The situation on the commercial property market has been very difficult over the past two years. As at the end of 2021, annual net rental income for office properties was about three percent below pre-coronavirus levels. Since the middle of last year, however, demand for premises has noticeably picked up. The leasing of commercial properties will remain difficult in general in the coming years. Creative solutions are needed: approaches involving conversion work and interim uses offer great potential.
Employees of the UBS Chief Investment Office (CIO) have taken a closer look at the market (“Leasing commercial space – office and logistics space at an advantage”, August 2022). Their conclusion is clear: “Market conditions for office properties improved slightly in the first half of 2022 as a result of strong employment growth.” Compared to the previous year, office employment increased by 2.2 percent. In addition, around one in seven companies said they planned to expand their workforce in Q1 2022. This more than compensated for potential space reductions due to the new reality of remote working.
Low unemployment and strong immigration generally point to continued robust development in demand for office space. However, at 0.9 percent, gross domestic product will probably grow much more slowly next year than in 2021 and 2022. Supply ratios are therefore unlikely to fall any further. The supply figure refers to the space that will be offered on the market in the next six months.
Furthermore, it is noticeable that many investors are still planning new buildings. UBS’s Chief Investment Office estimates that building permits for office market investments of around CHF 2.5 billion will be issued this year, the highest level in a decade. Competition for new and attractive office properties will therefore visibly intensify. Maciej Skoczek, Real Estate Analyst at UBS, comments: “For the market as a whole, predatory competition is a zero-sum game.” From the perspective of an individual investor, however, it may be worthwhile to use an attractive office property to entice tenants away from other, older buildings. One thing is clear: older properties in peripheral and poorly developed locations are being forced off the market by newly built properties.
Owners and investors with this type of building have to accept the fact that circumstances have changed. On the one hand, they need to be flexible. Whereas large companies in the financial and insurance sectors used to rent several floors or even entire buildings on a grand scale, demand is now much more heterogeneous. Today, it is no longer large properties that have a clear advantage, but those that allow an adapted “business model”. In other words, risks can be better diversified when space is divided between multiple parties and caters for different industries. Fewer and fewer companies in need of office space have fixed space requirements for years and are readily prepared to sign even very long-term leases. Some companies in the startup or IT sector are subject to rapid change and must be able to constantly adapt their space requirements to new circumstances. More and more often, tenants are demanding services and a customized infrastructure that go far beyond the mere supply of space.
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“From an investment point of view, converting office premises into residential properties is an interesting prospect,” emphasizes analyst Maciej Skoczek. Generally speaking, the earnings power of some locations with a high supply ratio is declining. Conversely, very brisk demand for housing is emerging. The authors of the study “Rising vacancy rates – regional analysis of the office market,” start from the basic assumption that a significant proportion of office properties tend to be located in the lower market segment and are also in need of refurbishment. The study comes to an interesting conclusion. If these buildings are renovated and converted to apartments, it becomes possible for the same property to be positioned in a higher market segment. In many locations in agglomerations, prices per square meter of residential space are higher than per square meter of office space. In the calculation, the authors assume that a property is initially in the 30 percent quantile for office space and can be repositioned in the 70 percent quantile for residential space thanks to reutilization. In other words, a kind of “switch” takes place from inexpensive office space to the upscale residential segment.
But where does such a promising investment make economic sense? The agglomerations of the cities of Zurich, Geneva and the Zug region have the best prospects. “This is because office vacancy rates in these agglomerations are among the highest in Switzerland, while demand on the residential market is looking good,” the study says. Office properties in the city of Zurich, on the other hand, are less suitable. Here, the low vacancy rates argue in favor of modernizing and refurbishing office properties rather than converting them. In the city, the “gap” between office rents and residential rents is too small on average – the cost of any conversion work would not be amortized.
The conclusion is clear: municipalities in agglomerations where residential rents are usually about 15 percent higher than office rents offer promising opportunities.
If cash flows can be increased and stabilized in this way, this definitely helps to achieve a sustainable increase in the value of the property. Since the capitalized income value depends on cash flows on the one hand and on the local discount rate on the other, there is a second effect: In locations with low capitalization rates, rent adjustments of this kind lead to higher value gains. If the remarketing of the property improves long-term rentability and at the same time reduces the risks, this de facto leads to a lower risk premium. This also arithmetically increases the value of the property. Since residential space is less subject to cyclical fluctuations than office space, capitalization rates for this sector tend to be lower. And according to standard valuation methods, this increases the value of the investment.
The authors of the study have provided some example calculations: The rent charged for an office property in Opfikon that is in need of refurbishment anyway could be raised from 200 to 300 francs per square meter. In addition, as mentioned above, there are other positive effects. In particular, an improvement in quality could be achieved, and the property would then appeal to a higher demand segment in the residential sector. If rental income can be raised by 50 percent and the discount rate falls from four to three percent, the bottom line is that the value of a square meter of space doubles from around 5,000 to around 10,000 francs. The conclusion of this case study is clear: thanks to reutilization and upgrading, even comparatively high conversion and investment costs can easily be met.
Before such an investment decision is made, however, careful verification is required. Not every office property is suitable for residential use. The current building standards and approval procedures alone mean that many details have to be clarified, such as the amount of daylight, noise protection, room heights and, of course, the need to equip all residential units with kitchens, bathrooms and an adequate room layout.
Prior to any change of use, it is necessary to ensure whether the applicable building and zoning regulations actually permit the envisaged redesign and change of purpose. For example, larger office buildings are often located in commercial or industrial zones where residential uses are clearly not permitted. Changes to the building and zoning regulations or, if necessary, a design plan with exceptions, are always associated with lengthy political procedures. The conditions are much more favorable if the existing office building is located in a residential zone or in a mixed residential and commercial zone.
If you want to protect your earnings situation and avoid vacancies, you should also consider the option of interim use. This is highlighted by Alexandros Tyropolis, CEO of Novac Solutions GmbH. The company specializes in avoiding vacancies and adopting creative solutions: “Many office property owners are so focused on leasing vacant space that they don’t even recognize other opportunities and potential.” One obvious solution would be to make some of the space available for flexible working and new forms of work (co-working). Many startups are interested in this type of service and attach importance to great flexibility. Depending on the surface area and equipment, meeting rooms or auditoriums in office buildings can also be put to new use.
“At its core, vacancy management is about breaking down an office property into its component parts and renting out the different areas and spaces individually,” summarizes Tyropolis. For example, larger commercial and office buildings often have 200 or 250 parking spaces in their underground garage, which can be put to a new use completely independently of the office floors above. Furthermore, office properties must be actively developed and, if necessary, repositioned. For example, offering catering services, hosting events and building a “community” could give the properties a new identity.
Interim and conversion uses are not just a specific problem for the office property market. Investors are confronted with similar difficulties in the shopping center, retail space or city hotel sectors. City hotels, for example, are coming under pressure due to declining convention and business travel and changing trends in tourism. Sometimes, reutilization as micro and business apartments or new models in the area of co-working and flexible work models are conceivable. Whether hotel, office or retail space: investors and owners must have a keen sense of which uses promise stable cash flows over the longer term.