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Stage 2 of the report, published in May 2005 reported that the predicted growth in
demand had occurred and that this had led to an increase in average workstation price
in 2004 of 3.3% to £410 per month. The growth was not however evenly distributed
with Edinburgh seeing a localised decline in prices and Newcastle and Leeds
experiencing double digit increases.
Interestingly, DTZ noted the first signs of structural change occurring in the FMO
market with certain operators specialising in different levels of service, and with a
differentiation between serviced offices and managed offices and an increasing use of
profit sharing leases.
Stage 3, published in October 2005, confirmed the pattern of growth of the industry,
which seemed to have accelerated in H1 2005 to the point where FMOs represented
1.7% of total office stock in the markets surveyed, compared to 0.8% initially
estimated. Average occupancy had risen to 86% and enquiries were r unning 50%
ahead of the level of a year earlier and the number of central London workstations had
grown to 52,000 compared to only 26,000 in 2000.
It went on to examine the nature of the users and concluded that the three most
important sectors were finance, computing and professional services. We agree that
these sectors are important and represent typical users of business centre space in that
companies in these fields tend to have lots of fee earners and fee administrative staff
available to manage office space. Small professional firms are very appreciative of the
one stop shop aspect of a serviced office.
What the Stage 3 report neglected to highlight was the counter-intuitive and perhaps
surprising incidence of public sector bodies as users of business centres. In most
developed countries, if one takes all public sector bodies including quangos together,
it represents the largest single user of serviced space. The reason for this unexpected
use of taxpayers’ money is the difference between revenue and capital accounting.
The capital expenditure of public sector bodies is tightly controlled, whereas revenue
expenditure is a lot looser, leading to some creative behaviour. For example, the Asset
Recovery Agency, which was set up quite quickly and without an adequate capital
budget, was for that reason located in a managed office.
The report then started to consider business centres as an investment, a theme which
was picked up and developed in thestage 3 report. It took as its starting point the IPD
index for flexible managed offices and compared that with the index for conventional
offices. It concluded that the total return for 1997-2004 for flexible offices was 9.8%
compared to 9.5% for the conventional office sector.
We are extremely sceptical about the value of the IPD business centre index because
of our concerns about definition and measurement. Flexible space produces a profit
which, if positive, is higher than rent paid (or the opportunity cost of rent that could
be attributed in an owner-operated enterprise). A positive net income by definition
says that the return will be higher than the same type of property conventionally let.
The problem is that many owner operators are unwilling to disclose their true income
returns and landlords don’t capture the full value generated by the operator, only the
rent paid. The problem is highlighted when looking atthe income return quoted by
IPD of 7.5% which is lower than the conventional office return of 7.6%.
The main topic covered in the FMO Stage 4 report is the investment value of business
centres in relation to the investment value of the property from which they operate.
The report noted that owing to the increase in buying pressure on conventional
property driving down rental yields, investors had been paying more attention to other
types of asset outside the usual categories of office, retail and industrial. Hotels, student accommodation, nursing homes and public houses were identified as
examples of alternative asset classes that had attracted investor interest. One might
suppose that this would mean that investors would consider investment in business
centres too, but with a limited number of exceptions, most notably Morgan Stanley’s
MSREF’s investment in Executive Offices and Deutsche Bank’s RREEF’s investment
in Longford, it hasn’t yet materialised on any scale.
Another issue with investment in business centres has been valuation. FMOs are
hybrid by nature, deriving their income partly from renting space and partly from
services. There is a significant difference in approach for company valuation and for
property valuation. A conventional property valuation approach when applied to a
business centre will tend to produce a low value owing to the relatively poor covenant
of most business centre operating companies. The RICS Red Book does of course
allow a different valuation approach for operational entities, but, as the report pointed
out, all other uses required specialist property with “strictly limited use” within the
RICS Red Book definition. Business centres typically operate from conventional
office buildings.
In our view the Red Book is outdated and needs revising. It should accommodate the
increasing number of property uses that lie outside the traditional sectors of
commercial, industrial and retail and it will have to take account of shortening
conventional lease lengths in any event.
The stage 4 report considers this issue in some depth and gets a bit confused in its
analysis of the problem, but ends up proposing a sensible combination of the two
approaches.
The general investment pricing that has emerged in the market is around 2.5 to 4
times EBITDA for operations in leased premises and around 10-12.5 times for
operations with the underlying freehold or long leasehold. This is broadly in line with
the approach that we adopt given that there is a positive trade-off between owning the
real estate and renting it. We also note that these multiples are moving upwards but
don’t reflect the multiples that are applied to listed companies in the sector where a
company’s price reflects prevailing equity yields.
The report went on to record the rise in market capacity from 125,000 workstations in
2000 to an estimated 200,000 workstations in 2006 and noted that over the last three
years the occupancy rate in the main market in SE England improved from 76% to
84%.
It also looked at the structure of the industry and correctly identified a process of
consolidation that is underway through a series of mergers and acquisitions. Some of
the latter occurred as a result of the down-turn of 2002-2003 which caused a small
number of operators to go bust. The report lists some of the unlucky ones but omits
Enterprise Business Centres, a five centre operator, that went into administration early
in the period. These centres were divided up among other operators or the buildings
were taken back by landlords.
More... (open / download the report )
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