Funding options for UK offices and the importance of negotiating a strong covenant

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UK office space is currently observing favourable trends, with significant overseas investment levels and funding providers willing to provide capital to this sector. However, strong tenant covenants are vital for securing successful development finance loans, refinancing and sale opportunities.                                                    

UK office investment was up quarter on quarter reaching approximately £6.3 bn. With Brexit looming over the UK, there is increased uncertainty regarding future pricing, in turn, spurring many core investors to consider providing real estate debt rather than investing in prime assets that may be priced to perfection.

Despite being the net sellers overall, funds were the main source of buyer capital, followed by publicly quoted real estate companies. Nearly four fifths of survey respondents across Europe expect non-bank lenders to increase their activity given the current environment, according to the 2018 Emerging Trends in Real Estate report by PwC. Debt remains highly liquid for prime assets and lenders claim they are maintaining conservative underwriting standards which, suggesting that this behaviour is not posing a systemic risk to real estate. Similarly, equity markets are not expecting investors from any part of the world to decrease their investment into European real estate.

Generally, commercial property leases in the UK typically last between 5 and 15 years, with the market average currently at around 7 years, however, both location and the size of the space occupied also have an impact on the length of the lease. For example, tenants occupying offices in central London may want greater flexibility and therefore shorter leases than office tenants in other UK towns or cities, whilst longer leases are preferred by tenants with more floor-space, as they are likely to have a greater level of upheaval associated with relocation and a higher capital expenditure for fit outs. With some leases including a ‘break clause’, the value of a property may be changed as the income stream is no longer guaranteed up until the expiry of the lease.

With Asian investors continuing to deploy capital in London offices, overseas capital continues to target the UK office market and accounts for more than 70% of all purchasers, which is the highest volume since 2014. Many consider the post-Brexit devaluation of sterling as the primary reason behind the increase in Asian investors’ appetite for office space, whilst European investors are less influenced by currency fluctuations. Furthermore, London offices represent 80% of investment volumes completed, reaching one of the highest quarterly proportions recorded and showing no sign of decreasing. The real estate community is carefully watching the shared and serviced office, as this sector has become the seventh most popular in the overall industry. Whilst traditional offices are unlikely to be entirely dislodged, this new sector is likely to change the standards and expectations of office tenants, who are willing to pay the extra premium for increased flexibility.

Covenant Strength

When considering funding options for office space, one should pay close attention to the strength of the negotiated covenant, which is seen as a key risk component and directly influences the yield of the project, especially in the case of an economic downturn.  The investment value of two identical office buildings occupied by tenants paying exactly the same rent is likely to differ if there is a perceived difference in the tenants’ ability to repay their debt, in other words, if there is a difference in the ‘covenant strength’ between the two tenants. Consequently, it is vital for tenants to negotiate a strong covenant, which will not only increase the chances of a successful development loan, but will also assist in the refinance or sale of the completed office.