1 OFFICE REFURBISHMENT IN GLOBAL CITIES: Which city provides the highest return?
2 1 SCOPE OF THE RESEARCH Our global cities research estimates the expected return on investment that can be generated from major and minor office refurbishment projects in twelve cities across the world. The report shows that Europe s financial centres have offered the best return for investors considering office refurbishment and analyses the different markets and investment strategies that help drive best performance and return from office assets. The research considers both major and minor refurbishment projects in twelve cities across the world, and ranks them by best return. This is based on the return on investment from increases in rental income and payback periods, and buildings that are at least 20 to 30 years old, which no longer meet criteria for Grade A space. Our research covered, Paris, Hamburg, Frankfurt, Brussels,, Milan, New York, Chicago,, Singapore and Shanghai. Executive summary Office refurbishment is the most effective way to improve the income and performance of older office buildings in most locations across the world even where there are conditions of oversupply Frankfurt, Hamburg, Milan and offered the greatest improvement in income and a relatively fast payback (see page 8) The location, design and condition of the office building are integral to the success of the investment In markets where there is over supply of office space, our research shows that well targeted investment in refurbishment will deliver a positive return whilst also defending the existing value of the building In markets where large multi-occupied buildings are the norm, such as New York, then maintenance strategies aimed at sustaining a building s competitive position are a cost effective strategy Fast growing cities in Asia present refurbishment opportunities that can deliver high returns when focused on retaining and increasing occupancy levels. Refurbishment of older office buildings in rapidly changing markets, like, is unlikely to be worthwhile because of the oversupply of better quality space in good locations.
3 2 3 THE FINDINGS The analysis below shows that refurbishment in Europe s financial centres have offered the best return, with Frankfurt, Hamburg, Milan and offering the greatest improvement in income with the fastest payback period. All of these European cities are in the early stages of the property cycle of increasing rental and capital growth. Crucially, these locations are in regions where the planning and regulatory environment is most favourable to improve floor plates and increase floor area through a major refurbishment. This means that investors in such locations are able to re-position and re-brand their assets to attract a different tenant profile. For example, there has been a growing trend in for refurbishment of older assets with character in good locations, targeted at the creative, media and technology sectors. The research focused on, Hamburg, Frankfurt, Paris and Milan for major refurbishment. However it is important to note that we are seeing an increasing trend of major refurbishment in Asian cities, such as Hong Kong, Shanghai and Singapore. This suggests that these locations could also be considered as offering a good return from major refurbishment. Minor refurbishment Analysis of return on investment post minor refurbishment Rank Location Return % 1 Milan 7.35% 2 Paris 6.99% 3 Shanghai 6.69% % 5 New York 5.43% 6 Hamburg 4.91% 7 Frankfurt 4.91% % 9 Chicago 3.40% 10 Brussels 2.67% 11 Singapore 0.75% % Minor Refurbishment: the primary objective of minor refurbishment is to prolong the economic life of the asset by up to 5 years and to keep existing tenants. Typical works include; upgrade to entrance hall, common areas, reception, toilets and lifts and any superficial re-branding works such as façade lighting, landscaping. No major planning requirements are required and all works are carried out with tenants in place. The average project duration for a minor project is six months. Return on investment: our assessment of return on investment is based on a comparison of the increase in annual rental income based on full occupancy as a result of refurbishment. The assessment does not take into account the impact of reducing voids. Return on investment is expressed as a percentage of total development costs. The rental calculation excludes tenant incentives. The assessment of development costs excludes finance costs and VAT. Costs represent all-in build cost for each refurbishment option, including alterations and temporary works, base build construction, developer s fit out and contractor s management and profit. Professional fees, VAT and finance charges are excluded. Indicative minor refurbishment construction costs New York Singapore Paris Chicago Brussels Milan Shanghai Hong Kong Warsaw Madrid Frankfurt Hamburg ,000 1,250 Major refurbishment Analysis of return on investment post major refurbishment Rank Location Return % 1 Frankfurt 9.93% 2 Hamburg 8.43% % 4 Milan 6.03% 5 Paris 4.29% 1,500 /m² Gross internal floor area Major Refurbishment: the primary objective of major refurbishment is to extend the life of the asset by up to years and enhance the office environment for tenants. There will most likely be significant structural changes, an upgrade to all areas, a replacement of the external fabric and major mechanical, electrical plant, machinery and fire protection systems. Major refurbishments which increase floor area through the re-planning or extension of floorplates or the addition of extra floors will generate the greatest additional return. Major refurbishment requires a vacant possession. The average project duration is 24 months. Indicative major refurbishment construction costs Paris Milan Frankfurt Hamburg Warsaw Madrid ,000 1,250 1,500 1,750 /m² Gross internal floor area 2,000 2,250 2,500
4 4 5 MAJOR VS REFURBISHMENT: What is the best strategy? The analysis shows that investment in major refurbishment delivers high returns in Frankfurt, Hamburg and. A key factor of higher returns in German cities are the lower building costs in Germany compared to the UK and other European locations. High costs of refurbishment in mean that, based on our analysis, a minor refurbishment in Milan will deliver a marginally better return on costs, excluding any asset value appreciation. PARIS will achieve a low return from a major investment due to very high construction costs associated with working in the historic core, together with constraints imposed by planning and by the existing building fabric. These factors combine to limit the extent to which the footprint of an office can be extended, which reduces the opportunity to add value through major refurbishment. The research also shows that based on returns from development costs alone, minor refurbishments in some over supplied markets have delivered lower results in the sample. In these instances, a decision to invest in refurbishment is likely to be driven by a defensive strategy aimed at preserving existing income and minimising risk of obsolescence. In instances where the refurbishment of a partly let building results in increased occupancy, then investment returns have the potential to be substantially higher. Looking at minor refurbishments, relatively high costs can be found in New York and Singapore as well as in some of the European cities.
5 6 7 DIFFERENT LOCATIONS, DIFFERENT STRATEGIES Different market locations offer different dynamics and therefore different strategies need to be considered to ensure the best return on an appropriate level of investment. Through our analysis, we have identified four strategies that can be tailored to make best use of the asset and the potential of the local market in which they are located. The analysis considers the potential for an office building to benefit from refurbishment investment in any city. The potential is determined by a combination of factors, such as the design, age and condition of the existing building, as well as the presence or absence of constraints which may limit the extent of investment, such as planning controls and political factors. In addition, we consider the potential to improve tenant quality through asset management activity, aimed at increasing both rental income and capital values. This may include designing and creating workplace conditions that have lower operation costs. The 4 investment strategies As outlined in the diagram below, there are four differing strategies that an investor could adopt, when considering refurbishment we have identified, this depends on the quality of the building and location, the quality of potential tenants and the likely return on investment. The table below plots opportunities to improve asset performance along axis of building performance and tenant quality. In for example, opportunities exist to improve values by increasing the quality and quantum of space and by shifting the market position of the building. By contrast, in New York, in multi-occupied buildings there is little opportunity to increase floor area and the objective of refurbishment is to maintain the position of the asset in its marketplace, benefiting from general upward movements in rent levels. The location of a city will determine which strategy should be undertaken to ensure the best performance and sustainable return is secured. MAINTAIN RE-PURPOSE New York MAJOR TRANSFORM DEFEND
6 8 9 TRANSFORM A typical case study of major refurbishment in LONDON The building: 1960s office building of 14,300m² gross floor area in the City of is a fringe location with the potential to re-plan and extend floor plates. Analysis of refurbishment costs and returns: Performance Metric Development expenditure Development expenditure (GIFA) Value 44.4m 2,800/m² The approach: A major refurbishment strategy to deliver a 25% increase in net floor area to 12,500m² of Grade A space and updates in all building services. Increase in rental income Increase in asset value Return on expenditure 7% 3.1m pa 41.3m Total return per million of development expenditure 940,000 Payback 14.1 years 1 The expected outcome: The improvement in the quality of space drives a 25% increase in head line rent to 700/m² Refurbishment costs include loss of rental income during a 22 month construction period. This case study demonstrates that investment in a major refurbishment delivers significantly better long term returns in markets where there is the potential to extend and reposition the asset in its marketplace. By contrast, in, a minor refurbishment delivers a lower return on expenditure (5.8%) and a significantly lower total return ( 646,000 per million). MAINTAIN New York MAJOR TRANSFORM These are locations that reach their desired potential when investment is made in major refurbishment. The transform strategy typically requires fully vacant space to enable major works to be carried out. Benefits include; increased rental income as a result of delivery of Grade A space increased floor area enhanced capital value driven by tenant covenant. Strong markets for the transformation strategy include, Hamburg and Frankfurt because these are locations where many older buildings have the potential for extension and increased efficiency through the replanning of the floorplate. These buildings may benefit from character that attracts tenants and a planning consent that is better than could be obtained in the current market. RETURN ON EXPENDITURE 7% RE-PURPOSE DEFEND
7 10 11 MAINTAIN New York MAJOR TRANSFORM 2 RE-PURPOSE DEFEND MAINTAIN A typical case study of minor refurbishment in NEW YORK Return on expenditure 5.4% These are locations that benefit from investment in minor refurbishment to retain a position in a diverse and competitive market that presents plenty of options for tenants. The maintain strategy is essential for large, multi-tenanted buildings in good locations, where rental growth will be influenced by general market dynamics as well as the condition of the buildings. Benefits include; improved tenant retention as part of a wider asset management initiative minimisation of loss of rental income associated with refurbishment. Strong markets for this strategy include cities in the US, such as Chicago and New York, where periodic refurbishment to meet tenant expectation could be considered to be a cost of business rather than a major investment. The building: Floor by floor refurbishment of multi-tenanted 1960s office building located in Central Manhattan. The approach: Minor refurbishment focused on improvement works to tenant space with some upgrade work to landlord areas on the affected floor only. The expected outcome: The refurbishment helps to secure a 13% increase in rent to 695/m² The tenant remains in situ during refurbishment works and there is no loss of rental income. Analysis of refurbishment costs and returns: Performance Metric Development expenditure Development expenditure (GIFA) Increase in rental income Increase in asset value Value 2.7m 1,100/m² 0.15m pa 0.23m Return on expenditure 5.4% Total return per million of development expenditure 90,000 Payback 18.4 years This case study illustrates the need to invest in minor refurbishment work as part of an asset management strategy to sustain the attraction of an older asset in an attractive location. To succeed on aspects of refurbishment that contribute directly to securing a rental increment and the need to work around tenants in situ is vital.
8 12 13 DEFEND A case study of minor refurbishment in SINGAPORE The building: 1970s office building of 17,000m² GFA located in the old CBD. This building has been vacated as a result of the relocation of a large corporate tenant to the new Marina Bay CBD. The building has been repositioned as a multi-tenanted building, has a 35% vacancy rate and is competing for professional and commercial tenants in an over supplied market. Analysis of refurbishment costs and returns: Performance Metric Development expenditure Development expenditure (GIFA) Increase in rental income Increase in asset value Value 13.7m 580/m² 1.5m pa 23.2m Return on expenditure 10.7% Total return per million of development expenditure 1.6m The approach: Payback 9.3 years 3 A refurbishment of the entire building is designed to improve the attractiveness of the building to new tenants. Rents are stable at 675/m². The success of the refurbishment is determined by an increase in occupancy levels and the retention of existing tenants. The expected outcome: Increase occupancy from 65% to 75%. In this scenario, the business case for refurbishment is based wholly on increased lettings from new tenants. However, in markets with low yields, increased rental streams can deliver very strong returns. This scenario shows that a 10% increase in lettings to 75% occupancy will generate a 10.7% return and a payback period of nine years. In this case, vacancy levels are higher than in other locations, creating further opportunities to increase the rent toll and demonstrate higher return. Nonetheless, this option is high risk, because if occupancy levels cannot be increased, there is little opportunity to increase income levels. These are locations where investment in minor refurbishment works is required to differentiate older office buildings in a market typically affected by an over supply of higher quality space. In many cities modern office space is being delivered in new city quarters, providing corporate tenants with the high quality space they now expect. This is encouraging them to relocate away from the old City Business District (CBD). Examples include Marina Bay in Singapore, and Zuid. Therefore, office space in the older CBD will need to be repositioned effectively to retain existing tenants and to attract a new target market. Benefits include; the avoidance of obsolescence the protection of existing revenue streams. Strong markets for this strategy include Singapore and Shanghai, and to a lesser extent and Brussels. RETURN ON EXPENDITURE 10.7% MAINTAIN RE-PURPOSE New York MAJOR TRANSFORM DEFEND
9 14 15 MAINTAIN New York MAJOR TRANSFORM 4 RE-PURPOSE DEFEND RE-PURPOSE A typical case study of minor refurbishment in DUBAI Increase in asset value 7.7m These are locations where further investment in an asset is not appropriate because these assets are already considered to be obsolete in terms of location, layout or performance. This trend can be seen in city economies that have seen a dramatic change in the growth, fall and re-emerging growth of GDP and therefore the quality and location of office stock in places such as has improved significantly in other areas. In these circumstances, there will not be an investment case for additional expenditure. Disposal or conversion into alternative uses may be a better option to maximise asset value. The building: 1990s office building of 30,000m² GFA located outside of the core commercial area. This building is in an off-pitch location, is inefficient, with a net to gross ratio of 0.65, and is underspecified compared to modern office product. The approach: Significant investment is required to bring the building up to standard and re-purpose of the asset should be considered. The expected outcome: A minor refurbishment of the entire building will cost 10.6 million, and is unlikely to deliver a positive return In this situation, a better investment strategy might be to re-purpose the asset. Analysis of refurbishment costs and returns: Performance Metric Development expenditure Development expenditure (GIFA) Increase in rental income Increase in asset value Return on expenditure Value 10.6m 260/m² 0m pa 7.7m nil% Total return per million of development expenditure 1m Payback 9.3 years
10 16 17 TIMING IS CRUCIAL As with any investment strategy, timing is absolutely crucial. One of the advantages of refurbishment is that an asset can be turned around at speed, which means that investors can respond to opportunities in recovering markets ahead of new build development. Our office refurbishment cycle (see diagram below) shows what stage a city is at according to the cycle of demand for space and rising rents. RENTAL GROWTH MILAN FRANKFURT/HAMBURG LONDON AMSTERDAM AS OUTLINED in the diagram, many European office markets are currently entering a rental growth phase. This is driven by a general recovery in developed economies that has extended to the Eurozone. Frankfurt, Hamburg and offer the best return on major office refurbishment, because they are entering their peak period, offering good quality space and high quality tenants. and Brussels both represent markets suffering from oversupply, leading to lower returns. Nonetheless, as shown, Brussels is likely to see rental growth over the next 2-3 years as it re-enters a growth phase, whilst has already reached the peak of its cycle and returns may take longer to materialise. Whilst the office market is recovering, obsolete space outside of prime locations is unlikely to deliver a positive return on investment in refurbishment in the near future. PARIS WARSAW MADRID/ HONG KONG/ SINGAPORE/ SHANGHAI NEW YORK CHICAGO BRUSSELS DUBAI TIME Why refurbish? Not all buildings are suitable for refurbishment, and it is important to consider the value drivers for an investment at the earliest stages of a business case. There are 7 reasons why an investor should refurbish 1 Make the most of the existing asset. Buildings require periodic refurbishment to maintain their value, and refurbishment can increase value by extending the economic life of a building, as well as reposition it within the local property market. Through refurbishment, carefully targeted investment can generate significant returns. 2 Shorter development period and quick delivery back to the market. Planning issues are usually simpler to resolve when refurbishing and the construction programme will be faster than an equivalent new build. 3 Achieve extra development. The existing building may achieve more development on a site than would be allowed for a new build. Refurbishment will retain the advantage of the existing building and benefit from planning consents. 4 Increase the net lettable floor area. On some schemes it may be possible to increase net lettable area, either by replanning existing floorplates and infilling lightwells, flattening facades, redesigning plant areas or through physical extension. Better floor plates may attract higher quality tenants. 5 Maintain and improve character to attract tenants. Original features which give a building character are very popular with tenants. Some investors are now focused on improving the workplace environment to create a brand for perspective tenants. 6 Lower costs. Reuse of elements of the existing fabric means that costs will be lower than new build, and that expenditure can be focused on value adding features. Depending on the scope of refurbishment, costs are in the range of 30-80% of an equivalent new-build. 7 Reduce the effect on the environment. Reusing the building fabric and improving building performance will reduce the environmental impact of delivering good quality office space.
11 18 19 CONCLUSIONS Office refurbishment offers an excellent opportunity to improve the income and performance of an older office building in most financial city centre locations across the world, even where there are conditions of oversupply. To ensure and drive the best performance from an existing office building in any location different strategies must be deployed, and these must be tailored to the particular local market requirements. We believe that more science in the assessment of relevant returns on investment is required to help investors decide where to prioritise their asset management spend or to help pre-acquisition bidding strategies. Our research suggests that the best and most sustainable returns can be made in office assets that are in locations where major transformation can easily take place and therefore where there is good quality tenant demand. As these locations change frequently, investors therefore should be tracking the key data that impacts increased rental income. In the current cycle, Frankfurt, Hamburg and are where we expect most refurbishment to take place for at least the next couple of years. However, in addition, Asia market trends are presenting us with potentially good opportunities for the future. Methodology We engaged with our colleagues from EC Harris and Langdon & Seah to collect essential data and commentary about their respective markets. All data on office refurbishment markets in selected locations was sought locally, using expertise of local agents. We worked on standard metrics (Office NIA, GIA, efficiency, rents, yields, construction costs, professional fees) and used common and standard assumptions for all locations (transactional, agents and statutory costs; loss of service charge; letting, marketing, legal fees). In addition we have undertaken desktop research to review all information and made sure it reflects as best as possible, the reality of chosen locations.
12 20 CONTACT Matthew Cutts Global Market Sector Leader. Financial institutions T +44(0) E