Offices in London will Become More Affordable as They Adopt Green Practices

The London office market is becoming increasingly competitive, but this is unlikely to deter property owners from undertaking energy-efficient refurbishments.

Despite strong demand from tenants, office buildings owned by British Land, Landsec and Great Portland Estates have seen their values decline.

Three of Britain's largest real estate investment trusts (REITs) lost an estimated 3% of their value over the six months through September, according to results posted last week. In London's financial district, prices were down by almost 10%.

Further price declines may be on the way as interest rates rise. At roughly 4%, the U.K.’s five-year swap rate, a proxy for real-estate borrowing costs, has more than tripled this year. When the owners of London’s best-located offices come to refinance their borrowings, the all-in cost of debt will likely be 6.25%, according to GPE. As that rate is higher than the rental yields these properties generate at current valuations, it will be hard to shift buildings without cutting prices further. This could be a headache for the U.K. property funds of asset managers such as Schroders and BlackRock that need to sell assets to raise cash for investor redemptions.

The demand for office space is linked to economic growth, so the slowing of U.K. output is a bad sign. The tech sector, which has been responsible for 20% of London office-leasing activity over the past decade, is shedding jobs globally. And remote work is sticking: Britain’s offices are being used half as much as before the pandemic. The vacancy rate in central London is now 8.1%, according to real-estate company Jones Lang LaSalle, almost double its late-2019 level.

This downturn is not expected to be as severe as the global financial crisis in 2008. London's listed landlords have stronger balance sheets than they did then, and there is some demand for energy-efficient office space as corporate tenants try to meet net-zero targets.

REITs are more likely to own buildings that are energy efficient than private investors, which may explain why their leasing teams are busier than the wider market. Around 40% of London office REITs’ properties are rated either A or B for energy efficiency, compared with 15% of the city’s offices overall, based on data from real-estate research firm Green Street.

There is expected to be a shortage of energy-efficient office space until at least 2025. Only 2.5 million square feet of new space is projected to be built each year, compared with an estimated annual demand of 4.8 million square feet. Buildings that are currently under construction and due to be completed within the next year are already 75% pre-let, which is a record. This is likely to push up rents.

Landlords are looking to take advantage by refurbishing older offices in their portfolios. However, this won't be cheap, as inflation in U.K. construction costs is expected to be around 10% this year and up to 5% in 2023. Although this is lower than the 14.1% rate in the U.S., high energy prices in Europe could make building costly for several years.

The alternative to going green is to do nothing and watch valuations fall further. GPE said the value of London’s less energy-efficient buildings fell 4.2% in the six months through September, while more sustainable ones were down a more modest 2.5%. Going green probably still makes more financial sense for the city’s better-capitalized landlords than letting their portfolios slip into obsolescence.