To address the shortfall in residential housing, the government changed the law on permitted development rights in 20131. The new legislation allowed developers to convert office space to residential use without needing full planning permission. While investing in a completely new housing development carries an element of risk – particularly if the market is stagnant and it’s difficult to attract buyers – if a solid commercial building already exists, the risks are lower and a conversion is more attractive to financiers looking for a reliable short-term investment.
REITA and the British Property Federation assessed average rental yields from commercial premises between 2002 and 2007 and found that they were about 50% higher than those from residential assets2. During the financial crisis at the end of the last decade, commercial property in the UK fell in value by up to 50%3, which made office space even more attractive to investors. They snapped up fully leased commercial buildings at modest prices and, within five years, were enjoying average yields of 5.7% pa2. At the same time, residential property only dropped in value by a maximum of 25%3, which meant yields remained comparatively low.
Landlords today, however, are finding it difficult to let office space in town centres. If the space remains vacant for several months, they can now consider residential conversions to prevent long-term losses. The basic economic reality is that, since the end of the recession, the property market has picked up and residential space is now worth more to landlords than commercial space.
The impact of flexible working
As more and more employers encourage their staff to work from home, the demand for office space, particularly in London, has fallen. And with an improved transport system shortening journey times between the capital, Birmingham and cities in northern England, many companies have moved their offices to the Midlands and beyond. This has led to a rise in vacant office space in London. When combined with the rise in the demand for affordable residential housing, this is a prime opportunity for investors looking to capitalise on the changes to permitted development law. Indeed, developers have been pouring money into converting offices that may have been gathering dust for years.
While reducing the number of offices may cut the footfall to local shops during lunch hours and in the pubs after work, an increase in residential housing provides a boost to the economy through increased footfall to other amenities. Assuming that the building is already vacant, secondary benefits include alleviating the financial burden on the building’s owners of maintaining a derelict space, as well as wider community issues such as reducing squatting, vandalism and anti-social behaviour.
There are pitfalls of course: building owners have realised the potential of these buildings and are now charging up to five times more per square foot than before the law changed4; many developers have tried to cut corners by using sub-standard builders for the conversion work, and title or environmental restrictions can force local planning authorities to limit the number of conversions. If the development is in a conservation area, for example, the council may issue an Article 4 Directive that prohibits the conversion.
The government initially proposed relaxing the law for a couple of years so it could meet its housing targets, but the change was made permanent in 20165. This created another problem because new legislation enabled owners to convert offices that weren’t in fact vacant and were still being used by local businesses4. The owners soon realised they could make more from converting the building to residential use and then selling the flats than they could from rental agreements with their business tenants. Many owners initially decided against converting their properties but then raised the rent to force the businesses out. Business leaders remain concerned that this could affect an area’s economy in the long-term.
However, when the conversion is approached professionally and there is a solid financial plan in place, the returns on investment, extra affordable housing and urban regeneration outweigh these drawbacks.
The Permitted Development Rights process
The conversion process begins with a developer identifying a building and having their planning consultant or architect submit a Prior Approval application. This must contain a full set of technical drawings for the conversion, as well as supporting documents that assess the impact on local transport and the highways, plus contamination risks, flood assessments and likely noise pollution during the development phase.
The council will then have eight weeks to check the property complies with its Prior Approval guidelines, after which no planning policies will be applied and approval will be granted. Development work can then begin at the site.
If councils can prove that they’re promoting sustainable developments, most local authorities have the flexibility to move into Green Belts to meet housing requirements. While this won’t please everyone, the government still needs to address the shortfall in housing and has been applying pressure on local authorities that unnecessarily oppose environmentally aware developments on protected land. When a developer gets the green light from the council, most will then need to raise funds to complete the project.
In the wake of the financial crisis a decade ago, traditional lenders like high street banks were forced to conform to new regulations that limited lending to higher-risk individuals and corporations6, 7, 8. Despite record-low interest rates in the interim, property speculators and developers have found it harder to borrow as banks reduced their transactional volume.
Reditum Capital’s JV finance model
In the last two years, Reditum Capital has emerged as a serious player in financing office-to-residential conversions. Despite the uncertainty after the Brexit referendum, vacant commercial property, particularly in the capital, remains a popular avenue for investment and a range of financing options is now available.
As the banks have tightened up their lending, there has been a rise in the demand for more flexible financing routes, particularly on time-sensitive projects. To mitigate risk, Reditum Capital assesses every project on a case-by-case basis before deciding whether to release finances. This includes rigorous analysis of the project’s location, the current market and the developer’s track record, all of which help build a complete picture of the transaction. Using a bespoke mix of debt, mezzanine and equity financing, we structure opportunities in a way that maximises the retuns on borrow capital employed. This approach also allows us to offer investors in those opportunities a blend of high coupon returns and ‘upside’ participation.
Reditum Capital is one of the main investors in a project to convert Sky’s former headquarters at New Horizons Court in Brentford. This self-contained campus covers 140,000 square feet in four blocks, plus a further nine courtyard buildings of 31,000 square feet and a total of 596 parking spaces. Original planning consent prohibits the conversion of the courtyard buildings but the four office blocks will be turned into 268 luxury residential apartments only nine miles from central London, 15 minutes from Heathrow and half an hour from Waterloo Station. The projected total gross development value (GDV) is £126 million, the loan-to-value (LTV) 62%, and the estimated total cost £82 million. The projected profit is approximately £42 million – with a target timescale of just 24 months – and very attractive investor returns of around 12% per annum.
In Milton Keynes, a number of relatively new commercial properties have recently become available. With its excellent transport links and proximity to London, the town is attracting plenty of permitted development activity. Reditum Capital has been approached to acquire and convert a high-quality office building – 152 Silbury Boulevard – into 29 apartments. There is also scope to build another 14 apartments in an additional two-storey development. The apartments will be made available under the government’s help-to-buy scheme so they will be ideal for people taking their first steps on the property ladder. The timescale for development is 21 months, with an exit strategy based on pre-construction sales to investors and then open-market sales within the UK. Based on a total GDV of £9.2 million and LTV of 68%, the projected profit after disposal costs will be £1.8 million. Investor returns of 1% per month are expected.
This model has been used as a template for many of our office-to-residential conversions because everyone from the developer to the financier and from the building sub-contractors to the new tenants benefits from the investment. Indeed, Reditum Capital’s track record speaks for itself: since 2013, we have arranged over £430 million in funding for real-estate acquisition and asset-backed transactions in the UK and across the world.
As the employment landscape evolves, there is likely to be more vacant office space in our city centres. The changes to permitted development law may have been designed to help the government meet its housing targets but the move has lured developers and investors to the office-conversion market in search of impressive short-term returns. With traditional lenders still unable to provide developers with the finances to deliver these conversion projects, there has been an increase in demand for alternative financing solutions from financiers like Reditum Capital.
Judging by our success at maximising risk-adjusted returns on borrower capital over the last five years, we are in a strong position to drive the tailored-financing marketplace.
- The Town & Country Planning Amendment: http://www.legislation.gov.uk/uksi/2013/1101/pdfs/uksi_20131101_en.pdf
- Commercial v Residential Property Investment:
Aldermore Bank Plc, 2014
- Skinner, M. (2009) Residential versus Commercial Property:
- Office conversions push businesses out of Tunbridge Wells:
- The Town & Country Planning Amendment:
- Banking Reform: What has changed since the crisis?
- P. Morgan Chase & Co.:
- Financial Services Act: