COULD OFFICE BLOCKS BE THE NEXT BIG CASUALTY OF THE BANKING CRISIS?

March 2023 Blog-compressed

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The commercial property sector may come under increased strain due to raised interest rates and tightened lending, on top of the impact of hybrid working.

One could easily mistake many modern central London company headquarters for a hotel, due to their comfortable open lounges, vegetation, coffee and technology bars, and library facilities.

In the contemporary property market, terms like "hotelification" - where five-star management is necessary - and "earning the commute" are popular among executives aiming to attract back employees accustomed to working remotely.

Many bosses recognize that hybrid working is here to stay, and some smaller firms have gone so far as to do away with traditional offices altogether.

Rising borrowing costs, weakened economic activity, and fewer office workers downtown due to the pandemic sparking apprehensions of a potential 'perfect storm' in the property market.

The collapse of Silicon Valley Bank and UBS’s rescue of Credit Suisse, in the wake of the crisis, has caused some City investors to fear that the next stage could place a strain on commercial real estate, whose value is estimated at $20 trillion globally. If banks are forced to restrain their lending for this sector, it could cause further disruption.

The number of commercial real estate deals in the UK saw a considerable increase during the first quarter of 2020. Transaction volume was up year on year, with a notable jump in activity compared to the same period last year.

Last week, the Bank of England pushed their base rate to 4.25%, their 11th consecutive hike as they attempt to rein in persistent inflation. Across the pond, the US Federal Reserve's quarter percentage point raise landed at a level not seen since 2007 - sitting between 4.75% and 5%. To round it off, the European Central Bank hiked their deposit rate by 0.5 percentage points to 3%.

Market leaders have cautioned that offices and stores could be the next victims of the Federal Reserve's tightening. This is already the case in America; when the Fed puts on the brakes it tends to create a domino effect. Real estate has particularly raised eyebrows, as many property developers are facing higher interest rates- so what will this mean for lenders dealing with this sector?

Thus far in 2023, UK offices have generally been at about one third of their capacity. Various media outlets have tried to encourage the market by suggesting higher occupancy levels; however, it is easy to uncover the truth if you take a closer look.

Office occupancy rates across the UK have only reached 29% of typical pre-pandemic levels in the 2023 year-to-date, with London seeing even smaller figures. This is according to the data from Remit Consulting.

UK working adults are now spending one day a week or more at home, compared to pre-pandemic when it was only 12%, the Office for National Statistics has revealed. This makes up 40% of employees.

Working from home tends to be most common on Mondays and Fridays, while office attendance is usually highest during the middle of the week.

Many think the office size won't change even with employees working remotely on Fridays. It's simply accepted that the workplace will likely be unoccupied on that day.

As has been highlighted in earlier posts, the central London housing market mirrors trends and developments in the world economy, making it far more unpredictable than other UK regions.

It's no surprise then that UK commercial real-estate values have been dropping. The UK monthly index showed that commercial value had risen in the first portion of 2022 but began to fall come July and continued through December, removing any earlier gains made. Ultimately, this led to a 13% dip in property values over the course of the year.

Investors have caused several real estate funds, such as the Blackstone Real Estate Income Trust, to impose restrictions on redeeming their investments over the past few months.

The recent strain in the banking sector has led to a major investment bank recognising that there is increasing anxiety around the potential knock-on effects on the commercial real estate industry.

In contrast, financing for CRE in the UK is more secure than in the US, where regional banks enduring difficulties are the principal lenders.

The UK banking system is unlike that of the US, where much of the housing loan market is serviced by small local banks. There has yet to be reported any British bank collapses, and the amount of creditors' exposure to real estate credit is relatively low with 6% of all debts, compared to over 12%, before the 2008 economic turmoil.

It is valuable to recognize that credit terms are likely to become stricter in the UK. This could make refinancing difficult, especially for offices where capital values have experienced a sharper decline of 15% since 2018, compared with an 11% decrease for all property types.

Due to an increase in interest rates, some owners of offices, shops and warehouses may not be able to secure refinancing when their current loans come due and consequently have to sell assets.

The property downturn could be exacerbated, meaning the recovery of UK commercial investment, which decreased to £61bn in 2022 from £1bn, is set to be more sluggish than hoped. Savills, whose annual profits fell, anticipates a resurgence of the sector come 2024 due to a lack of office building availability and an increased focus on environmentally friendly properties.

Commercial property prices in the UK are expected to decline by an additional 10% this year due to a lack of demand. Certain industry experts have predicted a greater drop, ranging from 15-20%.

The outlook for the UK commercial property sector is heavily intertwined with any changes to interest rates sparked by rising inflation. Should prices continue to inflate, there will be an associated increase in base rates - raising the risk of a crash. The Bank of England anticipate that inflation will reach its apex by summer with a gradual fall in the third quarter. Mortgage brokers appear to agree with this prediction.

UK inflation increased to 10.4% in February, surprising analysts and markets alike. This could signify that the Bank of England's period of base rate hikes is nearing its end, which would be a welcome sign for the UK's commercial property sector. However, many predict that rates will drop again later this year.

Can the remote working model endure the energy crisis? It is an interesting question, as this kind of work situation has become more popular in recent years. With energy costs on the rise, energy conservation is more important than ever. Will this trend continue to be viable with increased pressure on global energy resources? It begs the question if remote working can stand against the current backdrop of rising energy expenses.

Where we live, how we travel, the distance from our workplace and the expense of childcare will all be deciding factors in whether hybrid working persists past 2023. Should it remain, there is no possibility of a return to a full-time office job.

Two years into the global crisis, it's highly likely that employees in the UK no longer view the 9-to-5 as an attractive option, particularly when faced with the arduous and expensive commute that often accompanies it.

The changes to organisational life prompted by Covid-19 have, according to the Work after Lockdown project (funded by the Economic and Social Research Council), had a permanent effect. Forty percent of GB's working population are now employed in a hybrid, multi-location model. But will this be put on hold, due to an upcoming energy crisis? Is our new "culture" here to stay or not? We must await with apprehension the answer.

The intricate calculations being done are leaving it evident that socio-economic factors will be a pivotal factor in determining if remote working continues to stay ingrained in our lifestyle, and whether workers' choices concerning work are still strongly tied to their situation.

A public sector graduate trainee revealed that the expenses for travelling, coffee and snacks resulted in working at home being more cost-effective. However, with energy costs expected to rise substantially, she anticipates making the switch back to the office due to expensive heating bills. This inconstant picture is why it is difficult to anticipate what will happen this winter. Moreover, a senior manager from a London local authority mentioned that although some of her staff expressed their desire to come into work more often, there remains an absence of secure information.

When looking at how the cost of living may shape working trends, we must take geographical labour markets into account. During the lockdown, UK commuters gained financial benefits from cutback travel, and this was one of the most notable effects. As public transport costs keep rising faster than inflation, suburban-based firms may see their employees leaning more towards remote work as it helps them save money. Conversely, those who are in closer proximity to offices might prefer coming in due to the comfort of a warm workspace.

Our research revealed that, while people endeavoured to create the best possible workspace during lockdowns, such endeavours are increasingly difficult due to increasing heating costs. Worse still, amalgamating workspaces can lead to personal tensions, reduced productivity, and even family friction.

Home is a pivotal factor in people's job choices. According to one executive, the Sam Vines Boots theory - which argues that financial strain affects poorer groups more severely - is more applicable than ever today in the public sector. For example, those with better-maintained houses may still be able to bear minor price increases and