- The COVID-19 pandemic and the ensuing lockdowns’ economic ramifications have caused significant uncertainty over the future of work and rental income from office properties.
- Nearly 60% of the UK Quarterly Property Index’s office rental income comes from leases that expire or contain a break-clause date over the next five years.
- A review of lease events showed that in 2019 47% of offices were vacant for one quarter or more after a break clause and 72% were vacant after lease expiry.1 These numbers could rise amid COVID-19, leaving more rent at risk.
With new COVID-19 lockdowns and swaths of white-collar workers continuing to work from home, a question looms: What will happen to offices? As office tenants approach contract expiry and break-clause dates and contemplate what the future of work will look like for them, they may reconsider their need for office space. This could have significant consequences for office demand and income from office leases.
Impact So Far
The pandemic has already had a significant impact on real estate rental income. This effect has been most severe in segments where lockdowns and social distancing have hit hardest: leisure, hotels and retail. In these segments, the income losses were due to factors other than expiring or broken leases. Hotel leases are essentially nightly;2 and in the case of a sharp contraction in demand, the income hit is instantaneous. Although retail property generally benefits from reasonably long leases, tenant default rates had already been climbing steeply since 2017, in part due to headwinds from e-commerce. COVID-19 exacerbated these challenges, as so many tenants have been simply unable to pay rent. Office tenants, in general, have been less acutely impacted by the pandemic — and seemingly better able to pay their rent throughout this crisis.
Retail Income Has Been Hit by Surging Defaults, but Office Income Has Been Safer
But what has tended to happen when leases expire, or tenants exercise their lease-break clauses? According to data from our new client report, the “MSCI Lease Events Review 2020,” post-tenancy vacancy has risen for offices since the 2008 global financial crisis and in recent years reached an all-time high. In 2019, 72% of offices with expiring leases remained vacant for at least one quarter after expiry, as shown in the exhibit below. In addition, nearly 50% of office lease-break options were exercised, on a rent-weighted basis, and 47% of offices were vacant for at least one quarter after a break. With the dramatic impact of COVID-19 and ensuing lockdowns, many market commentators have been asking whether these numbers could continue to increase.
Post-Expiry Vacancies Neared an All-Time High for Offices in 2019
What Could Changes in Lease-Event Outcomes Mean for Office Income?
Given office tenants’ higher recent tendency to vacate leases, what could lie ahead for office income immediately post-pandemic and further into the future? In the MSCI UK Quarterly Property Index, nearly 60% of office rental income is tied to leases that expire, or have a break-clause date, within the next five years. The exhibit below illustrates how office income would be eroded if each tenant took their earliest contractual opportunity to vacate — at either a break date or lease expiration. The analysis assumes no renewal or reletting to a new tenant. In this sense it provides a useful worst-case-scenario benchmark (leaving the possibility of default to one side). Under this conservative analysis, nearly all income (86%) is eroded by 2034, with the remainder lost in 2035 and beyond. Of course, historically, income erosion in U.K. offices has never been this dramatic; some leases are renewed or re-leased within one quarter. Although COVID-19 may increase the tendency to hand back space, how can we develop more realistic and informative scenarios of potential income erosion for office properties?
60% of Office Income Could Be Eroded by 2025 — Assuming No Defaults
In the analysis below, we use data from the “MSCI Lease Events Review 2020” for the propensity for leased income to be lost at break date and lease expiry in 2019 as probabilities in a forward-looking simulation as follows:
- For each lease, we effectively “roll the dice” at every lease event to determine if the income associated with that lease is either broken or expires depending on the type of lease event.
- Leases arriving at a lease expiry become vacant with 72% probability.
- Those arriving at a break date become vacant with 47% probability.
- Any income that remains unbroken after a break date may be lost at the lease’s expiry date like any other lease with 72% probability.
The shaded pink area in the animated exhibit below illustrates the upward shift in cumulative erosion profile due to the propensity for only some leases (47%) reaching their break clauses to break. The shaded blue area shows a similar but smaller shift up since only 72% of income is actually lost at lease expiry. Together, these effects flatten the income-erosion trajectory over the next 15 years and beyond. Under these assumptions, however, the total potential income erosion over the next five years is still nearly 40%. Investors expecting the tendency for occupiers to vacate space at lease events to increase may expect the income erosion profile to land somewhere in the middle of the shaded area.
We repeated this simulation numerous times using the same probabilities. Because the modelled outcome varies for each lease at their specific lease event dates, the ultimate lease erosion profile also varies with each scenario.
Even Under More Conservative Scenarios, 40% of Office Rental Income Could Be Eroded by 2025
The Next Five Years May Be Telling
U.K. office rental income seems to have been largely spared from the impact of COVID-19, but there are already signs of change. With nearly 60% of the MSCI UK Quarterly Property Index’s office rental income in leases that expire or contain a break-clause date over the next five years, investors may wish to consider the implications for their portfolios. What the pandemic will ultimately mean for office properties remains to be seen, but U.K. office rental income could erode more rapidly than it has in the past.
1Tenancies weighted by contracted rent.
2Hotels under management contracts are subject to this variability of income. Some hotels operate under more traditional long-term leases with the owners (but not the operators) somewhat insulated from a downturn in demand.