Without intervention, a significant tranche of the UK’s office space will fail to meet tightening standards on energy efficiency over the coming years. Sobering as this is, an acute supply of future-proofed stock provides considerable opportunity to reposition secondary offices.

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Development Difficulties

The prevailing narrative around the UK occupier markets has been long-focused on ‘flight to quality’, reflected in strong lease-up and rental growth for prime office space. To date, this has mostly been seen in the core regional markets, such as Manchester, Birmingham and Leeds.

However, there are barriers to the roll out of prime space across all corners of the UK. Given where exit yields stand, the rental levels required to enable viability often sit significantly ahead prevailing prime rents. Even conventional grade A space has proven difficult to viably deliver in markets where corporate requirements and rental growth have been lacking.

As a result, for many locations, new developments have been few and far between in recent years. Often, the only means of delivering grade A space in the more challenging markets have come via occasional refurbishments in the very best micro-locations or through public sector intervention to fund or derisk development through income strips or wrapped leases.

But the Clock is Ticking

Even if the office markets can ‘get by’ with a predominance of functional grade B space, the clock is ticking on energy performance standards. Regardless of whether occupiers see the merits of relocating into higher-quality office space, Minimum Energy Performance Standards (MEES) will demand improvement from landlords over the coming years.

For clarity, the timeline for the tightening MEES standards is set out below. The current standard came into effect in April 2023, prohibiting landlords from leasing buildings with an EPC rating of F or G. The bar is next due to be raised in 2027, which will see the rules apply to any building with an EPC rating of below C, before rising again to a minimum threshold of a B rating by April 2030.

Admittedly, uncertainty remains around the validity of this timeline. In February 2024, the previous government proposed to delay the minimum EPC C rating from 2027 to 2028 for commercial buildings. However, as it stands, the new government has only confirmed a revised timeline for residential buildings (Minimum EPC C rating shifted from 2027 to 2030). Even if the timeline for commercial properties is moved out by the new government, it is very unlikely to scrap the targets altogether. Consequently, over time the costs of doing nothing will come to outweigh the costs of taking action.

Highly Exposed

LSH has undertaken a comprehensive analysis of the EPC Registers for England & Wales and Scotland respectively to ascertain the breakdown of existing stock by EPC rating at the local authority level. The results make for sober reading. 

With around 30% of stock rated as EPC A/B, the most ‘future-proofed’ key UK regional centres with regard to MEES are Edinburgh, Glasgow and Cardiff. Despite showing the strongest share of EPC A/B stock relative to the other markets, it still ultimately leaves a substantial 70% of stock non-compliant in these locations by 2030. 

The EPC predicament appears more acute in the UK’s other core regional markets, with Manchester (23%), Birmingham (20%), Leeds (18%) and Bristol (17%) all showing an EPC A/B rated share of stock at closer to just 20% of the total. However, unlike elsewhere, high-quality space has been speculatively delivered in these core markets in recent years, with occupiers’ willingness to pay the required rent underpinning viability.

The most exposed-looking markets to tightening MEES standards are those whose development prospects are constrained by viability challenges. Clear examples are Leicester and Nottingham in the East Midlands, where EPC A/B rated space makes up a marginal level of stock and development has been stifled by a lack of rental growth at the quality end of the market.

Demand in the Pipeline

While EPC A/B-rated stock make up a limited to marginal share of stock across the key regional markets, this presents an opportunity for investors to intervene and improve energy performance of lower-rated rated buildings in advance of 2030. As a proxy for future demand, an analysis of scheduled lease events offers valuable insight into the ‘pressure’ existing EPC A/B rated space faces across the key markets up to 2030. 

The results of this analysis, shown in the chart below, reveal striking differences between locations. Glasgow and Edinburgh’s existing stock of EPC A/B rated buildings is under the least pressure from pipeline demand, with total lease events up to and including 2028 equating to only around 25% of total A/B rated stock. 

At the other end of the spectrum, total lease events are equal to or more than the entire stock of A/B rated space in Exeter (100%), Nottingham (124%), Bristol (159%) and, most strikingly, Newcastle (167%). Notwithstanding viability considerations, the scale of opportunity for landlords to exploit MEES and provide to A/B standard therefore appears strongest in these markets.

Considering the Caveats

The above analysis is only intended to gauge the relativities of supply and demand for EPC A/B rated stock. Given that a significant proportion of A/B rated stock has been delivered over recent years, much of it is unlikely to become available before 2030 due to leases remaining active up to this point, further adding to the acute position some of the markets find themselves in.

One obvious counter to the analysis is that lease events are an unrealistic assessment of future demand, especially given the perception that many occupiers are downsizing / consolidating to better align with increased WFH. However, as revealed elsewhere in this report, take-up analysis shows that expansionary moves have more than offset consolidatory moves over the past two years. Moreover, an assumed reduction of, say, 20% in long-term demand still calculates through to a compelling case, and arguably gives impetus for landlords to move more quickly in order to avoid being left with stranded assets.

Value Destruction

While the basic rationale to upgrade space to an EPC A/B rating to capture demand in advance of 2030 appears compelling, viability has been a barrier in many markets over recent years. Alongside negative perceptions around structural change, the high build costs and finance costs associated with development / repositioning have been reflected in a substantial correction in values. 

Notional yields for good quality secondary assets have ballooned into the double digits over the past 18 months, reflecting circa 40% falls in capital values. Furthermore, polarisation in the market has been reflected in a substantial gulf in pricing between good and low quality assets – the  differential between the lower and upper yield quartiles on the MSCI measure recently moved to an unprecedented high of ten percentage points. 

Change of Use is Not a Magic Bullet

Permitted Development allowing change of use from offices to residential has certainly provided a ‘get out of jail free’ card to many landlords of secondary offices, and this will continue to provide opportunities to restore value while the rules remain. 

However, as discussed elsewhere in this report, the scope for change of use is limited by a host of factors, including a limited or lack of discount to residential values and the physical characteristics of the building. Consequently, in the majority of cases, landlords will have to ‘find a way’ to meet tightening MEES standards while maintaining office use.

Close to Stacking Up?

Positively, while the period of pricing discovery in the secondary market may have more to run, evidence increasingly suggests that values have moved down to a level that is starting to justify the capital expenditure required to upgrade EPCs to A/B. Indeed, as the market comes to recognise the acute absence of EPC A/B rated stock in the run-up to 2030, well-located offices that are most conducive to cost-effective upgrades could see the strongest recovery in values. 

Renovated buildings that can be delivered without the price tag of prime quality buildings have a crucial role in serving more economical demand in any market, be that Leeds or Leicester. Landlords may also look to drive income post renovation by offering fitted space at a significant premium to Cat A rents, with buildings aimed at the smaller end of the market where aspirations on ESG credentials, etc., are typically more limited compared with corporate requirements.

Download the Regional Office Market Report in full 2024 here →