Despite the exponential growth in the flexible offices market, far more capital would pour into the sector if values were widely known and accepted, argues Giles Fuchs, chief executive of Office Space in Town. Here, he presents one way to address the uncertainty and calculate the value of serviced offices.
Flexible offices have been the most exciting growth story in the commercial office market for the past 10 years. The UK, in particular, has witnessed explosive expansion, with take-up increasing at rates of more than 100% in recent years and flexible office floor space growing at a similar speed. This has naturally attracted a range of investors – so far largely alternative funds and private equity houses, rather than long-term, income-seeking institutional investors.
However, one key factor that has probably been holding them back is the lack of a market-wide accepted valuation for serviced offices. If this were resolved, it would help release a prospective flood of institutional capital into flexible offices and see the sector properly recognised as a new investment asset class.
According to JLL, the square footage of flexible office space has grown at double-digit rates globally over the past seven years, versus a 1% growth rate of traditional office space during the same period. As the sector has boomed, we have seen large flows of investment from big players such as Blackrock and Carlyle.
At Office Space in Town we have received the backing of other large alternative funds, such as Forum Partners – a US fund with $6bn invested globally – and Kailong, one of China’s leading property investors.
Earlier this year, FTSE 250 REIT RDI bought an 80% stake in our London owned portfolio – signalling the first time a mainstream, long-term, income-seeking institutional investor had committed to the flexible office sector. For RDI’s move to become a catalyst for further institutional investment, we believe that we need a market-wide accepted appraisal for such institutions to have more certainty on valuation of the freeholds, which would also underpin greater liquidity for their investments.
We have been pioneering a valuation strategy to address this significant gap in the industry, as well as helping advise the RICS on its plans to create a valuation approach for the flexible office space sector.
Extra income
Our approach, the Fuchs Formula, rests on the principle that, like hotels, serviced offices have an income stream over and above the standard office rental income. This includes revenue such as IT and reception facilities, meeting rooms, call charges, secretarial functions, franking, clerking and many more. The variable income typically makes up only 10-15% of the total income, meaning that 85-90% of the total income is contracted.
The first tranche of revenue is contracted and equal to (and as robust as) the market rent for that building, and therefore should be valued at the prevailing market yield of, say, 5%.
The second tranche, which is also contracted, can be given a higher yield. It is less robust and some part could conceivably be affected by market fluctuations. For the purposes of providing a consistent formula, we may value this at a 7% yield.
To err on the side of caution, only 90% of this second tranche of income might be taken into consideration, allowing for 10% to act as a safeguard for income that could be affected by market changes. Loss of EBITDA in a recession will be 10-20%.
Although, for prudence, no yield may be given to the top 10% tranche, the reality is that any buyer will give this a yield. This yield will be higher than the second tranche and will depend on location, quality of building, age of centre and average client stay.
Therefore, this second tranche of income can be valued at 90% of the remaining income at a 7% yield, which can be distilled into the following formula:
- Value of serviced office building = (EBITDA equal to market rent at 5% yield) + (remaining EBITDA x 90% at 7% yield)
The Fuchs Formula brings to light the way in which serviced offices are currently undervalued. However, to fully appreciate this, it is also important to address some of the common misconceptions about the serviced office market.
First, the stability of income generated by a flexible office is not widely understood. The average tenure of a flexible office client is two-and-a-half years, compared with just under four years for a commercial lease.
Additionally, the stability of revenue is increased as a result of the building being occupied by a number of different clients, meaning any one client leaving has little impact on the overall income. As mentioned, 85-90% of the income is contracted.
These factors are crucial in understanding the Fuchs Formula. Only by amalgamating all income streams can one establish the absolute valuation of a flexible office – and only then will it fulfil its potential to be a core holding in long-term institutions’ portfolios.
(The yields suggested and percentage of incomes used are dependent on location, condition of building, maturity, quality of management, services provided and so on.)
Giles Fuchs launched OSIT with his sister in 2010. The company’s first office opened in 2011 in the Euston Tower in central London.
