OFFICE REFURBISHMENT IN GLOBAL CITIES: Which city provides the highest return? imagine the result

OFFICE REFURBISHMENT IN GLOBAL CITIES: Which city provides the highest return? imagine the result

03 Our research estimates the expected return on Capital Expenditure (CAPEX), generated from office refurbishment projects in fifteen cities across the world. This report suggests that Europe s financial centres offer the best balance of risk and return for investors looking to invest in office refurbishment. SCOPE OF THE RESEARCH The research considers both major and minor refurbishment projects and ranks them by best return from CAPEX. In addition, we consider influential factors such as refurbishment cost/m², different CAPEX investment strategies, status of rental cycles and recommendations for investors to enhance asset performance through refurbishment. Our focus is on 20 to 30 year old buildings which in their previous state no longer met criteria for Grade A space. Our research focuses on the following fifteen cities; Amsterdam, Brussels, Chicago, Dubai, Frankfurt, Hamburg, Hong Kong, London, Madrid, Milan, New York, Paris, Shanghai, Singapore and Warsaw. EXECUTIVE SUMMARY Office refurbishment is the most effective way to improve the income of older buildings in most locations; it also allows investors to take advantage more quickly in rapidly changing rental growth cycles Recovering markets in Europe offer the best return overall; London is ranked number one for major refurbishment and Madrid number one for minor refurbishment Frankfurt, London, Milan and Warsaw are amongst cities that deliver a significant increase in rental income and a quick CAPEX payback Asian financial centres including Shanghai, Singapore and Hong Kong offer relatively high returns on CAPEX, but with increased risk, due to the increasing competition occurring from a high volume of new office supply coming to market New York, which is dominated by large multi-tenanted buildings, offers a relatively better return to investors if the CAPEX is spent on maintenance strategies that sustain the building s competitive position Changing the use of office buildings offers the best return on CAPEX in rapidly changing office markets, such as Dubai.

04 ARCADIS Office refurbishment in global cities 05 THE FINDINGS The research focuses on the increase in rental income following refurbishment and is based on full occupancy. Rental income is expressed as a percentage of CAPEX (or total development cost) and the research reviews both major and minor refurbishment projects based on our definitions outlined on pages five and six. In the case of major refurbishment, those locations in the early stages of the business cycle, in terms or rental and capital growth, such as the European financial centres including London, Frankfurt, Hamburg and Milan, offer a significant increase in income and a relatively quick payback period. London offers the highest return, at nearly 10% as a result of substantial rental growth in the past year. Crucially, these locations tend to be in regions where the planning and regulatory environment is most favourable to improving floor plates and increasing floor area. The returns on CAPEX varied from 6% to 10% in these locations. Although we are seeing an increase in major CAPEX projects for refurbishment in Asia, we conclude this is partly justified financially due to an expectant yield compression through local market trends rather than for asset competitiveness reasons. The impact of yield compression due to market sentiment is outside the scope of the research. For minor refurbishment, the Asian financial sector offers a similar level of return, at around 7%. These invariably occur where there are opportunities to reposition the tenant profile. However, the risk is higher due to the competitive nature of the office market in terms of the volume of new supply and shorter real estate cycles. Madrid offers the highest returns from minor refurbishment primarily due to the legacy of underinvestment in office assets. It seems that a small asset enhancement project will make a relative difference in terms of rental income. This is not sustained for major refurbishments in this market, due to the relatively lower rental levels compared with other global cities. New York offers a relatively lower return on CAPEX due to the more expensive construction costs and the nature of the tenant market. This is a result of the relatively low supply of office space and the multi-tenanted nature of office buildings. Therefore, owners do not have as much of an incentive to invest in their assets to keep tenants. Minor refurbishment Analysis of return on investment post minor refurbishment Rank Location Return % 1 Madrid 9.59% 2 London 8.46% 3 Shanghai 7.89% 4 Singapore 7.53% 5 Warsaw 7.47% 6 Milan 7.35% 7 Hong Kong 7.00% 8 Paris 6.99% 9 Frankfurt 6.02% 10 New York 5.43% 11 Hamburg 4.91% 12 Amsterdam 3.78% 13 Chicago 3.77% 14 Brussels 2.67% 15 Dubai 0.00% 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. Indicative minor refurbishment construction costs New York Paris Singapore London Chicago Amsterdam Brussels Milan Shanghai Hong Kong Dubai Warsaw Madrid Frankfurt 100 200 300 400 500 600 700 ( / m² Gross internal floor area ) 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. 800 900 1,000

06 ARCADIS Office refurbishment in global cities 07 Major refurbishment Analysis of return on investment post major refurbishment Rank Location Return % 1 London 9.86% 2 Warsaw 7.53% 3 Milan 6.03% 4 Frankfurt 5.78% 5 Amsterdam 5.46% 6 Madrid 5.18% 7 Hong Kong 5.15% 8 Paris 4.29% 9 Hamburg 4.26% Major refurbishment: the primary objective of major refurbishment is to extend the life of the asset by up to 15-20 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 Hong Kong Paris London Amsterdam Milan Frankfurt Hamburg Warsaw Madrid 250 500 750 1,000 1,250 Sources of variation in construction costs: ARCADIS has compiled international construction costs for many years. Our analysis has demonstrated that there are substantial differences in the costs of constructing functionally identical space caused by differences in specification standards, labour costs, productivity and so on. Refurbishment costs have the potential for even greater variation, associated with the quality and condition of the base build and the extent of improvement work required. Costs of refurbishment of offices in Paris and Hamburg illustrate this trend, with older buildings in Paris core being more difficult to bring to modern standards than post-war office stock common in Germany. 1,500 1,750 2,000 2,250 2,500 ( / m² Gross internal floor area ) 2,750 3,000 DIFFERENT LOCATIONS, DIFFERENT STRATEGIES Different market locations offer different dynamics. Therefore, different strategies must be tailored according to the local circumstance, to maximise the return on CAPEX. We offer four strategies that should be considered to enhance the potential return from an office building. Each potential return is determined by a combination of factors, such as the design, age and the condition of the existing building, as well as the presence or absence of constraints such as planning controls. The four strategies are summarised below and illustrated in the typical cases studies that follow: 1. TRANSFORM revenues through major refurbishment 2. MAINTAIN revenue through minor refurbishment 3. DEFEND revenues through minor refurbishment 4. RE-PURPOSE where existing revenues are at risk due to obsolescence. The table below plots opportunities to improve asset performance along axis of building performance and tenant quality. In London for example, opportunities exist to improve values through CAPEX refurbishment 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, benefitting 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. LOW MAINTAIN RE-PURPOSE Dubai HIGH BUILDING New York LOW BUILDING Amsterdam London (major) TRANSFORM DEFEND HIGH

08 ARCADIS Office refurbishment in global cities 09 The Four Investment Strategies The Four Investment Strategies 1. TRANSFORM A typical case study of major refurbishment in London 2. MAINTAIN A typical case study of minor refurbishment in New York 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 London, 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. The building: 1960s office building of 14,300m² gross internal floor area in the City of London is a fringe location with the potential to re-plan and extend floor plates. 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. The expected outcome: The improvement in the quality of space drives a 25% increase in head line rent to 820/m² Refurbishment costs include loss of rental income during a 22 month construction period. Analysis of refurbishment costs and returns: Performance Metric Value Development expenditure 47.9m Development expenditure ( / m² gifa) 3,070 / m² Increase in rental income 4.7m pa Increase in asset value 74.7m Return on expenditure 9.9% Total return per million of development expenditure 1.15m Payback 10.1 years The key to success in this refurbishment project has been the reorganisation of circulation cores and the infill of sections of the floor slab to improve the efficiency of the floor plate, increase overall floor area and to improve the overall quality of space. Older office buildings that are organised around light-wells present many opportunities to maximise development value. Refurbishment on this scale enables the developer to create office space that meets all modern expectations with regards to comfort and energy efficiency. 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 London, a minor refurbishment delivers a lower return on expenditure (8.6%) and a lower total return ( 900,000 per million). 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 Value Development expenditure 2.7m Development expenditure ( / m² gifa) 1,100 / m² Increase in rental income 0.15m pa Increase in asset value 0.23m Return on expenditure 5.4% Total return per million of development expenditure 70,000 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 and focus on aspects of refurbishment that contribute directly to securing a rental increment and the need to work around tenants in situ is vital. LOW MAINTAIN Dubai HIGH BUILDING New York Amsterdam London (major) TRANSFORM HIGH RE-PURPOSE DEFEND LOW BUILDING

10 ARCADIS Office refurbishment in global cities 11 The Four Investment Strategies The Four Investment Strategies 3. DEFEND A case study of minor refurbishment in Amsterdam 4. RE-PURPOSE A typical case study of minor refurbishment in Dubai In many cities modern office space is being delivered in new city quarters, providing corporate tenants with the high quality space they now expect in attractive, accessible locations. This is encouraging tenants to relocate away from established City Business District (CBD) to new centres. Examples include Amsterdam Zuid, Canary Wharf and Kings Cross in London and Marina Bay in Singapore. If vacancy levels increase as a result of competing development, then office space in the older CBD will need to be repositioned both to retain existing tenants and to attract a new target market. Benefits include; avoidance of obsolescence protection of existing revenue streams attraction of new tenant classes into existing office locations Many of the markets for this strategy are suffering from over-supply, including Amsterdam and Brussels, as well as Singapore, Hong Kong and Shanghai. The building: 1970s office building of 4,300m² gross internal floor area located in the established city centre. The building is vacant as a result of the tenant, a public sector body, rationalising their office requirements into a larger, modern office building. The building needs to be modernised to compete in its existing, over-supplied market. The approach: A minor refurbishment of the entire building, together with the updating of some time-expired central building services plant is designed to improve the attractiveness of the building and to make its running costs comparable with peer buildings. Rents are stable at about 170/m² with little opportunity for demand-driven escalation in the short to medium term. The success of the refurbishment will be determined by the extent at which the modernisation will differentiate the scheme enabling it to compete for tenants in the established city centre. Analysis of refurbishment costs and returns: Performance Metric Value Development expenditure 2.5m Development expenditure ( / m² gifa) 600 / m² Increase in rental income 0.26m pa Increase in asset value 1.9m Return on expenditure 10.7% Total return per million development expenditure 578,000 Payback 9.3 years In this case study, the business case for refurbishment is based on the ability to secure lettings in a competitive, over-supplied market. However, the impact of the refurbishment can be high, generating income from an otherwise under-utilised asset. The case study illustrates the results of the letting of 50% of available space generating a 10.7% return on the total refurbishment cost and paying back all expenditure in 9 years. Clearly, with the vacancy hurdle set so low, there is plenty of scope for improved performance. However, given that increased occupancy levels is likely to be the only route to increased income, this should be considered a high risk option. 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 quality and location of office stock as a result of dramatic economic growth prior to 2008. Dubai is a good example of a city with a stock of poorly located, sub-standard office buildings. 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 repurpose 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 repurpose the asset. Analysis of refurbishment costs and returns: Performance Metric Value Development expenditure 10.6m Development expenditure ( / m² gifa) 260 / m² Increase in rental income 0m pa Increase in asset value - 7.7m Return on expenditure nil% Total return per million development expenditure 0 Payback Not applicable LOW MAINTAIN Dubai HIGH BUILDING New York Amsterdam London TRANSFORM HIGH HIGH BUILDING MAINTAIN TRANSFORM RE-PURPOSE DEFEND New York London (major) Notes on performance criteria used in all case studies. LOW BUILDING LOW Duba~~i Amsterdam HIGH Development expenditure includes all costs associated with refurbishment including construction, professional fees and statutory costs. For major refurbishment, loss of rental income and letting fees are also included. Cost of finance and sales tax is excluded. Increase in annual rental income is for a full year and is based on headline rent, excluding adjustments for tenant incentives Improvement in asset value is calculated on the basis of capital values for the unimproved and refurbished asset and development expenditure. Values are calculated using headline rents and typical investment yields for primary and secondary office space in appropriate locations % of expenditure returned by annual income is based on development expenditure and the annual increase in income Payback is calculated on the basis of total development expenditure and the annual increase in income. RE-PURPOSE LOW BUILDING DEFEND

12 ARCADIS Office refurbishment in global cities 13 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. WHY REFURBISH? Refurbishment will continue to remain popular due to its inherent advantages over new build. These advantages are summarised as follows: The carbon cost is lower Shorter development period reduces exposure to rental market risk Owners can squeeze more value from original planning consents FRANKFURT / HAMBURG AMSTERDAM Opportunity to improve tenant business performance by tailoring upgrades to their changing workplace needs RENTAL GROWTH MILAN LONDON The CAPEX is lower and easier to finance. 8 ways to enhance asset performance At ARCADIS we believe that enhancing the value of an asset depends on 8 key factors, as illustrated below: MADRID / HONG KONG / SINGAPORE / SHANGHAI NEW YORK CHICAGO BRUSSELS PARIS TIME WARSAW DUBAI Refurbishment / Investment Projects completed within occupied buildings Faster procurement to increase speed to market Scope of works tailored to suit tenant sector user requirements Establishing metric of Return of CAPEX investment Flexible layouts and density for tenants Future proofing as set against asset depreciation Create Asset / Portfolio Brand Public Relations Strategy for asset Create visual brand e.g. Façade / Lighting / Reception / Lift cores / Landscaping / Signage Create performance brand e.g. Lift specs and Lift cores / Premium technologies for mobility services Create tenant community *Market conditions data has been taken from multiple sources and is indicative of market potential only. 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. London, Milan and Frankfurt for example offer superior returns on major refurbishment because they are entering the rental growth phase of their letting cycle. Amsterdam 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 Amsterdam has already reached the peak of its cycle and returns may take longer to materialise. Whilst the Dubai 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. Leasing and Management Strategy Active tenant management Lower service charge through energy efficiencies Renegotiate leases Revenues directly linked to occupiers business (no leases) Enhanced tenant mix New lease structure short-term v long-term Shared amenities strategy Improved Infrastructure Accessibility plan for tenants / occupiers re public transport Parking improvements Security improvements Link to public transport including hire bikes Extend Asset Life by 20 years 8 WAYS TO ENHANCE ASSET VALUE Pro-active maintenance plan to enhance building value Excellent reputation for estate / building management driving rental growth High LEED and BREEAM ratings Reduced vacancy More productive workers (less sick leave) Value through Planning Gain Zoning changes through lobbying Zoning rules relaxation Re-categorise net revenue areas Change of use New masterplan for area in collaboration with neighbours Signature Designs and Designers Signature architects Signature lighting and landscape solutions and speciality designers Use of innovative / non-conventional materials Add value through Sustainability

14 CONCLUSION Office refurbishment offers an excellent opportunity to improve the income and performance of an older office building in key global cities. To achieve the best performance, investment projects should be tailored to particular local market requirements. This can be summarised into four different strategies. We believe that more science in the assessment of relevant returns on CAPEX investment is required globally. This will help investors decide where to prioritise their asset management cash and pre-acquisition investment strategies. From our research, high returns on CAPEX can be obtained from both major and minor refurbishment strategies in European cities where such projects can easily take place and where there is good quality tenant demand. Major refurbishments offer the greatest opportunity to drive long term capital value appreciation as well as the immediate return on CAPEX discussed in our research. Investors will need to track the key that drives the increased rental income. Currently we see strong growth in London, Milan and Frankfurt for major projects and Madrid and London for minor projects as the priority cities for CAPEX. In the future, we predict that more Asian cities will enter these rankings as letting risks reduce. METHODOLOGY Project data was provided by colleagues from ARCADIS in Europe and US, EC Harris in London and Asia and Langdon & Seah across Asia. The rental income data was sourced from local agents. The calculations were based on standard metrics (Office NIA, GIA, efficiency, rents, constructions costs, and professional fees) and used common and standard assumptions for all locations. In addition we have undertaken desktop research to review all information and made sure where possible it reflects the reality of chosen locations. The information provided in this report is indicative and should not be relied on for investment purposes.

Contact us Matthew Cutts Email matthew.cutts@arcadis.com Tel +44 (0)7913 307 749 Simon Rawlinson Email simon.rawlinson@echarris.com Tel +44 (0)7715 759 997 Karl Stumpf Email kstumpf@rtkl.com Tel +1 305 562 4496 ASIA Simon Baxter Email simon.baxter@echarris.com Tel +65 9112 2438 Frank Kwok Email frankkwok@hk.langdonseah.com Tel +852 2830 3500 Weibin Xu Email weibin.xu@echarris.com Tel +86 136 1012 3648 MIDDLE EAST Terry Tommason Email terry.tommason@echarris.com Tel +971 56 216 3143 EUROPE Markus Reppenhagen Email m.reppenhagen@arcadis.com Tel +49 172 2461 612 UK Keith Perry Email keith.perry@echarris.com Tel +44 (0)7714 064 815 US John Braley Email john.braley@arcadis-us.com Tel +1 212 682 9271 @arcadiscorpcomm ARCADIS WWW.ARCADIS.COM 8893 EC JUL14