christian Hunziker.

Title image: Paul Langrock/Zenit/laif

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