Office market
Adapting to new realities
Executive Summary
In this section
The rebirth of the office market in 2015
Due to the enormous amount of new office development around the turn of the millennium, vacancy started to rise sharply in Amsterdam in this period and peaked at 18.7% in 2003. In the period to 2015, vacancy was never lower than 12.5%, but as of that year vacancy rates started to decline sharply as vacant offices were rapidly converted to other functions and occupier demand picked up again.
The relationship between vacancy and rental price development is strong and clearly visible in the figure below. During the 2002- 2015 period of high vacancy, top rents remained flat. Rents (finally) started to rise again only when vacancy rates started to fall after 2015. The graph below is for Amsterdam, but all other major cities in the Netherlands paint a similar picture.
Since 2015 prime office rents increased annually by
5.0%
“The office market is facing a transition due to the combination of working from home, the sustainability challenge and the concentration of occupier demand.”
Working from home
The 2020 Covid-19 outbreak meant that offices were temporarily used very sparingly and that working from home became the norm rather than the exception, even among people who had previously barely worked from home. Office take-up remained low, while vacancy rates did not decline any further (although this was almost impossible in prime locations) and rent increases ground to a standstill.
The office market entered an intermediate phase, with many companies taking pause and starting to think about the role the actual office should play in the post-Covid period, as well as the optimal location and the required surface area that came with it. As we expected at the time (see the previous Outlooks), this had no immediate effect on vacancies. Only recently have we seen an acceleration in the number of companies consolidating locations, subletting floors and renting flexibly.
For the office market as a whole, Bouwinvest still expects a maximum of around 10% of the current office stock to become redundant. And we expect the surplus to mainly arise at secondary and tertiary locations.
The focus of companies on the most accessible and vibrant locations is permanent and because the number of square metres that companies rent is declining due to working from home, the best locations are coming within reach of more and more companies. However, even these prime spots will not escape the short-term increase in vacancy rates. It will take time for the office market to settle into a new equilibrium.
Major market developments and potential impact on offices by quality rate
Source: Bouwinvest (2023)
Finally, Bouwinvest expects the growth of flexible renting to continue for the time being, while companies will pay increasing attention to the design and ‘health’ of their offices, as well as the services and quality offered to employees. We also expect companies to encourage employees to come to the office at least three days a week and that employees will mainly continue to use Mondays, Tuesdays and Thursdays for this purpose.
Sustainability in the office market
The previous image already referred to increasing sustainability requirements. In the Netherlands, since 1 January 2023, offices must have at least energy label C to be rented out (listed buildings excepted). Owners are still within a transition period during which they must demonstrate that an upgrade is underway.
Nevertheless, this does place considerable pressure on the part of the office market that does not comply with this requirement and that will require significant investments to do so. Part of this office stock is expected to be taken off the market eventually as a result of this legislation. This will mainly affect offices in less attractive locations, where investing in sustainability is less likely to translate into a higher occupancy rates and higher rents.
31%
of office buildings do not have an energy label
Ultimately, the bar is much higher: from 2050, all real estate will have to meet the Paris Proof level, which means that offices will be allowed to use a maximum of 70 kilowatt hours of energy per square metre per year. All long-term investors, very much including institutional investors, are already fully taking this into account. The costs that will have to be incurred to upgrade the asset in question to (a minimum of) Paris Proof level are generally assessed when investors look at potential acquisitions.
Recent research by among others Eichholtz and published in ESB shows that offices with at least a C label are now worth 20% more than offices without a label. That difference is mainly due to the sharp decline in the values of offices with a G label (the worst label). There is no significant difference yet on the rental side. Whether or not you have a C label does not yet play a decisive role (but will in the short term).
In Bouwinvest’s opinion, rent increases will only apply to offices that meet the highest sustainability requirements (and where higher rents are partly recouped in lower energy costs). Investing in office buildings to bring them to the Paris Proof level is easier to calculate in the best locations in the Netherlands, where demand is the strongest, rents can grow and the risk is therefore more limited.
New construction versus redevelopment
New construction is currently extremely difficult to realise in the Netherlands due to high and rising construction costs (further increased by the necessary sustainability requirements), the decline in valuations and the construction restrictions as a result of the nitrogen problem. This also means that the number of investment opportunities in new-build offices will be limited.
This will shift the focus to the purchase of (upgraded) existing offices. For the institutional part of the market, this involves buildings that can be made Paris Proof and are located in multifunctional, vibrant locations that are easily accessible by public transport.
Energy label C offices in better B- locations are also interesting for investors who are further along the risk spectrum. There will be no new-build competition in the short term and if they can also be converted into homes in the long term, there is a fallback option.
Challenges and opportunities on the office investment market
In the first half of 2023, the investment volume of offices came in at a meagre € 650 million, remarkably with barely any transactions in Amsterdam. The reasons for the general decline are known: high interest rates and financing costs, the uncertainty regarding the general development of the office market and the continuing write-downs on the office market.
Another potential factor is the fact that the uncertainty regarding the ultimate costs of making new acquisitions Paris Proof is creating a larger gap between the buying and selling parties. The fact that rents for prime office stock continued to grow had a somewhat dampening effect on the capital decline.
But why does Amsterdam seem to be hit harder? Here the difference between bid and ask prices plays the biggest role. There remains a clear interest among purchasing parties for office real estate in Amsterdam, but they would like to see the general market uncertainty translated into adjusted sales prices. Sellers do not want to deviate too much from historical initial yields and will otherwise just keep hold of the office properties.
The rapid and large depreciation of the office market probably also means that the floor will be reached quicker, which is essential to get the investment market going again. We saw this after the GFC, when depreciation continued in small steps over a long period of five years. Bouwinvest does expect a further (more limited) write-down in H2 2023 and H1 2024, after which the market will slowly return to positive territory. This re-pricing will generate buying opportunities, especially for non-leveraged buyers, as financing costs are substantial due to higher interest rates.