Higher-risk buildings: the subprime mortgage time-bomb of commercial real estate?

New safety regulations are reshaping London’s commercial property market, turning once-prized assets into potential liabilities.

In a previous article I shared some insight on HRBs (higher-risk buildings). We had just completed two of the first commercial fit outs in London under the new regulations, and we were pretty happy with ourselves!

Since then, we’ve had plenty more enquiries about fit outs within HRBs, which has pushed us to really dig into the time frames and challenges involved. This has led me to the conclusion that HRBs could, in a small way, become the sub-prime mortgages of the commercial asset management world (search up 2008 credit crunch AND sub-prime mortgages for a brief explainer on the role that sub-prime mortgages had in 2008).

 

The ticking clock

 

Where it was a mandated 8-week review process for the Building Safety Regulator (which turned into 12 weeks with our first applications), the delay can now easily extend up to 40 weeks! Very few tenants plan that kind of buffer into their property plans…

 

A costly surprise

 

We know this only too well! HOP recently looked at moving to a bigger office space. It was a fitted space but needed an upgrade and a bit of a reconfigure to suit our needs. At the last minute we discovered the building was on the HRB register (yep, we know we should have checked).

No one, not the agents or asset manager, mentioned this in the process despite knowing that we planned to do work to the floor. There is definitely an ignorance in the property world around the definition and time frames for an HRB and I think this should be tabled at the very start of the letting process. We could not afford that kind of delay so pulled out, although we had already spent money on legal fees etc.

 

Assets in jeopardy

 

This has led me to think that we have an asset class that is going to cause issues down the road. What was designed to protect against the appalling scenes we saw in 2017 in West London, has made a whole class of building potentially unlettable as office space.

The HRB that we first worked in was 100k sq. ft of office space with two flats on top, which is very common. If the commercial and residential units share an escape staircase or a basement then that is that – welcome to HRB Land.

If a tenant is aware that there is a potential 40-week delay in taking one office space, over another that is not an HRB, then they are very likely going to choose the latter property. Very few businesses are building 40-week approvals into their property plans. Floors in these buildings are going to sit empty for lengthy periods, which will lower asset values.

 

Landlords in limbo

 

So, what do landlords and asset managers now do?

They could potentially explore converting residential units into commercial space, which would remove the issue. Another option could be to plan to refurbish floors into a Cat A+ condition, a year before leases end, aiming to secure Gateway 2 approval in line with the lease expiry.

Delivering ready-to-let space for the next tenant can be a risky past time with the market a flood with average Cat A+ floors. Building one extra meeting room requires an application to building control, which triggers the HRB process, which will start that clock ticking again. As a result, these spaces must be let with the clear understanding that further changes aren’t possible quickly.

Some 7,500 buildings in London are designated as HRBs. Given how many enquiries we have received for fit outs to HRBs, alongside the drive in the 2010s to build mix-used developments to create more robust investments, I would not be surprised if the number of those that contain office space is in the thousands.

 

What happens next?

 

For landlords, higher-risk buildings mean more than just compliance headaches and delays for tenants. As tenants take easier options, rental voids increase and asset values could fall.

I am hopeful that the government will review this problem, but I think there are quite a few things higher up the to-do list for this to be resolved any time soon. In the meantime, those landlords and asset managers with HRBs in their portfolios will have to be creative to ensure they are not sat with a potential time-bomb in their portfolio.