When a market experiences fundamental change it can be hard to separate cyclical and secular growth drivers. Or, to put it another way, the market for offices in London is changing and I’m not sure how much of this is down to changes in the way that businesses work, linked to technological and cultural changes, and how much is attributable to a late-cycle surge in demand for office space as new, possibly short-lived, businesses are created.
RDI Real Estate Investment Trust (Reit) (RDI), formerly known as Redefine International, owns a range of properties but in recent months has rebalanced its portfolio away from the retail sector towards hotels and, most recently, serviced offices.
I last wrote about the £660 million company in 2013. Back then, it had been busy expanding its German shopping centre portfolio. Last November, however, it announced the sale of its entire German retail portfolio for €205 million. The management said they were made an offer well above their valuation for these assets. Other asset sales, including a House of Fraser store in Hull and a shopping centre in Bristol, brought in another £29 million. Nevertheless, retail is still the largest element of its portfolio, about 46%.
A small part of the fund’s liquidity went to buy an office and light industrial park just next to Kingston upon-Thames station for £18.8 million. There is potential upside from a mixed-use development of the site and, if it happens, Crossrail 2. A combination of its shares and cash were used to increase RDI Reit’s stake in hotel group, IHL. RDI’s hotel exposure should end up being about 21% of its portfolio, comprising hotels operated by the likes of Travelodge and Holiday Inn.
The deal that caught my eye, though, was the purchase of four serviced offices in London, valued at £162 million. Generally, London offices are not the place to be at the moment with developers such as Derwent London (DLN) trading on chunky discounts to asset value. RDI, however, is buying into a fast-growing segment of the London office market. Currently flexible offices/co-working accounts for about 7% of the central London office market but JLL thinks that could hit 30% by 2030.
Companies such as IWG (IWG), the office provider formerly known as Regus, and WeWork have led the way in developing this area of the market in London. In an effort to attract entrepreneurial, start-up businesses, the design of these spaces and the range of centralised services that they offer has become ever more imaginative.
It seems to be working. The boom in London’s IT industry, and in fintech in particular, is driving demand for flexible space that can accommodate the needs of companies that are expanding rapidly and unpredictably. They are prepared to pay for this flexibility too. The average serviced office is charging £450-£600 per desk per month in Shoreditch, £650-£850 in Victoria and a whopping £900-£1,500 in the West End, according to Knight Frank.
RDI’s deal gives them an 80% stake in four serviced offices in the areas around Liverpool Street, Monument, Waterloo and St. Paul’s. The other 20% is owned by Office Space in Town, a private equity backed firm managing six serviced offices in London and five in the regions (RDI has said that it is only interested in expanding in London).
The building in Monument is relatively new and occupancy there was 86% as at the end of December 2017. Occupancy at the other three sites ranged from 92% to 99%. The ungeared yield on this portfolio is about 6%. With gearing, RDI Reit thinks it can extract an income yield of about 9% on its equity investment.
RDI believes that it is important to own the buildings that you are offering as serviced offices. IWG and WeWork are renting much of their space and then sub-letting it. Bloomberg reckons that WeWork could soon overtake IWG as the largest private office tenant in London, with 2.4 million square feet of office space compared to IWG’s 2 million. If the market runs into trouble, these are the companies that may struggle first (maybe that’s why Brookfield just decided not to bid for IWG) but WeWork has fairly deep pockets given that SoftBank and its Vision Fund invested $4.4 billion in the company last year.
But, in a way, that is what is ringing the alarm bells for me. I think that a lot of the money being used to pay the rent in these serviced offices may be coming indirectly from the VC backers of the booming tech industry in London and its suppliers. In a downturn, if the taps get turned off, this could unravel quite quickly – that’s the ‘it’s all just cyclical, top of the market stuff’ argument.
Against that, perhaps technological change is making the old office model redundant. RDI Reit has made a modest bet (its total property portfolio including loans is valued at about £1.4 billion) on that being the case. The shares trade at 10% below net asset value, wider than the 4.5% discount of the past 12 months.