Eyes are on Europe's office sector, after COVID-19 lockdowns sent many workers home to work remotely and the economic impact reduced the capacity of companies to pay their rent. However, the solid performance of European office real estate holding companies and investment trusts (REITs) last year dispelled some of the concern about the landlords' capacity to maintain rents and asset values. S&P Global Ratings continues to assume that rent and valuations for rated companies will remain flat or decline by no more than 5% in 2021 and 2022 after a slight increase of about 1% in 2020. In Europe, five of the 19 REITs operating in the office property sector that we rate carry negative outlooks or are on CreditWatch with negative implications (see table 1).

Table 1

Challenges for office landlords are likely to be gradual and linger toward 2022

We believe that demand for office space in Europe will weaken as companies revisit their needs in the next two years, as working from home becomes more routine, and cost cutting and the search for productivity gains gather steam in response to the pandemic's economic fallout (see chart 1). We think the actual need for office space in the main European markets could be 15% lower than pre-pandemic levels and constrain leasing activity for the next two years. In 2020, leasing demand fell well below the five-year average in all major markets--Paris, London, Berlin, Madrid, and Barcelona--due to direct effects from the pandemic (see chart 2), and we think recovery of the market could be only gradual and linger into 2022.

Chart 1

Chart 2

Deliveries of new office buildings could push up vacancies in some markets

We believe office buildings to be delivered vacant in 2021 and 2022 could be hard to lease, given the slow recovery of the leasing market. Moreover, large deliveries of vacant spaces for let could threaten the absorption of existing supply in the main European cities. We think Paris, Stockholm, Frankfurt, and the West End of London are less exposed to that risk. But Bucharest, the City of London, and Warsaw could see higher vacancy levels, which were already high as of Dec. 31, 2020, because of the large numbers of deliveries due this year and next (see chart 3). The situation sometimes differs within the same city. For example, we observe much lower vacancy rates for Paris' central business district (3.4%) and the center of Bucharest (7.7%) than Paris La Defense (10.5%) and the western part of Bucharest (13.6%).

Chart 3

The impact of the softer market on REITs is moderate so far, and risks appear manageable

Office rents of the REITs we rate have been resilient to the pandemic so far, remaining on average stable since 2019, despite some rise in the vacancy rate and lower growth. The few declines in rental income that we observed were all contained in the 0%-5% range. Immofinanz and Société Foncière Lyonnaise experienced the sharpest declines due to some temporary rent concessions and a longer time to find tenants for a few assets. Collection rates remained high (97% on average), with tenants showing limited stress, even at the peak of the lockdown, because of the companies' sound and diversified tenant base. We believe that a decrease in demand should have only a moderate revenue impact for the companies we rate, as less than 5% of their rental income in 2021 on average is not yet secured (extended or replaced). We do not expect any further rent concessions ahead of lease maturities.

Chart 4

Chart 5

Remote working will complement, not fully replace, the office workplace

While we expect remote working to expand and become an option for more employees, we do not think offices will disappear. Office workplaces can foster social interaction, promote the corporate culture, and offer greater data security. According a CBRE survey, 81% of organizations anticipate at least half of their workforce to be based in the office—but with options for remote work ("The Future of Office Survey," September 2020). The French business newspaper Les Echos reports that managers of larger companies (more than 1,000 employees) are much more interested in having staff work from home than smaller ones (less than 100 employees), and most for two days a week. After years of space densification, the trend may reverse, where space required per employee and indoor air quality could increase and partly offset the lower number of leasing transactions. Moreover, we believe the long-term adoption of working from home could vary by country. We already observed that returns to workplaces after the first wave of the pandemic were uneven in Europe, with the U.K. significantly lagging other countries despite government calls (see chart 6). We believe there may be several reasons for uneven adoption, such as commuting time, share of international tenants (generally applying widespread and more stringent policies), office density and verticality, trade unions (which may require more protection and compensation for remote workers), and possibly other sociocultural factors.

Chart 6

Valuations continue to rise, against all odds

Valuations growth for office properties remained slightly positive on average, at about 1% in 2020, supported by few benchmark transactions that further reduced capitalization rates (the rate property appraisers use in their valuations) and by the expectation that rents should remain resilient. We note that most asset disposals closed at prices above last appraisal values, such as Icade and Gecina in the first quarter of 2021, which reported 6% and 4.3% price premiums to their appraisal values on Dec. 31, 2020. Still, we believe valuations could erode, by 0%-5% on average in the next two years, assuming that lower rent indexation rates and higher vacancy rates than previously anticipated would reduce appraisers' revenue expectations. Moreover, we expect investment in European office real estate to remain subdued and selective this year. This would come after a 39% contraction in investments in office assets in 2020, the second most affected property segment after hotels (-66%), according to CBRE's "EMEA Investment Snapshot Q4 2020." We believe that prolonged investment inertia or the emergence of potential distressed asset sales could weigh on future valuations of office assets.

Chart 7

Central or non-central?

Central versus non-central: preferences are becoming clearer. Valuations and rent increases were stronger in the center of large cities, where 70%-80% of the assets of the companies we rate are located. For example, Gecina's assets in central Paris gained 2.2% value in 2020 while those in La Defense and other areas declined 7.6%. Although rent affordability and cost of living remain major issues in central business districts, we continue to think these areas remain the best for attracting talent, access via public transportation, and proximity to business partners. According to a CBRE global survey in September 2020, only 3% of companies were considering moving away from high-density urban city centers. Office leasing conditions may ease in most European capital cities as landlords' bargaining power weakens somewhat, and we have seen rent incentives slightly growing this year, but central business districts should see less of an impact on rent than secondary locations, according to the Colliers' report "EMEA Occupiers conditions Q4 2020." In central Paris for example, rent incentives range from 10.1% to 19.7%, while they reach around 27% in La Defense and the Western Crescent of Paris, according to the "JLL Office Property Clock Q4 2020," Jan. 14, 2021. Moreover, the supply-demand imbalance is more pronounced in most central locations given the scarcity of good quality assets, the barriers to entry (such as building rights on protected buildings), and the lack of available land. We therefore see stronger potential for vacancy absorption in central areas.

Flight to quality

Tenant inquiries in our view will increasingly target service-oriented grade-A assets, with a higher proportion of collaborative spaces and green credentials. New ways of working are likely to dictate the configuration of future offices, requiring more attention from landlords. Cost consciousness and growing environmental awareness are also pushing occupiers toward more energy-efficient buildings. At the other side of the spectrum, grade-B assets with weak green and social credentials are likely to increasingly suffer.

The flex office: both a threat and an opportunity

Traditional office landlords, whose leases generally exceed six or nine years before a potential exit option, are exposed to competition from short-term lease, flex-office providers, which were popular in the years preceding the pandemic. Although flex office providers have more volatile occupancy rates, we think the prominence of this business model can drive market occupancy more quickly than the traditional long-term lease model. We think the U.K., in particular London, is most at risk in Europe given the sizable share of flex-office sites in its office stock (see chart 8).

On the flip side, this type of business model should recover quicker from the crisis and capture significant tenant demand, given that companies are still hesitant to make real estate decisions and cannot commit for several years. We believe traditional landlords' embrace of such a model can provide them with a competitive advantage by providing flexibility and scalability to their existing tenants, as long as it does not disrupt the overall fixed lease structure and sharply reduce average lease maturities.

Chart 8

Shorter leases and subleasing are not the norm, yet

Remaining lease durations declined slightly in 2020, by about 2.4 months on average, for the companies we rate, with eight companies reporting a decrease out of the 12 that disclosed the data. However, we understand this slight decline is linked more to longer tenant negotiations in 2020 than new lease standards with shorter durations. Moreover, the average remaining lease maturity as of Dec. 31, 2020 (about 5 years) was still in line with the long-term average. What's more, while we understand subleasing is an option in case of difficult asset commercialization, we have not yet seen evidence of it for the companies we rate. We will continue to monitor whether shorter leases or subleasing will take hold in the near future, as we think they could harm office landlords' revenue predictability and their tenant base.

Chart 9

Our base-case scenario: REITs maintain comfortable ratio headroom

Under our base-case assumptions, we conservatively assume that rents due to expire in 2021 and 2022 would be renegotiated or replaced at a 15%-20% discount to the previous level. This assumption could also depict a situation where 15%-20% of the leases maturing would not be renewed and become vacant, with the remainder 75%-80% being renewed at the same rent level. This would represent a 1-2 percentage points increase in overall vacancy in 2021, depending on issuers' maturities burden. As a base-case scenario, we also assume a valuation decline of 0%-5% in 2021 to underpin potential yield expansion this year and a stabilization in 2022. Under this scenario, most REITs we rate would maintain ratios that are commensurate with their current ratings (see charts 10, 11, and 12).

Chart 10

Chart 11

Chart 12

Stress scenario: Credit ratios would significantly weaken, likely increasing pressure on the ratings of most office pure players

We ran a more severe scenario for the six large pure players we rate in the traditional long-term lease office market, where we assumed that only one-half of the leases maturing in 2021 would be renewed, subject to a 25% discount. This would represent a 3-5 percentage points increase in the overall vacancy rate in 2021, depending on the issuer. In 2022, we assume all leases maturing will be renewed—again with a 25% discount. In this scenario, we assume a valuation decline of 10% in 2021 and no rebound in the following year. Under this unlikely scenario, headroom for the current ratings could reduce significantly and, in most cases, breach our ratings thresholds (see charts 13, 14, and 15). However, this scenario is highly hypothetical and unlikely in our view. Moreover, it doesn't take account potential remedy measures such as further reductions to capital expenditures or cash dividends, equity increases, or asset disposals.

Chart 13

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Editor: Rose Marie Burke. Digital Designer: Joe Carrick-Varty.

Related Research

• Industry Top Trends 2021--Real Estate: Recovery In The REIT Sector Could Be Long And Uneven, Dec. 10, 2020
• COVID-19 Is Only Part Of The Threat Facing U.K. Real Estate Companies, Nov. 16, 2020
• European Office Real Estate Companies: After A Resilient First Half, Upcoming Lease Maturities Should Test The Market, Sept 18, 2020
• European Corporate Credit Mid-Year Outlook 2020, July 30, 2020
• How Are Lockdown Measures And Remote Working Affecting European Office Landlords? May 27, 2020
• COVID-19: Implications For European Real Estate Investment, As Tenants Begin To Suspend Rent Payments, March 26, 2020