Office properties as an asset class

"Unmistakable signs of misallocation".

Credit Suisse Real Estate Research also notes: "Low interest rates are increasing the present value of estimated future rental income and tempting investors to take on too many office space projects. The consequences: rising vacancy rates, falling rents - similar to the situation abroad, although not quite as dramatic: In European office strongholds such as London, Frankfurt or Paris, economic market fluctuations generally leave a more pronounced mark on the office market than in Switzerland. Nevertheless, office buildings remain the classic and still popular investment category for real estate investors, globally speaking. For example, the "office" use is traded most frequently on the global office real estate market; according to RCA Real Capital Analytics, its share of global real estate transactions was 37 percent in the first half of 2013. In Switzerland, multi-family dwellings traditionally dominate real estate investments, but commercial properties with office space also play an important role among institutional investors, as they do on the transaction market.

Investors know what they are doing

At first glance at the risk-return profile, this preference is not necessarily obvious. If the total returns, i.e. the cash flow and change in value returns, of the various property uses were compared with each other, offices performed poorly, Wüest & Partner states in the autumn edition of "ImmoMonitoring 2014/1". Their returns are lower - although not massively so - and above all their fluctuations over time are significantly higher than elsewhere. In other words, when buying office properties, investors accept more risk in order to achieve a certain level of return - investments in residential or retail properties therefore generate higher returns with less risk. This raises the question of why the office segment has been so attractive for years. In its search for the causes, Wüest & Partner has conducted a study for the "ImmoMonitoring"24 institutional real estate investors and developers domiciled in German-speaking Switzerland were surveyed. The vast majority of the survey participants are active throughout Switzerland; their portfolios (total market values: over CHF 70 billion) consist exclusively or to a significant extent of commercial properties. The majority of respondents agreed that the risk-return profile of office properties is weak within the investment universe of established investment properties. Investors are well aware that office returns are more affected by market trends than other uses, both during downturns and booms. According to the results of the W+P survey, the fact that office properties are the first and in some cases the only choice for many local investors in the course of their investments or construction projects, along with multi-family houses, can simply be explained by the lack of alternatives: Half of all decision-makers surveyed expressed this view. They emphasized the lack of critical mass of other investment options: Office properties tend to allow larger investment volumes than multifamily properties, for example. "This assessment is likely to be particularly true in the case of trading in existing properties," commented Patrick Schnorf, Head of Research at Wüest & Partner. Furthermore, office space has different characteristics from apartment buildings or retail space; in particular, there are differences in operational management: It is true that the initial letting or re-letting of an office building is more complex than for an apartment building due to the lower degree of standardisation of both the rental properties and the terms of the lease. However, once the leases are signed and sealed and an office building is fully let, the necessary commitment on the part of the management is less than in the case of apartment buildings, for example.

"Suffering at a high level"

Another, albeit very individual, reason for investing in office properties lies in the legal requirements of the investors. For example, listed real estate companies are required to invest in commercial and not in residential properties due to the Lex Koller. "This has an impact on the investment demand for office properties," says Schnorf. In addition, aspects such as optimisation opportunities for VAT on rental income, specific regulations in the insurance environment or tenancy law also play a role. "It is precisely the legal framework that can positively or negatively influence the property-related cash flow or even the change in value yield," says Schnorf. On the other hand, the claim to achieve a diversification contribution is of secondary importance: this has not been significant in the case of office properties in Switzerland, at least in the past ten years. The fact that office properties have their own charm for real estate investors is shown not least by a comparison with investment alternatives. "If the average annual total return of Swiss office properties over the past decade is compared with the returns achieved in other asset classes, the diagnosed "yield weakness" of office properties can be seen as suffering at a high level," Schnorf states. "Especially with regard to the current income statement of investors, office properties are able to convince with a relatively high and stable cash flow yield." The component of the less convincing change in value yield is relevant in two constellations: Firstly, when changes in value are recognised in the income statement, and secondly, in the case of divestments, i.e. sales. Due to the greater fluctuations in the value of office properties compared with apartment buildings, the time of purchase and sale is even more important than is already the case with all investments: "Timing is therefore important.

Exciting and interesting product

While focusing exclusively on the risk-return profile, it should not be forgotten that there are many reasons to invest in office properties, Schnorf points out. "Many investors see office use as an exciting and interesting product that is important for 'telling' a credible story to the investor target audience." Furthermore, many investors have built up a wide range of expertise precisely in relation to this type of use. According to Schnorf, it is sometimes these factors that favour or explain the establishment and successful existence of real estate companies with purely commercial properties. Furthermore, the tendency observed over the past ten years to separate portfolios with mixed real estate holdings according to more uses underlines the need for transparent, clearly oriented investment opportunities.