Why net zero ‘green tape’ means the office downturn has only just begun

Britain’s offices faced a severe reckoning in 2023 as stubbornly high interest rates sent values tumbling. But experts warn the downturn is far from over.

“Property values have further to fall,” says Fraser Greenshields, a partner at EY’s corporate finance division.

The value of commercial property – which covers things like offices, shops and factories – has dropped by 3.7pc over the last year, as surging interest rates have made it more costly for investors to borrow money.

“Debt has been cheap for a pretty long time,” says Greenshields. “We’ve had over ten years of cheap money, including the last two. And interest rates rising the way they did was a shock to everyone.”

Surging rates around the world have sent properties businesses that were built on the back of cheap money tumbling into trouble.

Signa, the Austrian property company that was an owner of Selfridges and the Chrysler building in New York, filed for insolvency last month. WeWork, the US flexible office company once worth $47bn, also collapsed this year.

The headline fall in commercial property rates masks the much sharper downturn for offices, where average values have plunged by nearly 20pc. An increase in hybrid working has left many companies reevaluating how much space they need, with many looking to downsize.

In April, The Telegraph reported that John Lewis was planning to reduce the size of its central London headquarters by more than half, after staff left their desks to work from home.   

Canary Wharf residents such as Clifford Chance and HSBC have announced plans to quit the district as they downsize, with the vacancy rate for offices in the docklands now at 16pc – the highest level in years.

Falling office values may sound abstract, but it has broad implications. Pension funds hand their cash to money managers that invest in property, meaning a downturn in values can lead to smaller returns on your retirement cash.

You may think 2024 will bring some relief. Interest rates in Britain are forecast to fall to 4pc by the end of the year, easing downward pressure on prices.

But experts say new net zero rules intended to boost the eco-credentials of office blocks, and the continued trend of working from home, means the outlook is bleak.

“Valuations have been hugely affected by the uncertainty of future office demand and ESG considerations,” Greenshields says.

New rules came into force in April requiring all office buildings to have an energy efficiency rating of at least E in order to be let out. The minimum threshold will ratchet up quickly over time, which will require many owners to sink more money into upgrades.

A minimum rating requirement of C will come into force by 2027 under the new “green” tape rules, before rising to B in 2030.

In London, only around 23pc of all offices are rated A+, A or B. When the minimum E rating came into force, around 8pc of all commercial stock was effectively illegal to let out according to BNP Paribas.

With money to fund these upgrades now much more expensive to get hold of, the worry is that many investors will simply sell up rather than make the necessary requirements. It risks leaving London littered with empty properties that aren’t up to standard.

Sellers also risk offloading buildings at a loss. Consultancy Green Street found more than €3.3bn (£2.8bn) worth of UK and European office buildings that had failed to sell in 2023 after being put on the market.

Analysts at Green Street say: “For Grade B/B+ office buildings, sellers face lean bidding tenants and steep discounts.”

Financial pressure means some investors will have little choice but to swallow a loss.

Research from AEW estimates that there will be a €90bn debt funding gap across the UK and Europe between 2024 and 2026, signifying the gulf between how much companies need to pay and what banks can lend. This huge difference will only close once property values level off, making it easier for companies to refinance.

Property investors that are looking to drum up cash quickly could mean fire sales, which would put further downward pressure on prices.

After a brutal year for offices, 2024 may be even worse.