Buildings suitable for conversion are giving investors greater flexibility amid the Covid-19 pandemic. This flexibility is crucial given the rising concerns about the viability and profitability of office spaces, among other real estate investments, in an environment where a large number of employees are working from home, with many unlikely to return to their pre-Covid working routines after lockdown restrictions are lifted.
Indeed, research by O2 Business in partnership with ICM and YouGov states that “45% of the workforce in the UK believe flexible working will increase permanently, and 33% expect to increase the time they work from home by at least three days a week”.
This increase in remote working looks set to result in lower demand for office buildings, risking a surge in the number of vacancies.
The average vacancy rate in the European office market was 5.8% in 2019, down from 6.2% the year before, according to data from BNP Paribas Real Estate. The data also shows that while the vacancy rate has consistently declined over the past decade, average prime rents have been increasing.
Among the European cities with the highest vacancy rates in office buildings in Q4 2019 are Manchester (15%), Birmingham (12.8%), Riga (11.8%), Helsinki (11%), Budapest (10.5%) and Glasgow (10.1%), according to the 2020 European office market report published by BNP Paribas Real Estate.
However, a high level of vacancies in office buildings doesn’t necessarily mean that these spaces are suitable for conversion.
“The success of an office conversion to an alternative use depends on various factors, such as macro and micro location, building character, slab heights, facade-to-floor ratio and the depth of the floor plan,” says senior project manager at professional services firm Arup in London Emanuel S Rebelo. “When converting, a balance must be found between supply – the building location and characteristics – and demand, which is the alternative use requirements. The greater the gap between supply and demand, the greater the challenges and expected cost when converting.”
Appetite for conversion
With many office buildings ticking the boxes for conversion into hotels, several investors have opted for this type of investment in recent years.
“While there is an appetite for converting all sorts of buildings, such as warehouses and military barracks, into hotels, developers mainly focus on either older or poorly maintained office buildings with little potential for conversion into residential space, or on very large buildings in need of substantial refurbishment as part of a multi-use repositioning,” says Ilias Manoukas, head of transaction at real estate development company Immobilia and Dr Lubke & Kelber.
Dutch hotel group Citizen M announced in May that it had acquired an office building in Rome that it was going to convert into a 160-room hotel. The company is also looking for similar opportunities in Milan. Other recent examples of office buildings being converted into hotels include Transport for London selling its headquarters to Integrity International Group in 2019 for more than £120m, and Spanish hotel chain Riu Hotels & Resorts acquiring what had been an office building close to Victoria Station in London in 2018.
However, co-head of London markets at BNP Paribas Real Estate Simon Glenn says that it is likely that converting an office into a hotel will become more difficult in the future in London, as the city’s planning authorities are focusing on maintaining or extending commercial activity in business districts, particularly where new office accommodation will provide better environmental, social and governance standards.
Hit in the profits
With restrictions imposed as a result of the Covid-19 pandemic, there has been an immediate negative impact on tourism, hurting the profitability of hotels and posing a number of questions about investment in the sector.
“Currently, due to the uncertainty regarding the operation of city hotels, the difficulty in finding attractive bank financing, the high demand for residential space and the low office vacancy rate in Germany, where the top five cities have a 3.5% vacancy rate, a conversion is more likely to happen in secondary cities that have a growing population or are becoming more popular as a destination, and that have a limited supply of hotel rooms,” adds Manoukas. “A prerequisite for the realisation of conversion projects is a financially secure hotel operator and a healthy equity participation from the developer or investor.”
Glenn suggests that as appetite and market dynamics for residential and hotel use potentially wanes in central London, previous planning consents granted for these alternative uses may be re-evaluated as an office-led scheme.
“If you were a developer that owned a consented hotel development site that now doesn't look viable, you could see an office developer stepping in and reviewing it as an office instead,” he adds.
Even if people continue to work from home more frequently after the lockdowns are eased, there will still be a necessity for physical offices, as many professions will still require a physical presence.
US head of research at Newmark Knight Frank Alexander Paul says it is likely there will be some net reduction in demand for office space as more people work remotely, but social distancing inside the workplace will mitigate that impact to some extent. He adds, however, that it is too early to say how demand for office space will respond to the issues raised by the Covid-19 pandemic.
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Rebelo adds that the pandemic has accelerated the digital transformation and workplace revolution that started in the early noughties.
“For most companies, far more employees are likely to regularly work from home in a post-pandemic scenario,” he says. “This could dramatically increase a company’s desk-sharing ratio in an office, as well as their appetite to downsize real estate portfolios and associated costs.”
However, any move towards downsizing could bring with it an opportunity for developers to break down their office spaces into smaller units and fit more companies into the same building.
Converting office buildings into residential units could also become increasingly popular, as there is a strong demand for housing in many cities. Paul also suggests that it is possible that demand for multi-family units over the next few years could accelerate the conversion of some obsolete office assets into properties that cater to this need.
“Conversions can be an effective way to retain an asset’s value and [they provide a quick and easy way to reduce other shortages], particularly data space, residential, student accommodation and other forms of co-living and co-working requirements,” explains Rebelo. "From a broader economic perspective, many conversions are likely to take place in single-use urban districts, which will benefit from a [more diverse] use.”
In the aftermath of Covid-19, the appetite for office buildings and hotels will depend on the local dynamics of each city, as well as on the social-economic indicators of each country. Hub cities for IT, such as Berlin, will probably continue to enjoy a strong appetite for office space when compared with areas that are more reliant on retail or tourism. In the shorter term, as the pandemic has affected some countries more severely than others, those that have kept death rates low and eased lockdowns faster are set to experience a smoother return to the ‘new normal’, which will assist their economies in their recoveries.