(Bloomberg Markets) — Nestled in a bed of the River Thames between London’s twin financial districts, Canada Water is about to become a testing ground for the future of real estate in a post-Covid-19 world.
After more than a decade assembling a parcel of land almost double the size of New York’s Hudson Yards, developer British Land Co. expects to start construction this year on a multibillion-pound neighborhood of office buildings, homes, and shops at a time of dramatic change in how people work, live, and buy.
“The pattern of work—how we work, when we work—you have got to feel there is going to be a shift at a much greater pace,” says Emma Cariaga, co-head of the Canada Water project at British Land. “We are going to have to be much more nimble.”
It didn’t take a virus to force developers to think about a different way of operating. But now the future of real estate is on fast forward.
With commercial real estate no longer a passive investment in which landlords could sign up long-term tenants and then sit back and collect rent, investors and developers are being pushed by a series of disruptions to become much more active. Amazon.com Inc. has stolen footfall from malls. WeWork Cos. redefined the office. Airbnb Inc. challenged the very idea of hotels. Now the Covid-19 pandemic is leading companies to rethink their need for communal workspaces.
In London’s commercial real estate market, an early adopter of long leases to appeal to investors, the length of office rental agreements had already been falling steadily for two decades. Average lease terms declined from 21.7 years in 1996 to about 5.5 years in 2017 and 2018, according to data compiled by Colliers International Group Inc. In Canary Wharf, the East London financial district that’s home to the European headquarters of several global banks, the average lease is still about 10 years.
The pandemic forced employees to stay away from those headquarters and work at home instead. Many companies found the transition surprisingly smooth, and executives have publicly questioned how much real estate their companies need. Can modern office towers be adapted without forcing thousands of employees to share elevators? When will it be safe for workers to commute together into major metropolises? These questions are increasingly urgent for real estate investors.
Before the coronavirus crisis, “tenants were asking for more flexibility and service, but most landlords refused to give tenants what they wanted,” says Dror Poleg, author of Rethinking Real Estate and co-chair of the Urban Land Institute’s New York Real Estate Technology and Innovation Council. “Landlords will now be willing to take on more of this risk, because they simply no longer have a choice. When your building is suddenly 20% to 30% empty, you become much more open-minded about a lot of things.”
This change could mean landlords will offer smaller so-called core offices on long leases, topped up with additional space that can be rented for shorter periods as needed, Cariaga says. For stores and restaurants, landlords may begin to calculate rents based on the turnover generated by each unit, rather than insisting on fixed leases.
Rework the Plan
In the office market, WeWork introduced some of the changes likely to become more widespread: flexible rents, shared resources, advanced technology, design, and customer service. Plagued by questions about its management and financing, WeWork had to call off an initial public offering, and the company is likely to be tested further by the economic fallout from Covid-19. But there’s a growing sense among real estate investors that elements of its model point the way to the future, offering customers a cheaper and more convenient product.
“The fallout of WeWork doesn’t mean the business model isn’t entirely viable. There are other operators coming that I think could get it right,” says Hugo Machin, co-head of global cities at Schroders Plc. He uses an analogy from the early days of mobile phones: “Is WeWork the Nokia of the office world, and an Apple product is just around the corner?”
British Land has already moved to embrace more WeWork-like flexibility, offering short-term offices within small parts of its large London campuses. That’s likely to be a prominent feature of Canada Water, too. The project’s master plan includes a traditional town center with about 50 potential store and restaurant units. “Do I think we’re going to offer 50 leases to businesses that are all going to take a five-year term and be happy to be on their way? Not a chance,” Cariaga says. “We are going to have to become almost a department store-type operator, allowing retailers and restaurateurs to come and go much more than we have historically. Our role as landlords is going to be a much more intensive one than it has been before.”
Location, Location, Dislocation
This new way of doing business will require more operational skill and risk and a different approach to financing and underwriting property. “When I arrived here, I was used to thinking about credit risk,” says Chris Grigg, a former banker who became British Land’s chief executive officer in 2009. “Yet people seemed very content that if they had a 20-year lease, that it was good for 20 years. That is OK until the [tenant] company goes bust.”
Contrary to previous crises, the pandemic has affected all real estate investors, not only those with too much leverage or properties leased to high-risk companies. The widespread shutdowns have imperiled corporations with strong credit ratings and buildings rented on long leases.
That’s a shock for investors who’ve allocated growing shares of their portfolios to real estate because the asset class supposedly provided secure income and diversification from the stock market.
“Covid-19 is going to highlight to investors and managers that their ability to underwrite isn’t purely governed by location, location, and a bit of income risk,” says Adrian Benedict, head of real estate solutions at Fidelity International. “If real estate is not seen as a stable source of income, you question the rationale for holding it.”
Sidders and Wong report on real estate for Bloomberg News in London and New York, respectively.
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