European Offices: the Path to Repurposing

The European office market is undergoing an unprecedented transformation. Rental demand has become decoupled from economic growth, with hybrid work models permanently reducing space requirements. Companies are growing and hiring, yet simultaneously shrinking their tertiary footprints, consolidating their occupancy into the prime segment of the available stock.

This situation has led to two persistent imbalances: a structural oversupply of vacant secondary offices existing alongside a dramatic shortage of housing and diverse amenities in the same geographies. So, why isn't the repurposing of offices into housing, hotels, or warehouses proving to be straightforward?

Roméo Yombo-Nguitongo and Thierry Cherel at Natixis CIB Research are clear: the market's bottleneck isn't that technical or regulatory. It lies in a more fundamental obstacle: the recognition of losses. In a comprehensive report, they analyze the various options available to owners of depreciated assets and explore the diverse economic models driving repurposing initiatives.

In the persistently depressed office market, not all assets are faring equally. Prime assets, on one hand, are recent or thoroughly renovated properties compliant with European taxonomy requirements, well-connected, and situated in established business districts. They experience residual vacancies below 5% (sometimes even 3%) and have seen record rent growth of 4-7% annually between 2022 and 2024.

In stark contrast, secondary stock comprises buildings constructed between the 1970s and 2000s, located on the periphery, energy-inefficient, and featuring challenging floor plates. These appear to have entered a phase of structural vacancy that no rental cycle recovery will resolve. Environmental regulations are accelerating the obsolescence of these "stranded assets," which suffer from prolonged vacancy and prohibitive upgrading costs that rental income cannot amortize.

The vacancy rate outside of prime locations reaches 8.6% across Europe - an average that masks highly degraded situations, some exceeding 25%. However, as we identified in our previous report, there are exceptions; one must not "throw the baby out with the bathwater" and discard performing office districts along with the obsolete stock.

This situation is not entirely new, but this time, it is not a cycle. The market has permanently bifurcated. The un-provisioned exposure of European financial players to secondary offices remains to be fully quantified. Currently, €52 billion in loans are classified as Non-Performing Loans (NPLs), representing 3.7% of the €1400 billion exposure European banks have to commercial real estate.

Owners facing difficulties are presented with three primary options: accept a discounted sale, renovate, or convert. Yet, the market is hindered not by technical or regulatory hurdles, but by a fundamental reluctance to acknowledge losses.

The decision to hold onto an un-let asset incurs significant costs, such as property taxes, insurance, maintenance, and debt servicing. Continuing with an "extend and pretend" strategy merely masks a widening gap between market value and outstanding debt, a gap that will inevitably surface at maturity - especially given that the market has definitively turned.

Classic residential conversion appears to be the most value-creating destination in areas with high housing demand. However, rent control policies can sometimes dampen the economic attractiveness of this route. Managed Residential (including student housing, coliving, and senior residences) often presents a more robust economic profile due to optimized space utilization (allowing for second-daylight access in common areas) and rental agreements with operators.

Hospitality, particularly aparthotels, in city centers or areas with low competition, are also a pertinent option. Data Centers represent the highest value-add destinations but are also technically the most demanding. Activity units, urban logistics, and flex-industrial facilities constitute an underestimated but economically very attractive destination.

As a last resort, public amenities like training centers, military housing, schools, libraries, and sports facilities serve the most degraded assets. While their exit value may be below market rates, the risk of non-sale is virtually zero.

In this respect, current geopolitical tensions are exerting concrete effects on the conversion market. The massive need for defense infrastructure and the lengthy construction timelines for new builds are incompatible with operational schedules. For an investor seeking to secure an exit, a buyer from the defense sector presents a counterparty with low execution risk. Similarly, the relocation of supply chains presents an opportunity to transform ground-floor office spaces into commercial premises, urban distribution centers, and production workshops.

Office building conversions face specific constraints, foremost among them technical feasibility. The deep floor plates common in 1980s-1990s buildings often preclude compliance with natural light regulations without costly internal courtyards. Clear ceiling heights must exceed 2.70 meters post-HVAC reorganization, while asbestos removal is a costly risk to consider. When multiple constraints align, demolition and reconstruction may emerge as the most profitable path.

Furthermore, the heterogeneous nature of European land-use change regulations creates arbitrage opportunities. The UK's 56-day prior approval mechanism enables investors to start work in less than six months, a stark contrast to the 18-36 months required in Berlin or Paris.

Ultimately, a conversion is financially viable only if the transformed asset's value surpasses acquisition and conversion costs. The report delves into the various economic models and types of acquirers to navigate these complexities.