The brave new world of serviced office valuation

Serviced offices are part of the wider market for commercial property in which businesses can choose between buying property or renting/leasing office accommodation. Serviced offices offer a flexible arrangement for companies, although this typically comes at a premium to cover the additional costs of marketing and managing multilet buildings on short-let agreements. Serviced offices are let on a predominantly fully fitted and furnished basis. The operator is responsible for the building maintenance and can also provide a range of business services, including meeting and conference facilities complete with support, catering etc; provision of presentation equipment; reception, secretarial and clerical services; and IT and telecoms support. These enable clients to occupy the premises and easily outsource costly internal operations. The charges that companies pay for serviced offices include almost all of the costs that they would normally expect to pay on top of the rent in a traditional office, for example, service charges and rates liability. Although serviced office costs can be significantly higher than longer term accommodation costs of comparable quality and location, providers are able to offer comparative flexibility, and these premises may actually be more affordable for some occupiers when the fit-out, deposit and legal costs associated with traditional lettings are factored in. In terms of flexibility, some office providers rent space on a per-day basis. The usual occupancy period is three months, although licences are often typically for nine to 12 months and many tenants simply renew the agreement annually. This varies considerably from the five to 10-year leases normally associated with a traditional office and thus gives many companies the flexibility to shrink or expand as their needs dictate. Adding serviced office space into a tenant mix in larger buildings can also be an advantage for other building occupiers, who can enjoy the option of “spillover” space to grow into in the same location. Similarly, serviced office occupiers may seek larger areas within the same building. In weaker occupier markets, demand for serviced offices can actually increase while demand for conventional leases decreases, thus hedging risk and maintaining occupancy levels. Business models Serviced operators often purchase freehold buildings, fit them out, multilet them on short leases and “brand” the property. This tends to be a model of an established operator or a small company that owns a building which would often be difficult to let on proper leases because of its secondary location. Some operators lease the building (or part) from a landlord and pay standard market rent while trying to profit from the difference between the premium rent and the headline rent. Another method is for the serviced office provider to agree a management agreement and run the business on behalf of the building owner, receiving a management fee and often a profit share. Valuation approach Serviced offices comprise a large number of tenants and hence generate rental income at a cost of managing the service. Standard valuation methodology for commercial property in the UK primarily uses the investment method, whereby the net operating income is capitalised using a market-derived yield. The higher rents for short-term leases and income generated by the services enable a premium net operating income to be achieved compared with a standard rent on a standard lease, provided that a sufficient occupancy rate is achieved. Analysis of the net operating income requires a review of the current tenancy schedule, an understanding of occupancy levels, workspace rates, operating expenses and ultimately what level of stabilised EBITDA (earnings before interest, tax, depreciation and amortisation) can be reasonably expected in the future. The sustainable net operating income once the business is stabilised can then be capitalised at a yield that currently reflects short-term income in the particular market location. Valuation examples Method 1: investment approach. In this example, there are 200 desks each let at £450 per week, which provides a total income of £1,080,000 pa. Other services include a virtual office offer and letting meeting rooms, which provide an additional £120,000, giving a total annual income of £1,200,000. It is important to analyse three years of accounts to see how the desk rates have evolved and determine the occupancy rate, which is significant in determining price, particularly against competing operators. From the total income are deducted costs, including wages, business rates and property expenses including insurance, maintenance and agent fees, marketing and telephony, which in this case totals £365,000 pa. When deducted from the total income, this provides a net operating income or EBITDA of £835,000. Using the investment method, this is then capitalised at a yield of 7.75% to reflect a comparable transaction of either serviced office properties or short-term office income transactions. This provides a value of £10,090,000 after deducting any purchaser’s costs (see table 1).  Method 2: split yield approach. It is always useful for analysis to compare the EBITDA against what the estimated rental value for a conventional lease would have been in order to review the premium rent that is being created by the serviced operation. Some valuers undertake a split yield approach to the valuation through applying a low yield to the conventional estimated rental value and a higher yield to the premium rental value. For secured lending valuations, a vacant possession value is normally required based on a conventional market rent. This is because if the serviced office business operation has failed then the property would be sold on a vacant basis (see table 2). Method 3: discounted cashflow approach. An alternative method is the discounted cashflow (DCF) approach, where more explicit assumptions in relation to the projected cashflow including components such as fit-out costs, inflation, changes to occupancy levels, increased revenues and operating costs are made. The methodology involves projecting expected cashflows over a holding period (generally five to 10 years) and discounting these back to a net present value. The primary advantage of this method is the ability to accurately model more complex cashflows. Specific cashflow events can be plotted on the timeline such as base rent reviews, projected profit rent increases, fit-out costs, rent-free periods, capital repayments and exit/sale values (see table 3). The key assumptions include the exit yield applied at the end of the cashflow and the discount rate, which should reflect the nature of the asset, and the business relative to comparable investments within the market place. Once the cashflow has been modelled it is discounted using the selected rate to arrive at a net present value of the cashflow, which after subtracting purchaser’s costs is the market value we adopt for the investment. This is also checked by assessing the internal rate of return of the full investment cashflow (including the purchase price). This should mirror the discount rate and verifies the cashflow from the alternative perspective. Understanding the dynamics With a significant increase in serviced office accommodation in the UK driven by occupier demand, valuers are having to understand the business dynamics of the offer and relate them to the current real estate markets. Traditional valuation methods are used to determine the fair value of the property assets. The premium rents that can be generated provide value to the asset but the yield based on comparables currently still reflects the short-term income. It is simple to analyse the premium through a comparison of the capital value per sq ft against the vacant possession value of the building and the value on a conventional estimated rental value at a conventional value.  Chris Strathon is a director in the JLL valuation advisory team