The outlook for office markets: How will energy performance impact office stocks?

Will increasing energy efficiency standards eclipse flexible working as the primary driver of changes in tenant office demand? In the last of this three-part series, Tarrant Parsons, RICS Senior Economist, charts the growing influence of minimum energy efficiency standards on the outlook for office markets.

Energy performance and the outlook for older office stock

It is not only the increased prevalence of remote working that is weighing on demand for older office assets. Another critical challenge for the sector across Europe is the increased legislative requirements from governments regarding Minimum Energy Efficiency Standards.

At the EU level, a system of Minimum Energy Performance Standards (MEPS) has been proposed. According to these proposals, public and non-residential buildings will need to achieve at least an energy performance certificate (EPC) level ‘F’ by 2027 and ‘E’ by 2030. Meanwhile, in the UK, the Minimum Energy Efficiency Standards (MEES) regulation proposes existing commercial property should achieve a minimum EPC rating of ‘C’ by 2030.

Research by Savills finds that close to 50% of offices in the UK are below the required benchmark for 2030, potentially creating a significant risk for capital returns on account of the proposed regulatory changes.

On a similar note, a study by Cushman and Wakefield estimates that by 2030 as little as 24% of the existing office stock across Europe will still be fit for purpose. That is, unless measures are taken to improve the buildings’ credentials. Cushman’s research goes beyond purely focusing on the future impact of energy efficiency regulations and evaluates how much office product could be left unsuitable by the evolving needs of a hybrid workforce. Their analysis places Europe’s office stock into three categories, top, middle and bottom.

Facing the greatest risk of obsolescence, 14% of stock sits in the ‘bottom’ tier. This includes office buildings that are 30+ years old, have not been renovated in over ten years and fail to meet sustainability criteria. This lowest quality category of office building also falls short in providing several other key features now demanded by tenants including:

• versatility of space including core working zones
• dynamic meeting areas
• conference spaces and
• flexible coworking arrangements.

In addition, these buildings score poorly with regards to accessibility and the provision of desirable amenities such as retail, cafés and gyms.

If this type of office is to avoid becoming obsolescent, investment (substantial investment in some cases) will be needed to upgrade these buildings in-line with both legislative criteria and transforming tenant preferences.

Repurposing the middle tier

The ‘middle’ tier is also at risk of becoming derelict further down the line. Cushman and Wakefield’s analysis categorises 62% of European office stock as being in the ‘middle’ tier. Although difficult to quantify at this stage, they consider a large amount of this space will also require upgrading to reposition its offering.

In some cases, even if office stock can be brought up to adequate energy efficiency standards, it may nevertheless be unable to compete with higher spec or better located buildings. ‘Middle’ tier offices may still struggle to attract increasingly selective tenants and may therefore still carry higher risks of vacancies. For these office buildings, repurposing may be the best option to preserve income generation and maximise the asset value for investors over the longer term.

Potential options for repurposing could include (where appropriate):

• residential
• data centres
• life sciences
• healthcare or
• industrial space.

These sectors have seemingly bright longer-term prospects with regards to occupier demand strength. They could also provide a much better return on investment than offices that are struggling to attract tenants amid the enduring structural shifts.

The cost of repurposing those assets where no investment has been made (and are at the greatest risk of obsolescence) will need to be capitalised in valuations to entice investors looking for new value add opportunities. Reaching that point could require a significant downward adjustment in some older/secondary office values. Such an adjustment would be similar to that seen in parts of the retail sector over the past five or so years (also caused by changing structural dynamics). For example, CBRE data shows shopping centre capital values have fallen by 58% since 2018. For the next year at least, projections for secondary office capital values (taken from the RICS Global Commercial Property Monitors) are firmly negative at the global level (-5%), with the steepest declines on a regional comparison anticipated in Europe (-6%) and the Americas (-7%).

Outlook for top tier offices

In contrast to the troubled outlook across secondary office markets, longer-term prospects for their prime counterparts are more optimistic.

Even with the structural difficulties posed by remote working, Savills research foresees demand for the highest-grade office space across the UK outstripping supply over the next five years. This is anticipated to drive an acceleration in prime office rental growth once the shorter-term macro headwinds of high interest rates, rampant inflation and sluggish economic growth dissipate. Likewise, Cushman and Wakefield forecast demand for the best-in-class office space to outweigh the supply of new stock through to 2030 across many key European cities including London, Paris, Frankfurt, Munich, Madrid, Barcelona and Milan.

In another sign of confidence behind the sector, CBRE Investment Management sees both office rent and capital value ‘green premiums’ increasing across most developed countries going forward as sustainability standards rise globally. Moreover, they state that one of their ‘preferred global equity strategies is investing in best-in-class smart, amenitised and energy efficient offices.’

Knight Frank estimates that office buildings with a BREEAM or NABERS rating (sample based in London, Sydney and Melbourne) command an 8–18% sales price premium compared to equivalent office buildings without such ratings. Similarly, their research finds there is a 3–13% rental premium (depending on the exact rating) compared to the equivalent unrated office buildings in central London.

Energy efficiency driving top tier demand

Increased working from home has certainly reduced overall tenant demand across the office sector throughout many parts of the world. However, this impact appears much less significant when it comes to the top end of the market. Take-up data suggests changing occupier requirements have reallocated demand away from secondary office markets towards prime, further compounding issues for the former.

Energy efficiency regulations are widely seen as the dominant driver pushing demand towards the newest or highest-grade office stock. Going forward, the impact of more stringent legislation may begin to overshadow the structural hit to demand for lower grade office space from remote working as companies cement their longer-term workplace strategies. Either way, it is difficult to escape the reality that both elements are likely to exert sustained downward pressure on secondary office markets in the years ahead.