First there was the global financial crisis of 2008 and its fallout. Then there was a global pandemic in 2020. Now, Western economies are experiencing sustained increases in inflation and steep interest rate rises. Against this backdrop, the real estate sector is operating in an incredibly transformed world to the one it knew and understood even just 15 years ago. Yet continued and radical changes are no reason to throw out the old rule book in its entirety. Real estate investment and management professional Nick Millican explains how both legacy and innovation are vital to the commercial real estate industry.
Real estate is an industry used to change and transformation, says Millican. Going back even further than the global financial crisis, real estate professionals were conditioned by dramatic upheaval every few decades. The 20th century saw extreme fluctuations in commodity prices that impacted building costs, increasingly higher levels of regulation that enhanced regulatory risk, the rise of the green building movement, and a shift in priority to environmental factors that impacted tenant demands. At every stage, the real estate industry adjusted with the changing times. One could argue that there’s no difference today between real estate’s legacy operating procedures and current new innovations, since innovation itself is real estate’s legacy state of operation.
That’s not to say that current conditions are surmountable by continuing in the same old ways, warns Millican.
“Today [you have] an industrywide change where interest rates are higher and therefore people want to have a higher cap rate to buy real estate,” says Nick Millican. “That’s pretty universal, though it varies depending on the market and the quality of the asset. But virtually everything is worth less than it was. The second [issue] is more specific to [office space], which is the legacy of working from home and increasing regulatory pressure to ensure that buildings consume less energy — which is pretty expensive to retrofit or to construct new buildings on that basis.”
The result, says Greycoat Capital CEO Nick Millican, has been a “huge” increase in construction costs — both because of inflation and changing specifications.
“You’ve [subsequently] seen a softening in the investment market because of interest rates. And I think there’s also a big differentiator between the U.S. and [other] markets.”
Millican explains that the U.S. office market is, from an occupational perspective, “pretty weak” and distressed. Investors sometimes view it as “the next retail,” referring to the dramatic drop in tenancy that came with the pandemic and the near wholesale shift of consumers to online purchasing.
“You’ve got such oversupply in some markets, and working from home is a relatively strong phenomenon,” says Millican.
Yet the same drivers don’t apply in the same way in other markets — like London, where returns to the office are stronger, Millican observes.
“What it has led to is a bit of a mismatch between sentiment and the fundamentals in some markets. In London, for example, rents are going up quite fast and the vacancy rate for the top 10% of specification buildings is actually very low,” says Millican. “You can actually make a reasonably good case that now would be a good time to be taking a bit of risk to deliver new space for occupiers over the next few years.”
Yet weighing against such an argument is the fact that it’s become “quite tricky” to convince U.S.-based investors to invest in offices in London, regardless of the fundamentals, notes Millican, whose investment firm had “slightly” pivoted more toward European investors over the past 12 months. Of overall market conditions, he says, “It feels like it’s getting cheap enough to go back in to buy stuff again.”
For Nick Millican, the whole situation is a good example of how smart real estate investors can thrive in today’s environment by basing their decision-making on traditional, legacy ways of viewing the market — focus on the fundamentals, read the market, and understand what’s driving both tenancy and investment.
“I think there’s enough for sellers to reset pricing. What normally happens is most people are waiting on the sidelines. Someone does something and everyone says, ‘Wow, that was cheap.’ And then [they ask themselves] ‘Why didn’t we do this?’ And [demand] tends to turn on quite quick, once you hit that bottom,” says Nick Millican. “And I think there’s a fairly good case to be made that that bottom will be hit at some point in Q4 .”
While traditional ways of viewing markets and market fundamentals will remain important to real estate operators and investors, the ability to innovate will increasingly become the difference between surviving, thriving, or failing for many companies in the sector, Nick Millican believes.
The impact of the global COVID pandemic on the way society uses the built environment has become a singular issue for building owners — particularly the owners and operators of commercial office space.
The continuing trend of a preference toward remote and hybrid work has the potential to drastically change the way organizations use their office space — and in turn, what office space they choose to rent.
Millican says savvy real estate operators will continue to innovate in terms of the types of spaces they offer prospective tenants. Offices in central locations that emphasize collaborative workspaces and healthy environments will attract tenants, while traditional spaces will not.
“I don’t think we [will ever] get back to exactly the way things were in 2019,” says Millican, adding that if companies are going to drag their staff 45 minutes away from their house to come and work in the same place, then businesses need to “do a better job of making that place somewhere they’d actually like to be” and give them a compelling reason to be there.
Real estate companies that take this lesson to heart will thrive, says Nick Millican. Those that don’t will find the market challenging.