A perfect secondary property storm looming 13th December 2011

Poor quality secondary office stock accounts for more than two-thirds of total floor space for the sector, with the proportion set to rise as restricted redevelopment appetite curbs the recycling of moribund properties. Almost 70%, or 721m sq ft of total UK office stock, is categorised as “poor quality secondary” – or grade C – with the highest proportion of stock, around 85%, in provincial markets as a result of much lower development, according to research by DTZ Research. The availability of grade C stock availability - surprisingly - has been low, despite the economic headwinds. The report states: "Contrary to popular belief, availability of grade C office space is lower than grades A and B. Despite doubling in regional markets since 2008, grade C availability across major markets is estimated to be only 3.5%, compared to 12% for B and 19% for grade A.” Grade C stock in London, outside the City and Fringes, reflects more than two-thirds of total office stock in those locations (68%), again driven by low development activity outside the West End and west London. In central London, where the value of land has justified a more intense level of development and superior build quality, grade C space accounts for more than half of all stock (54%). Grades A and B office stock account for around 9% and 22%, respectively. The research, which DTZ said is its first step in sizing the non-prime UK market, concludes that the overall proportion of poor-quality secondary office stock – particularly in the provinces – is likely to rise in line with lease events, such as break clauses and expiries. Rising total grade C stock will exacerbate an already entrenched property market polarisation, both in terms of geography and lot size. DTZ’s analysis shows that, outside of London, the appetite for redevelopment is slim creating “a problem for grade C owners in terms of recycling unwanted stock – especially as grade C availability is likely to be higher in smaller markets”. The research is based on a bottom-up assessment of nearly 3,000 buildings covering 164m sq ft in Birmingham, London City, the fringes and Reading as representative markets for the UK as a whole. The analysis was further extended to the rest of the UK by using a variety of sources and by assuming a certain relationship between quality and age of office buildings in these other markets. Hans Vrensen, global head of research at DTZ, said: “Non-prime property is collateral for much of the [outstanding] circa £300bn real estate debt in the UK. The work-out of loans against non-prime property still has a long way to go, as we saw in the lenders survey we conducted as part of this year’s Money into Property research. Over half the lenders surveyed believed that the work-out for non-prime assets had yet to start.” As Vrensen argues, the proportion of total UK stock believed to be poor secondary is already substantial, and if lease events trigger tenant upgrades it will result in increased obsolescence among segments and geographies of the market for which refinancing is already difficult. The trend towards greater volumes of poor quality assets will, therefore, make an already huge problem even more difficult, which could be further intensified if a predicted slowdown in the economy, or even double-dip recession, weakens the underlying occupier market adding pressure on companies, from expansion plans, to headcount reduction, or even, survival. Vrensen added: “Given its stronger capital value recovery so far, much of the bank-controlled property sold has been prime or good quality secondary floor space. But as for non-prime property, where over 50% of respondents felt that the work-out had yet to start, a lot of progress evidently still needed to be made.” The pace of this secondary stock deleveraging by the big three property sellers – Royal Bank of Scotland, Lloyds Banking Group and Ireland’s NAMA – is the dominating theme of the next 12 months and beyond. One argument is that a backward lurch in sentiment, rental growth and capital values will tempt sellers to slow down the pace of offloading poor quality secondary and the “tertiary dogs” as to offload in a falling market will increase losses. But the counter argument to this is that a falling market will speed up the incentive to sell off stock quickly, as sellers seek to meet their aggressive deleveraging targets. Incoming regulation and banks’ capital raising requirements may add to this. Quite which way the wind will turn makes for a less predictable short term than usual, but suffice to say the momentum building up in the market ahead of the summer, through expected property loan portfolio sales, has waned somewhat, given the contagious impact of peripheral sovereign Eurozone debt. The outcome of seemingly indirect events in Europe could well be the deciding factor in determining the direction of travel for the year ahead, for secondary stock and all that is related to the troublesome part of the domestic property market