MAGAZINE: Occupiers call the shots on office needs

Developers are having to live up to increasingly tougher demands for office space that is sustainable, flexible and supports the wellbeing of its occupants.

After a long period of strong growth in capital and prime rental values, 2019 finds developers pondering how long this will last – and what lies ahead. PropertyEU has taken the temperature of the European office building market by inviting developers to tell us how much office space they constructed between 2016 and 2018, and how much is in their pipeline.

Across mainland Europe and the Nordics, the 10 developers in our survey completed a total of 2,059,830 m2 during the survey period, which is down 18.9% on last year’s
volume.

For the second year in a row, Skanska tops our league table of office developers in Europe. The multinational developer – the fifth largest in the world – put up 443,653 m2 of new office space from 2016-2018, the most in our snapshot of the sector.

Interestingly, every square metre that Skanska developed from 2017-2018 in mainland Europe was in Central and Eastern Europe (CEE), where it operates in four countries.

The company continues to establish itself in the fertile – but heated – CEE region with a total of 17 new schemes in progress, the majority of them in Poland. It has three underway in Romania, two in the Czech Republic and one in Hungary.

French rival Altarea Cogedim, which takes second place in our ranking this year, has only been kept off the top spot by dint of Skanska’s activity in the Nordics. Altarea Cogedim built a total of 431,850 m2 in the three-year period. The French developer delivered eight projects in 2018, down on the 21 it completed in 2017. Its pipeline through 2021 comprises 49 office developments, all of which are in major French cities.

The final podium position for delivered office space in this year’s ranking is taken by another Gallic company, AXA IMRA. Indeed, French firms comprise most of the top five, with BNP Paribas Real Estate in fourth spot. In common with Altarea Cogedim, BNP Paribas has a strong focus on the domestic French market, with 26 of its 29 completed projects located in France. European developer HB Reavis rounds off the top five places.

Coming through loud and clear from the developers and investors PropertyEU spoke with, is that in 2019 it is occupiers who are calling the shots. Understanding tenant appetite and focusing obsessively on satisfying it are major planks of developers’ strategy.

Nowhere is this more evident than at the company which tops this year’s survey. Aurelia Luca, Skanska’s acting business unit president for commercial development Europe, tells PropertyEU: ‘Employers increasingly focus on the well-being of their employees to improve productivity and attract talent in global labour competition. Skanska meets this demand by developing WELL-certified buildings with better air quality, light conditions with natural light and sound levels.

Already, green buildings are being developed into buildings that offer a better working environment and ultimately increased productivity. ‘We observe a significant evolution of needs and expectations when it comes to the quality of modern office space. Taking into account that employees spend approximately 90% of their time indoors, a well thoughtout and well designed office space becomes an important employer-branding tool to attract and retain talent.’

Jan Odelstam, Skanska’s business unit president of commercial development for the Nordic region, echoes that. ‘Today tenants and investors are looking for well-located A Class
buildings intensively,’ he says. ‘We want to deliver them best-in-class assets, which will not be just an office space. Our goal is to provide healthy, sustainable, human-focused and future-proof workplaces. That’s why we are happy that our Visionary project in Prague was awarded WELL Core & Shell Certification as the first office building in the CEE region.’

The trend of developers focusing on occupiers’ needs is widespread and not just for the big beasts of the sector. Diversified real estate investor Cain International has schemes in Barcelona, Madrid, Dublin, Krakow in Poland and a mixed-use project with an office component in Warsaw.

Richard Pilkington, Cain’s head of European equity, says: ‘Really understanding what occupiers require is critical to what you develop. In our discussions with occupiers the key message we hear is “this space has to be right for our people”, which didn’t used to happen. It used to be more, “where does the CEO have his office?”

‘Now it is about how people get to work, where do they live, what are the amenities, what is the space they are in, and does that space work for them? Modern office is not just space for employees to work in; it has got to be more than that.

‘I think the trend in developers now is all about being very, very smart about the way you profile your occupier and create the space for the workforce.’

In Barcelona, one of the key design features of Cain’s development is concerned with the number of terraces. Daniel Harris, head of European investments, says: ‘It is not just maximising the number of square metres in the building because actually that’s not necessarily the most important thing to feature anymore.’

Mixed-use trend
He said that Cain’s development in Krakow, Poland is going to be ‘unique’ as an absolutely tenant-led business park. Meanwhile, in booming Dublin where Cain has a joint venture with Kennedy Wilson for a 35,000 m2 project in the North Docks area, it is focused on public amenities. ‘What we’re creating there is quality amenity space – public realm that will service the whole, so you get a combined residential and office community,’ comments Pilkington. ‘This is the essence of mixed use and in my view that’s ultimately the big trend. And then of course you have technology, which cannot be ignored.’

Of course, there are plenty of other issues occupying developers this year, besides what occupiers want. Our survey finds companies weighing up the economic cycle. Will the
next phase be marked by decline, or gentle stabilisation? The industry consensus is that 2019 finds the eurozone in a late-cycle period.

Yet economic forecasts remain positive, with continental GDP growth projected at 1.8%, according to Savills, supported by a strong labour market, friendly monetary policy and low inflation. This year’s top developer Skanska says market conditions remain favourable and that its portfolio and pipeline each retain good leasing momentum. Others see clouds on the horizon. Real estate broker Colliers International observes that several countries in CEE are running at full capacity and are expected to begin cooling in the near future.

Indeed, there appears to be some cooling-off taking place in our survey results too, with the 2019-2021 pipeline this year standing at 5,057,074 m2 – down 16.5% on last year’s figure. Skanska for one appears to be moving in the direction of moderation – in development at least. The total volume of space it developed in 2018 was down slightly on the amount delivered in 2017, which itself was a reduction on 2016. With Altarea Cogedim, this trend is even more pronounced. Last year, the amount of office space it developed dropped to 115,000 m2 from 236,850 m2 in 2017.

Ben Sanderson, director of fund management at Hermes Real Estate Investment Management, says the office sector remains strong, but is facing up to some big questions. In this late-cycle stage, the question is are we facing moderation, or will values be going down? It feels to me that in the major cities there’ll be moderation. So, there’s no reason to be alarmed.

‘A good example is that we see tremendous activity in Paris and Frankfurt, which has made things viable that weren’t possible in the past. But you have got to question whether
there is enough demand to fill those buildings and make them good investments.’

The presence of more equity and less debt in the system is a positive indicator, by softening the likelihood of fore-selling in the event that companies adjust their plans, believes Sanderson. ‘Markets have been going up for ages and the suggestion is that there’s a bit too much going on,’ he says. ‘However, Europe is not too extended compared to Asia. On the plus side there is mild economic growth and employment growth in the EU.

‘On the other hand, you have a general dynamic of office users using less space than they used to. It used to be 15 m2 per employer, now it’s 10 m2 or less. There is also flexible working to take into account. These are structural trends that are not going away and the question is, are we developing space in the right way?’

Investment spree
Prime European cities continue to generate deals despite questions about how long this phase at the top of cycle can continue. This was recently illustrated by Invesco completing a €620 mln deal for an office complex in Frankfurt’s central business district. Comprising 80,500 m2, the purchase of the Die Welle asset also spotlighted a big issue for the sector: scarcity of space at the heart of many booming cities’ office market. Die Welle is the German city’s sole urban business campus.

According to Invesco, the forecast for Frankfurt is positive, with low vacancy rates and below-average development pipelines likely to drive demand as employment growth increases by an expected 5.7% over the next decade.

The transaction also highlights how the office development map of Europe resembles a patchwork of differing outlooks, depending on a city’s fundamentals. This is why the likes of Patrizia are adopting a strategy of investing in cities, not countries, and carrying out ever more granular research.

So which traits do prime cities such as Frankfurt, Paris and London have in common, that make them so attractive for office developers?

Chris Urwin, director of research for real assets at Aviva Investors, says three crucial attributes make a city an appealing destination for investors. Aviva has just identified 12 so-called ‘Future Cities’ across Europe. Urwin says: ‘Cities today need three key characteristics – talent, clusters and scale – to thrive. The role of the city has changed drastically and, while location matters no less than it did 50 years ago, being a conduit for knowledge exchange and ideas creation will define a city’s success going forward. A city’s prospects are defined more than ever by knowledge exchange and information sharing.’

Brexit effect
In Brexit-impaired Britain, the picture is mixed. Jessica Berney, fund manager of Schroder UK Real Estate Fund, with €2.9 bn of offices and other commercial space, says London sub-markets are interesting. ‘There’s a trend in terms of occupier demand to London sub-markets, which is a result of the tech sector being quite a disruptive force in the occupier market. Those guys are taking space and driving occupier demand because the type of people they are trying to attract just aren’t aligned to the more core city and west end locations.’

Many effects of the UK’s decision to leave the European Union remain indirect at this point – but not the impact upon construction costs. Hermes’ Sanderson says: ‘What is unambiguously the case in the past three years is that construction costs for UK developers have gone up. It is a combination of the exchange rate, material costs and labour shortage. The exchange rate change was Brexit-related, and the others can be called indirect effects.’

Present late-cycle conditions and supply shortages are driving some office developers to broaden their horizons in the search for yield. Office yields in secondary cites can exceed
6% in the UK, as well as in the Netherlands, Sweden or Belgium. Tom Newman, fund manager at Schroders, believes regional markets are an attractive option for investing. Schroders has planning permission for five office buildings in the UK, comprising 250,000-300,000 m2. One is already built and let to the UK tax collector, HMRC.

‘Our forecast moving forward is that office in particular is going to be pretty stable and the most resilient,’ he says. ‘The regional market has seen very high levels of take-up and in 2018 we saw take-up in excess of the fiveyear average, more than 10.7 million m2, as well as higher than the year before, and 30% above the 10-year average.

‘That has meant that there are low levels of supply and good levels of rental growth. Of course, this is all at a discount to central London, with prime yields at 4.75%, whereas
in London, they’re at 3.5%. So, from an investment perspective, there has been a lot of attraction.’

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