Lenders tightening office financing requirements as occupier demand evolves

Lending to the UK office market is becoming much more selective. As banks and debt funds increasingly focus on lending to modern offices and those with a clear pathway to carbon net zero, significant ‘legacy’ office stock is at risk of failure to secure refinancing at upcoming loan maturities.

On the surface, this narrowed finance liquidity within the office market is driven by lenders’ own public carbon reduction commitments. But it is more direct than that. Lenders are responding to a confluence of catalysts that are modernising the office market – from environmental and technological, to social and well-being drivers – which are reshaping occupier demand dynamics.

Long term adoption of hybrid working, with employers dividing work between the office and home, continues to cause uncertainty over future occupier demand for workspace. Many companies are still working through the most appropriate working practices for their businesses and there will likely be wide variations between industries and markets. In addition, sustainability, well-being and the provision of amenities are driving occupier demand for offices. Lenders see these combined office metrics as proxies for long-term office cash flow security, which underpins loan repayments. Thus, failure to provide these sustainability-led office features will relegate stock to legacy office status, accelerating stock obsolescence.

From lenders’ point of view, correlating financing liquidity with these metrics is pragmatic and economically sound. Lending against an office building which does not meet incoming ESG requirements equates to increased default risk, because the demand for older, less sustainable stock has collapsed. This is an example of how sustainability has now aligned with financial incentives.

Lenders’ approach to new office market dynamics

As reams of legacy office stock without a viable pathway to carbon net zero risks becoming unattractive for refinance, these new office market dynamics also find themselves requiring increased due diligence and foresight to underwrite loans. For example, lenders must quantify how accumulated climate risk may impact a building’s liquidity in five to 10 years’ time, and how such risks may create volatility in an asset’s operating costs. Given the evolving hospitality focus of offices, understanding forward operating costs becomes increasingly important. 

New risks are dominating lenders’ decision-making processes – from climate risk and flooding risk, to regulatory risk and, ultimately, obsolescence risk. As occupiers demand higher building energy and resource efficiency, those landlords that meet these evolving requirements will have no problem securing financing. However, office buildings that meet modern ESG requirements are a relatively small proportion of the market. 

Quantifying the scale of the office market at risk is difficult. Reliable data on the size of the legacy office market remains elusive as definitions are still loose. However, it is broadly accepted that the legacy market in the UK – and globally – represents a significant majority of the investable office universe. Furthermore, it remains to be seen what proportion of the legacy office market successfully transitions to modern best-in-class office standards, how much transitions to other use cases (e.g., residential), and how much becomes obsolete. 

There are many complexities involved in modernising older legacy offices. For example, most UK offices are energy inefficient by modern ESG standards, but transitioning older assets to sustainable energy sources is difficult and expensive. Old, listed buildings in central London cannot simply switch off their reliance on fossil fuels. With financing increasingly tied to ESG compliance, investors that cannot secure building insurance on ESG grounds (without significant capex to retrofit old buildings) risk failure to secure funding from lenders. 

Lenders will look to resolve these ESG considerations with a mix of insurance and capex. But forethought is crucial because unforeseen issues left unattended for years can lead to an asset becoming effectively obsolete, requiring significant capex to remedy or risk loan default. All of which implies that the problem of legacy offices will endure for many years to come.

Securing finance for the transformation of legacy offices remains difficult, but possible. With the right mix of in-house engineers and asset management expertise alongside a clearly defined business plan, some debt funds will step in to provide terms, but few banks. Often, legacy office transformation business plans emerge after existing owners have walked away – due to lack of capital, skill and time to turn assets around or because a liquidity event (e.g., loan maturity) has forced the asset’s disposal. Office transformation is complex and there is no one-size-fits-all method. Ultimately, many legacy office assets will never be modernised. 

But the rewards for lenders and investors from the successful transformation of legacy to best-in-class offices are compelling. ESG-compliant offices, rich in amenities and flexible floorplates, deliver long-term risk-adjusted returns, reflecting a ‘green premium’ which drives higher rents and selling prices, and lower vacancy rates, compared to otherwise identical office buildings nearby.

However, there are at least three risks to this bullish outlook for the best-in-class office market, which lenders should bear in mind. First, the macro-outlook for the UK economy posited by the Bank of England – that the economy will now avoid a recession – may prove overly optimistic. A counter-scenario is that the full impact of accumulative monetary tightening and inflation is still to be felt in the economy, which will eventually break the back of the UK’s resilient labour market and trip the economy into a recession. In this scenario, occupier demand for prime office space would soften as corporate real estate footprints and headcounts are downsized.

Second, the hybrid working trend continues to be a permanent feature of corporate work life, forcing a reassessment of long-term corporate office space requirements. It is a debate which has raged for more than three years, and the outcome will likely vary markedly between industries and office markets. Third, the combination of the first two scenarios could prompt a reassessment of investor appetite for large-scale capex and asset management-intensive legacy office refurbishments. This is not to suggest office refurbishments will disappear. More likely, in a recessionary environment, corporates will look to trim operating costs and lean into hybrid working for longer, extending the window for legacy office refurbishments to pick up momentum.

There is a possible fourth risk – which is by no means certain – of a contagion from the legacy segment of the office market contaminating pricing and sentiment for the best-in-class segment. While conceivable, this outcome is probably unlikely. Real estate is replete with sectoral repricing between different asset types, such as in the retail sector, where multi-channel retailers successfully have combined e-commerce and bricks and mortar stores to complement one another. Lenders are fast adapting to a more nuanced office market. Liquidity is likely to narrow for all but the best offices and the best transformation business plans in the years ahead. 

If you would like to understand your office refinancing options, please do not hesitate to get in touch with our team today.