The Great Office Myth

Ovation is currently considering an office move and I am looking around at what the market offers. It’s got me pondering – what next for commercial property as an investment?

Property (I’m thinking mainly office and retail here) has traditionally been a great part of any investment portfolio, especially funds which actually own physical buildings. Ongoing rental yields, increasing values, and people do love bricks and mortar.

The value of such property is in the income stream. The value of an empty building is very different to a building with the Govt as tenant on a 15 year upwardly only lease.

A stockbroker friend of mine had a few words to say on this recently. What’s happening (he said) is that managing agents are quoting the same rental yields (price per square foot) as they always have. But there are deals to be had. He quoted one client who had a 5 year lease with a 2 year rent free period.

Hang on (says I), why not just quote two fifths of the rent? It’s the same income over 5 years, and after all it’s income that matters with property.

But no (says my friend). The value of the building is rent per square foot multiplied by size of building. The agents are paid based on value of the building. The owner of the building doesn’t want to lose money on the value of the building. The value of the fund (if it’s owned by a fund) is dependant on the value of the building. The values of all the other buildings in the area/fund are established by reference to the value of this building.

Which is why there are so many empty offices/shops. If one landlord admits that the real rent isn’t, for example, £20 per square foot but £10 per square foot, the value of his building will halve. And other buildings will follow suit. And fund values will dive. Better to have an empty office on the market at the current rent than let it out at a lower value.

Of course, it’s entirely possible that my friend’s cynicism is unfounded, and that in 10 years time (say) the economy will be much more buoyant, offices will be occupied, and values quoted will be real values once again. No-one will have realised that underlying values plummeted during that period but were kept high by creative rental deals.

And yet it doesn’t seem quite right to me. I don’t think a retail investment product would get away with this kind of pricing, for example.

I’d love to hear comments and thoughts of others on this sector.