Extension of office-to-resi PDR raises the question: “Which use creates highest value?”
Permitted development rights (PDR) for office-to-residential conversions are to be made permanent, after initially being introduced in 2013 as a temporary measure until 30 May 2016.
The politically-motivated move comes amid concerns about under-supply and strong upward pressure on rents and prices in the UK’s housing market. It is hoped that the proposed changes to PDR will continue to spur on office-to-residential conversions, helping to address this shortfall and making the most of neglected and underused buildings.
The measures have been largely successful so far, seeing almost 4,000 conversions approved between April 2014 and June 2015.
Side effects
Although it is unlikely to have been obvious to the politicians, this change has a significant impact on lease-end dilapidations and surrender negotiations.
For most older office buildings there is a question of where future value lies. Historically this was usually around re-letting with or without refurbishment and involved comparing the potential reduced letting void and rental uplift from refurbishment against the cost of refurbishing. Residential conversion, while an option, often resulted in a lower potential value due to the risk of not obtaining planning consent and the common time delay in needing to try and fail to re-let in order to convince the local planning authority of the case for loss of employment use.
The temporary relaxation of PDR changed this, as the planning delay and risk was removed from residual appraisals. Since the relaxation we have seen many more buildings converted to residential use; or at least the valuation appraisal for residential conversion now competes with or exceeds continued office use.
For example, if you take a typical South East secondary office building rental value of, say, £220 per sq m at a yield of 6% when let and then deduct letting void, refurbishment costs and the like, you might get to a value of £2,500 per sq m. If you take a converted flat end-value for the same building of £250,000 less £50,000 conversion costs and assume a floor area for the flat of 80 sq m, that also produces a value of £2,500 per sq m. As a result, you can see that many of these valuation comparisons can be quite marginal. You only need to increase the relatively low value-per-flat and be a bit more pessimistic on the office letting void for the residential value to become the clear winner.
Interestingly, it appears PDR will extend to demolition and new residential building, although the detail on this is unclear at present. This would mean that the physical viability of transforming an office building into residential is no longer an obstacle. In some cases the existing structure and configuration of a building can make conversion problematic and, so far, a redevelopment appraisal has been impacted by the planning risk.
Lease-end impact
Consideration of the two limbs of section 18 of the rather ancient but still relevant Landlord and Tenant Act 1927 becomes important in these situations.
First, is the landlord’s intention to convert or redevelop the premises for residential? This is much more likely following the PDR changes and well-advised tenants will seek clarity on a landlord’s intentions. Second, the office versus residential valuation appraisal will be a key part of the dilapidations negotiation. This can be subjective and is often very sensitive to small changes in the input variables. It is also sometimes unfair to owners of buildings who are office investors rather than residential developer converters, and who may prefer the more comfortable office refurbishment and re-letting route.
Nevertheless, if there is a clear valuation case for residential value over office value, the assessment of any dilapidations liability should be on that basis, with often much of the liability being superseded. This has been frustrating to many landlords but will only continue.
Market changes
The first generation of residential conversions generally tried to make the end product not look like an old office building, with re-cladding being common. This was not helpful in supporting dilapidations recovery.
Some more recent conversions involve less external cosmetic changes and lower-priced end flats or often flats for rent rather than sale. Market perception seems to have changed; there are end users willing to buy or rent obvious ex-office stock, which did not seem to be the case several years ago, much like the loss of stigma with ex-local authority housing.
The growth of the private rented sector has seen a number of speculators looking for such opportunities with a view to letting rather than selling. This means in some cases the dilapidations impact is less – internal strip out and external envelope repairs can survive a residential conversion.
Paradoxically, in some locations the loss of office stock to residential use is starting to generate an uplift in office values. If there is demand and little supply, office letting voids become shorter and landlords can increase rental levels. With a permanent relaxation, we may see office stock fall further and the rather subjective valuation comparison may swing the other way in favour of continued office use. This of course means the dilapidations defence may not be as easy to prove.
The relaxation of PDR in 2013 encouraged a shift in lease-end negotiations: from arguments around the cost of works to valuation analysis concerning office and residential value differentials.
The recent changes mean that we can expect tenants to be increasingly assertive with these arguments, requiring comfort around landlords’ intentions. Advisers in lease-end negotiations who understand and can articulate the valuation case for and against office-to-residential conversion or redevelopment will be in demand.
Mike McChesney is a partner at Deloitte Real Estate
