It may be the best of times for European commuters, but it’s not so great for office landlords, who have watched the value of their assets fall an average of 28.7 percent over the past 12 months, according to Green Street, a financial advisory firm.

Although residential fell more in the first quarter of 2023, office remains Europe’s most scarred commercial real estate sector, according to Green Street. Government mandates around sustainability are also tightening, and Cushman & Wakefield says 76 percent of European office space could be obsolete by 2030 unless landlords start investing now.

Analysts say tenant preferences for higher-quality, more sustainable space, and regulator concerns about sustainable buildings have led to a flight to quality among lessors and investors. These days, analysts say, tenants and buyers are shunning everything but Class A, centrally located property with excellent transportation connections, and good environmental credentials.

Office owners weren’t the only ones suffering in the first quarter. Commercial real estate prices fell generally all over Europe in the first quarter of 2023. The Green Street Commercial Property Price Index dropped 6.7 percent in Q1, falling to 21 percent below where it stood in May 2022. This quarter, residential led the fall, with a 10.4 percent price decline, followed by office with a 9.5 percent drop, making industrial and retail look positively healthy with their 4.8 and 2 percent respective falls.

“The first quarter of 2023 failed to quell many of the anxieties that plagued markets last year,” explained Peter Papadakos, head of European research at Green Street. “In fact, some might say that it has only introduced new ones.” One big worry noted by Papadakos: U.S. regional bank failures, as investors feared the problems that showed up first in Silicon Valley Bank might prove contagious. 

WFH Woes 

In terms of traditional metrics, conditions facing the office sector don’t look all that dire. Office vacancy rates in Europe rose in 2022, but just from 7.5 percent to 8 percent, according to Savills. Considered desk by desk, however, it’s a different story.

In 2020, European offices were about 70 percent full on any given day. That dropped during the pandemic, of course, but even last year, the glass towers were only 43 percent full and today the average is back up to 55 percent.

Office numbers rose all over Europe, with Paris and Madrid in the lead, according to Savills. Barnes speculates that part of the reason may be commuting time: more Parisians and Madrileños live in the city centers and have shorter commutes than Londoners, keeping London’s in-office average closer to 48-50 percent.

Despite the increase this past year, Barnes doesn’t see office attendance ever rising back to that pre-COVID norm. “I don’t believe we’ll ever be at those 70 percent levels again,” says Mike Barnes, associate director of European research at Savills.

Unfortunately for tenants looking to cut leasing costs, that 55 percent isn’t spread evenly across the week. “I think a lot of that lower occupancy is reflected over the course of a week on a Monday and certainly a Friday afternoon,” Barnes says. In Madrid, he says, people are now working longer hours Monday to Thursday and then “maybe finish around lunchtime on Friday.”

Nor will co-working spaces help better distribute the load. “If you have 10 employees, you want your own front door, you want your own services. Companies aren’t looking to share space throughout the course of the week—’we’ll have two days, you have three’,” Barnes says.

Lease activity rose 14 percent year on year in 2022, pushing European take-up to 9.9. million sq. meters, nearly matching pre-COVID levels, according to Savills. In Q1 2023, however, uptake slowed dramatically, to just 2 percent.

Barnes expects this kind of volatility to continue. “I think generally we are going to have these sorts of fluctuations with the economic sentiments of zero growth expected for this year and next year across the Eurozone economy. Of course, that’s going to feed into employees’ sentiment and hiring expectations,” he says.

Signing incentives stayed stable all 2022, at 10.3 percent of total lease value, still more than the 7 percent rent-free period in 2019. But that masked major differences between markets. Incentives rose in Paris La Défense from 30 to 35 percent, while in the City of London they fell from 21.7 percent in Q1 to 20 percent in Q4.

Despite so many people still staying home at least part of the week, European prime rents increased by 6 percent last year, while secondary increased by 3 percent, as some tenants moved into smaller, but nicer spaces. “Even if they are downsizing, they are looking for better-quality space and are paying higher rents,” Barnes explains.

One reason for the demand differential is that despite living in the era of virtual work, many lessors are thinking more about location than they did before COVID, in part to entice people back into the office. High on the list of priorities is good public transportation connections in a neighborhood with nice amenities. “Location becomes a very important aspect in terms of determining whether a building is going to be long-term suitable—or sustainable, if you like—as an office product,” says James Young, head of investor services, EMEA & Asia Pacific for Cushman & Wakefield.

Attractive isn’t cheap.  Thanks to rising labor and materials costs and added demand for more complex interiors, such as more conference rooms and collaborative workspaces, fit-out costs have risen about 14 percent over the past year, according to Savills statistics.

Bringing buildings up to sustainability standards such as BREEAM and LEED and well-being standards such as WELL have also added to the expense, according to a Cushman & Wakefield report. Those costs vary wildly between markets. Costs range from €825 per square meter ($83.31 per sq. ft.) in Madrid to €1,151 per square meter ($116.22 per sq. ft.) in Paris, and €2,798 per square meter ($282.54 per sq. ft.) in London, according to Cushman.

Savills notes that landlords in some markets are picking up some of those bigger fitout tabs as an alternative to traditional rent incentives.

B is Not to Be?

Concerns about sustainability or rather the lack thereof also spooked investors. In a recent report (Obsolescence Equals Opportunity), Cushman & Wakefield analysts estimate by 2030, 76 percent of office stock could be unleasable unless landlords begin to reinvest now to meet tightening energy and environmental efficiency rules.

It’s not just upcoming regulation that’s the issue, either: many tenants aren’t interested in renting buildings that don’t meet high environmental standards, Young says.

Demand is skewing now toward higher-end space, which tends to be newer and more energy efficient. Top-grade stock accounted for over half (54 percent) of total lease demand in Europe between 2019 and 2022.

Some tenants are getting more impatient to trade up. In the U.K., more tenants have been leaving at the end of their lease. Some are not even waiting: breaking leases has also become more common, with lessees generally choosing spaces with better amenities and location, leaving landlords with more vacant space they are unable to be leased, according to Cushman.

However, Young thinks that ultimately most properties won’t be left behind. “The good news is that the vast majority of landlords are aware of it and are taking action,” Young says.

In a higher-rent market, the necessary upgrades may be affordable for landlords, but landlords in smaller cities with lower rents may have a harder time. “I think in some of those locations where rents are lower, you’re not going to be able to see that same uplift…There we will face this challenge of redundancy,” Barnes says.

What will happen to the redundant stock? Residential conversions are one frequently proposed option, but it won’t work everywhere. “Now the issue there, of course, is, do the bones of the office building that you’ve got, are they suitable for that particular purpose? And in many instances, they’re not. And in that case, maybe you’re looking at demolition and rebuild as an alternative,” Young says.

After the Cube Farm

Apart from the challenge of converting the properties, many office districts would also need to be transformed to turn them into attractive, 24-hour communities. “Who wants to be living in a financial district?” Barnes says. But he notes that transforming those business districts won’t be easy. “There are going to have to be big changes regarding regulation and planning in terms of making these more mixed-use districts,” he adds.

Besides homesteading those old cube farms, the three-day in-person work week may drive other real estate opportunities as well. After all, fewer people coming into the office means fewer people ordering coffee or buying lunch downtown. But Barnes notes that they are seeing some growth in retail in commuter towns, as people spend more money close to home. “I think there’s a bit of an opportunity there,” Barnes says.

As for the office sector, Barnes thinks lease demand is likely to decline in the near term. “I do think there’s still a little post-COVID positive leasing momentum—high requirements, low vacancy rates—especially for good quality space, but I think now during a period of weaker economic growth, we’re going to see lower levels of office demand as well.”

On the bright side, European landlords can take some solace in the fact that it could be worse; they could own American property. “Some of the fundamentals in the U.S. market are very challenging, for a number of reasons,” Young says. Many U.S. markets have very old stock, said Young, with some still running on systems that were built in the 1970s.

At 18.6 percent nationwide, U.S. vacancy rates now stand 10 percent higher than Europe’s, and Americans really, really don’t want to go back to the office. Forty-three percent of American workers would prefer never to go in to work, the highest percentage among all 18 major markets Cushman & Wakefield tracks, including France (14 percent), Germany (16 percent), and the United Kingdom (17 percent).

Is this what a bottom looks like? Business optimism in the U.K. hit a 10-month high in June.