How Covid-19 has reshaped the market for office space in Europe

Investors in office property in Europe’s largest cities are concerned about the direct and indirect effects of Covid-19. We cannot answer their most pressing questions conclusively: it is still too early to tell whether we will see a second wave of infections after the lockdowns are eased. Similarly, the dark clouds of a potential euro crisis are appearing on the horizon with unpredictable consequences both for eurozone states and those outside.  

Despite these major uncertainties, however, I want to propose three provisional conclusions about the state of the European office property market. 

1)    Demand for office space is weakening

Faced with a highly uncertain outlook, many companies have cancelled or postponed plans to lease additional space. The “home office” model has worked well for most of them and, I believe, will have a lasting impact on their need for office space. If the economic outlook continues to darken and recovery is slow, as most economists currently forecast, demand for office space will stagnate or decline in the medium term.

On the other hand, companies will have to allow more space per employee in their offices to comply with new distance regulations. There are also negative aspects to working from home: many long to go back to their social life in the office. 

Early studies I have seen indicate a modest increase in vacant office space in the top seven German cities. According to the brokerage firm Colliers, their overall vacancy rate is expected to rise from 2.9 per cent before the pandemic to a peak of 5.5 per cent. As a result, the rental dynamics of recent years are likely to weaken: space will become harder to let and the impact this will have on rents remains unclear, although it likely to vary from city to city and one sub-market to another. However, the increase in supply will be partly eased by a slowdown in construction activity as projects are postponed or even shelved altogether. 

2)    Investor demand for core assets with good tenant profiles will remain strong

In times of crisis, many investors seek the safest possible assets: their priority is to preserve capital rather than maximize returns. This will increase their focus on well-located core properties with long-term leases, and I therefore expect prices in this segment will remain stable or increase, particularly given the long-term backdrop of ultra-low interest rates. However, investors are likely to pay much closer attention to the creditworthiness of tenants.

Market experts report that almost all purchases of core assets initiated before the crisis will complete. Price reductions of around 5% have been agreed in some cases to get deals over the line. 

 
3)    Prices for riskier, value-added, properties are under pressure

Investors shun risk during periods of market turmoil. As rental risk increases because properties have become harder to let (see point 1), vacancies are viewed in a negative light and therefore push down prices. If the price of value-added office properties falls, as I expect, the price gap between core and value-added assets – which had become extremely narrow by historical standards before the crisis – should now start to widen again.

Our recent experience in negotiating to buy a value-added property with relatively high future rental risk for Ardian Real Estate European Fund II is relevant here. We were able to achieve a 10%-plus cut in the purchase price to reflect the increased post-crisis rental risk, and we expect to see similar price cuts on other value-added deals in the coming months.

Investing successfully in office markets in future is going to depend increasingly on the skills and experience of the asset manager, and their ability to turn these new market dynamics into an opportunity. It will become cheaper to purchase risky properties, while the potential gains from more extensive refurbishments that transform them into core office assets are likely to increase. 

In addition, there is already a clear increase in investor appetite for more stable markets that have been less affected by the pandemic. These include Germany, where the country’s safe-haven status has been reinforced by its relative success so far in managing the Covid-19 pandemic. Some cities in Southern Europe may experience a deeper downturn on the leasing side, but I expect cities across Northern Europe to prove relatively resilient as the pandemic progresses.