How close is the UK office sector to fair value?

In the last blog in this series, we showed that UK indices implied office values were down -28%[1] from their previous peak, with markets appearing to price in a fall of more than -40%. In MSCI’s data, the equivalent yield for all offices was 7.5% in Q4 2023 – against 5.6% at its peak[2].

The key question is this: does this yield represent good value, or are offices still expensive given their risks?

There are various techniques to compute fair value. As this is a blog, we won’t overdo the quantitative analysis, but we have crunched some numbers to ascertain what yield we think would represent fair value. We can then use this yield, together with expected rental value change, to work out the peak-to-trough change in values required for offices to offer fair value.

Before I summarise the results, it’s worth highlighting a view that, before COVID-19, office yields did not always reflect expected and after-the-fact risks. These include management time, heightened occupier engagement and resultant irrecoverable costs, capex on both upkeep and to avoid structurally higher depreciation, and void costs. In hindsight, many investors paid what they had to in order to purchase assets ahead of the competition, with subsequent costs either value engineered (to the detriment of occupiers and to specification) or absorbed.

Yields and therefore risk premia – the theoretical compensation investors receive for risk – should, in theory, have been higher as a result.  In fact, our calculations show that the risk premium for holding offices in the past was lower than the all-property average. This suggests that both these known and ‘surprise’ costs of holding offices where never efficiently reflected in values and pricing. This did not make much sense before COVID-19, and certainly does not now.

In other words, a re-priced sector could be a good thing for new investment – and occupiers – if yields offer sufficient compensation to run offices ‘properly’.

After conducting our own analysis, we estimate that current office yields (MSCI equivalent) are between 20 to 170 basis points (bps) too low versus fair value, with an average of 80bps. This is quite a range, but this is an inexact science, and we attempting to estimate magnitudes of risk. Of course, the market doesn’t have to deliver the value changes required to meet these target yields: they are a measure of what we deem to be fair, not what the market will pay. It is also possible that the market overshoots into ‘cheap’ territory.

Translating required yields into peak-to-trough valuation changes shows that a range of between -31% and -42% (an average 35%) might be warranted compared with the current valuation index measure of 28%[3]. We’ve italicised that last term because, compared with an estimated change in actual market pricing – which takes time to feed into valuations – the market may already be delivering a discount of around -40% discount compared to its peak[4].

We also ran this exercise on low-yielding assets (good quality, low risk) and higher-yielding assets (poor quality, high risk) using MSCI valuations. Despite the much higher yield offered by the latter, we do not think they offer sufficient compensation for lower long-term rental growth and for a depreciation rate that is expected to be structurally higher. Primer assets, despite their lower yield, were much closer to fair value with the opposite drivers seen.

There will, of course, be significant ranges in price adjustment in the real world. And, as we said above, there are pricing pressures still to come from the sale of investment product from motivated leveraged investors and via pension risk transfer. But it does seem that valuation indices are not far away from fair value, if we assume our forecast of a further -11%[5] coming off office values on the MSCI index this year. Market pricing may already be there.

This is the third in a series of four blogs which explore the implications for institutional investors of the recent evolution of the office market. You can read the first, on the challenges facing the UK market, here, and the second on the global context here.  In the next and final blog in this series, we’ll ask the biggest question of all. If the offices sector is at or near fair value, what should we do about it?

[1] MSCI Quarterly Digest, Q4 2023

[2] Peak in December 2010, MSCI Quarterly Digest, Q4 2023

[3] MSCI Quarterly Digest, Q4 2023

[4] LGIM Real Assets estimates

[5] LGIM Real Assets forecast, January 2024