Ryan Wray, Managing Director and Principal at Avison Young, Czech Republic, talked to Property Forum about the perils of today’s macroeconomic conditions investors may reckon with in their decision-making and looked at possible scenarios and working strategies for office occupiers in the Czech office market.
Skyrocketing inflation is causing a major headache for everyone. How do you see real estate investors adapting their strategies in response?
The answer isn’t that straightforward, investors don’t look at inflation in isolation and adjust their strategy. They must look at inflation alongside numerous other economic and market indicators to define a strategy that makes sense over the medium to long term.
But there are few direct implications that most investors will consider in a high-inflation climate.
Inflation is also making construction a lot more expansive. How are developers tackling this problem?
Developers are in the toughest spot at present. Land acquisition for future development typically means equity investment with no income. This is particularly painful when interest rates are high. Secondly, the rapid changes in construction costs, including labour costs, make budgeting extremely difficult, the risk curve has just gotten a lot steeper and the potential returns a lot less, so it’s a hit on both sides.
We see Developers looking at alternative ways of funding their acquisitions; I believe that in the next 12 months we will see a notable increase of activity in the alternative funding market, as banks are more cautious and not notably cheaper when funding in CZK.
But, if you are a well-capitalised developer, with cash ready to spend, the next 12 months will present some good opportunities. We are already seeing a cool-off in land acquisitions and pricing, and a huge surge in land projects available for sale. So if a developer can be patient and keep their eyes closely on the market, there will be opportunities available that are cheaper than they would have been in January 2022.
Does the situation make the renovation of existing buildings a more attractive option in comparison?
Yes, as I said before, existing assets are very well priced when compared to the cost to build new. Upgrades and (partial) refurbishments typically involve fewer unknown quantities that are included in green-field development, so the budgeting is easier. The existing asset will also have some trading history, so the demand dynamics of that micro-market can be analysed in greater detail. This means the rental value is a known quantity. If the location is right, and the property has the potential to maintain occupancy via upgrades and a smart leasing strategy, then yes, existing buildings look more attractive.
With energy prices rising at an unprecedented rate, many occupiers are in for an ugly surprise over the coming months. How do you expect them to react? Are we in for an exodus of occupiers leaving less energy-efficient buildings?
I don’t believe that we will experience a mass exodus as companies need premises to carry out their daily business. Occupiers will place a greater focus on some fundamentals of the occupancy cost structure within the lease agreement. They will seek to understand in detail their indexation clauses, how/when it is applied and calculated. There will be higher scrutiny of service charge budgets, what they include, how the budget is set, and the efficiency of the building. Efficiency can be related to the performance of the technologies or the proportion of common areas in relation to exclusive areas (the add-on factor). So, Landlords that can demonstrate both energy efficiency and gross to net efficiency will be the winners.
Additionally, everybody needs to accept inflation will also affect fit-out costs. Therefore occupiers can expect substantial increases in relocation costs. In some cases, expansion within current premises might be more affordable than relocation to a new, even more efficient building.
We believe the foresightful occupier should push the landlord to improve the building’s efficiency through operations and upgrades and negotiate harder to reduce potential shocks in operating costs and rental increases.
Combined with the continued underutilisation of office space due to WFH, can rising utility bills drive occupiers to downsize?
Let’s not enter the discussion around the impact of COVID-19 and the new normal of hybrid working. We could talk about that for hours. But just a note that the focus on efficiency will be combined with a re-evaluation of how much permanent workspace is required and how much common or break-out space is required. Occupiers will seek to utilise fewer exclusive premises in an effort to be more efficient themselves. Shared break-out areas and facilities within buildings are extremely attractive today, as tenants can then reduce the sqm they lease exclusively and contribute proportionately to the shared facilities that are only needed for use on a more ad-hoc basis.
It is true a percentage of tenants are downsizing however most occupiers are actually realizing they need to use the space they occupy differently. If the building does not offer shared break-out facilities, the occupier is re-drawing its own space plan with less focus on fixed workstations to create space that can be a social hub for its employees.
With ESG compliance becoming high on the agenda of every corporation, the pressure will be higher than ever for landlords to invest in increasing energy efficiency. How will that impact the market?
ESG and energy efficiency are distinct but interrelated clearly. Energy efficiency is a must; it can be measured and therefore it is the first port of call in the application of an ESG strategy. It also benefits tenants’ bank balances, so it’s a win-win.
The market is already rapidly adopting ESG as a fundamental part of real estate strategy. We are in the process of conducting numerous ESG Audits on existing buildings for our clients; the result is an output for the landlord which shows the current status of the property from a best-practice perspective. We can then plot a clear step-plan for the building manager to improve the property’s ESG credentials. These form what we call “Quick wins”; those easy actions that are low cost and actionable in the immediate term, but just are not being carried out by the operations team today. Then we have medium to long-term actions, often these involve Opex and Capex planning; usually, they dove-tail with prudent and proper building operation and maintenance, so they are not tasks that only serve to be ESG-friendly, but actually provide a multitude of benefits to the landlord and the operation of the building.
There are EU grants available for certain works, this also lightens the burden, and the implication of EU Taxonomy means that the property that has an efficiency and ESG plan in place will be future-proofed against significant taxation that is expected to arrive in the coming years.
Impact on the market? More energy-efficient buildings, more socially conscious landlords and more business decisions focused on long-term stability rather than short-term gains.
How do you expect all these trends to impact rental levels in different sectors over the next 12 months?
Rents are rising across all sectors with the exception of shopping centres. Inflation and construction cost growth mean developers must apply higher rents to maintain profit margins. Industrial demand is at record highs and demand is expected to remain strong for the foreseeable future.
Office rental levels will reflect inflation, but we also see office rents have been rising for quite some time thanks to rising construction costs. This is specific for new development as existing office buildings are obviously not affected so severely. This trend is expected to continue into 2023.
Residential (apartment) rents will grow as demand is driven by higher mortgage costs and the trend towards BTR living concepts, where renters are provided with all-inclusive services in their residential lease contracts.
In light of rising rental rates and occupancy costs, it is paramount for occupiers to carefully review the terms of any new lease agreements. At Avison Young, we are here to help guide clients through this process and use our expertise and best practice to negotiate the best available terms today.
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