A WeWork that actually works – and highlights the value in UK property

Property website Zoopla has just announced that the number of homes sold in the UK this year is set to hit the lowest level in a decade, forecasting a 21% drop in completions as the rapid rise in interest rates hits mortgage affordability¹. 

Over in commercial property, the outlook appears just as bad. Headlines in this area have been dominated by the potential collapse of WeWork, which admitted in August that “substantial doubt exists about the company’s ability to continue as a going concern”.

As London’s largest private tenant with about 3 million sq ft² of office space, the failure of WeWork would have severe implications for British landlords, with data from The Telegraph showing they are exposed to £3bn in rental commitments from the company³. 

There has always been scepticism about WeWork’s business model – it lets office space from landlords on long-term leases, which it then attempts to sub-let on shorter terms for more money, while giving away free beer.

Running such a large mismatch in the duration of income and liabilities has been the downfall of many business models in the past – Northern Rock and Silicon Valley Bank are just two of many high-profile examples. 

New long-term leases have become significantly cheaper in the past few years as property owners seek to fill the growing number of vacancies caused by the trend towards working from home. This has come at a time when rising interest rates have hit valuations, and unsurprisingly investors have panicked: the wider AIC Property – UK Commercial sector is now on a discount to net assets of close to 30%.

Such fears are not unfounded – I walk past too many vacant offices in Edinburgh not to see that the sector is facing an uphill struggle. 

Yet it is in those moments when investors blindly buy or sell entire sectors and sentiment trumps fundamentals that contrarian investors often find the best opportunities. Today is no exception. 

REIT between the lines 

Earlier this year, we bought Workspace, which lets shared office space to SMEs. This is the first office REIT we have invested in since I joined Artemis in 2015. 

Workspace has flexible buildings where tenants can rent a unit the size of a single room, or the size of several. They start with an equipped shell that they can customise to their needs and, as their business grows, can move into larger offices in the same building. 

This flexibility attracts a broad range of tenants, whether that is creative industries such as set designers and media companies who need studios for recording, life sciences companies looking for laboratory space, or more traditional office users. Workspace’s reputation means that customers operating in niche areas often approach the company, rather than the other way around, reducing the amount it needs to spend on expensive estate agents. 

We started analysing Workspace last December, visiting a few of its buildings, then began buying in March, when the crisis in US regional banks hit and sentiment around property fell. That gave us an opportunity to buy more shares at a lower price. 

Location, location, location 

People say no one’s coming back to the office. But while the way we work has certainly changed, companies still need a place where staff can meet. It might be smaller. But in a world with a shortage of skilled workers, where employers face a struggle to attract and retain the best talent, companies need to provide somewhere that people want to work.

The result is that employers are looking to move to smaller, higher-spec offices in prime locations. This is a trend that has been accelerated by the need for more sustainable and energy-efficient buildings. Recent high-profile examples include HSBC, which announced it will move from Canary Wharf to the City. It needs less space and has used the money it saved from downsizing to move to a more central location. 

Similarly, our research has shown that many large corporations based in areas such as the M4 corridor are looking to downsize and again move to central locations such as the West End or Paddington Basin. In these areas, high-quality office space that meets forthcoming environmental legislation is scarce, resulting in much stronger rental dynamics than in the broader office sector. 

Workspace has a head start on this trend, with most of its 40-plus offices based in and around central London either compliant with 2030 energy-efficiency targets or with plans in place to get there.

Why now?

Property is valued off long-term interest rate expectations. This means that if interest rates fall, the value of Workspace’s assets should go up.

At the top of the cycle, property trades on a premium to NAV because values and rents tend to rise. At the bottom of the cycle, when pessimism is at its highest, property REITs can trade at a 40 to 50% discount to NAV. This is where we are today, with Workspace available at about 45% below its NAV. For an investor buying the shares today, the see-through yield onto the actual assets is just over 9% – a level we view as attractive, particularly as the rental income is growing ahead of inflation.

At some stage in the next 24 months when the interest rate cycle turns, investors will pivot to the sectors well placed to benefit, with property and housebuilding likely to be among the first ports of call. Both are relatively small in a UK market context and history would suggest that when the turn arrives, the re-rating of London commercial office property back towards NAV will be rapid. 

There is no way of knowing when this turning point will arrive, so investors need time for this thesis to play out. Fortunately, all the property-related investments we hold afford you that luxury: they are all profitable businesses that generate strong cashflows and pay a healthy dividend.

They don’t give away free beer.