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The flight to quality in the UK’s commercial real estate market has been covered extensively over recent months. Nowhere is this shift being felt more acutely than in the office sector.

According to Cushman & Wakefield, take-up of Grade A office space in Central London reached 2.44m sq ft during the first half of 2023 - increasing by 7 per cent on the five-year H1 average.

There are many factors driving this shift. One aspect is the fact that landlords, tenants and investors are currently getting to grips with the evolving Minimum Energy Efficiency Standard (MEES), which may result in the inability to let - or continue to let - property that has an EPC rating lower than E. 

Meeting the current MEES legislation may require capital expenditure to upgrade space and improve a building’s EPC rating. Many in the commercial property sector are also anticipating the regulations to become stricter, with the minimum EPC rating potentially rising to C in 2027 and B in 2030. 

It is not only regulation that is putting pressure on landlords and investors to refurbish and redevelop their commercial property portfolios; tenant demand is also pushing the top of the envelope into ‘super prime’ territory - keeping the values high for what the market may judge as best in class buildings.

Occupier demand

During and immediately post-pandemic, there was a level of uncertainty surrounding working patterns and what this might mean for the future of the office.

Research from Savills has, however, revealed that between January 2021 and May 2023, 41 per cent of occupiers were in fact taking on more space, not less. This is perhaps unsurprising given that many offices are now back at full capacity, albeit only for parts of the week in some circumstances.  

The current challenge for office providers is how to support companies in enticing employees back - ensuring that working in the office supports collaboration, creativity and culture. 

The research shows that professional services firms are driving much of this activity. Shoosmiths has, for example, invested in new landmark locations at No.1 Bow Churchyard, London and 103 Colmore Row, Birmingham – supporting its growth ambitions and enhancing its client and staff experience.

Strong demand and growth in rents at the top of the market does create questions around the future of other office assets that may now be less desirable when it comes to occupiers and investors.

Many of these properties may meet MEES requirements, so do not legally require renovation. In certain markets though, MEES compliancy may not be enough to remain competitive, and the focus should be on creating workspaces that meet environmental obligations, but also provide ‘better than home’ experiences - supporting employees to do their best work in inspiring surroundings. 

This was echoed at a Shoosmiths’ roundtable where Steven Mew, customer experience and flex director at GPE, said: “The building has to earn the commute. There has to be a reason for people to come into an office building, that’s why you’re seeing this bifurcation between the best and the rest.”

Funding works and supersession   

A combination of changing occupier demands and tightening regulation could mean that refurbishment and redevelopment are increasingly key to unlocking rental income. But, how will this work be funded?

Landlords and investors must firstly consider the risk of outgoing tenants seeking liability for dilapidation claims covering repair, reinstatement and redecoration obligations under their lease.

Where an occupier can show that - shortly after the end of the tenancy - its landlord would be required to pull down or make structural alterations to the property that would render any repairs valueless, the occupier will not be liable for the costs of those works. This is known as supersession. 

While legally it is a narrower defence than many tenants will seek to argue, it can apply to properties where serious structural works are required to bring the building’s EPC rating up. 

In this situation, landlords should consider instructing expert surveyors that can separate the works required to put the premises into the condition the tenant was required to leave them, and also evidence that even where there may be an element of supersession in parts of the property, the landlord still has a claim for damages in relation to those other works. 

Without a dilapidations settlement, the current high cost of debt might be prohibitive to carrying out the renovation or redevelopment work needed to attract future tenants. Even if the property is put into the state of repair required by the lease, it may still be challenging to let in competitive markets. 

Creative solutions

Green lease clauses are increasingly being incorporated at heads of term stage. If structured effectively, these clauses can benefit all parties - creating a more sustainable future for properties. 

The increased data sharing that can be brought in through these agreements can help landlords decide where to focus their investments in order to increase energy efficiency, while assisting occupiers in meeting their own environmental, social, and corporate governance (ESG) targets.

There is a potential administrative burden though, and landlords should remember that there is no statutory obligation on tenants to contribute towards any works required to meet MEES targets.

While green lease clauses might be adopted more widely going forward, the onus is likely to still fall on building owners to fund the initial basic upgrades required. What works can be merited will depend on financial viability and the market for the property - geographically and in terms of potential tenants.

This situation will call for creative solutions and we’re increasingly seeing many clients and other businesses across the sector consider ways to diversify space. As well as the traditional office-to-residential redevelopment, other ideas such as the ‘hotelification’ of flexible workspaces could enable landlords and investors to establish new uses - encouraging tenant activity and spend in the building. 

While the office market continues to find a settling point – managing the long-term impacts of Covid-19 and new legislation – it’s critical that we continue adapting and working hard to identify opportunities.

 

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