Over the past three years, the real estate industry has seen quite a bit of innovation and continues to adapt to the changes in the labour market caused by the Covid-19 pandemic and the rise in energy costs. A major focus of this article is the office market and the issues that are and will be relevant to office developers, building owners, and tenants.
Real estate industry is one of those economic indicators that provide timely and accurate information about the mood of the economy and confidence in future developments. A number of factors confirm this, including the volume of investment in new real estate projects, trends in supply and demand, and price dynamics in the market.
Offices do not disappear, they transform
Up until recently, working from home was considered exclusive and difficult to achieve, but is now something that is both self-evident and commonplace. Even though business managers strive to gather their employees in the office, employees prefer to work remotely. Covid time has demonstrated that those who work well in the office continue to work well at home (and vice versa). Offices are important for another reason - they bring employees together in one corporate culture and value system. Therefore, offices will still be in demand, while experiencing transformations. According to Colliers data, Riga has new offices, at different stages of development, that cover more than 140 thousand square meters, which surpasses the area of the construction offices in Vilnius (125 thousand sq.m.) and Tallinn (134 thousand sq.m.). True, it should be taken into account that the number and area of offices previously built in Lithuania and Estonia greatly exceed those in Latvia. There is also evidence of persistent demand for office space in all Baltic States - in Riga, the rent for a class A office has risen from about 15 to 18 EUR per sq.m.
In terms of office transformations, two trends should be highlighted. To begin with, remote work experience has created a hybrid work model, which involves a combination of remote working and working at the office. This means that a modern office should provide both facilities for face-to-face work, as well as technological opportunities for continuous communication with people working remotely. Keeping a unified team spirit within organizations is a great challenge for HR specialists (it is for this reason that many companies subordinate the design of their offices to the values and culture of their organization). Second, this hybrid-work model raises the logical question of how large an office will be required in the future? Tenants will probably expect more flexibility in the new lease contracts, both in terms of lease terms and the ability to change the leased spaces.
The most important aspect is the energy dimension
At the end of the year, tenants received utility bills, and for most, it was rather a negative surprise. A building owner should be prepared for tenants to ask more frequently about how costs are calculated as well as whether every effort has been made to reduce the building’s energy consumption. In this regard, the trend that started last year will continue in 2023: energy consumption and efficiency will play a greater role in the development and purchase of real estate, since the factor of energy consumption is expected to play a significant role in determining a company’s competitiveness (especially in the manufacturing sector) in the future).
The topic of energy costs will be relevant to the annual indexation of rents, as many lease contracts are tied to inflation. Regardless of whether the lease contract specifies a maximum rate of lease indexation, it would be naive for building owners to expect rents to increase at the same rate as Latvian inflation of 20.8% (CSB data, December 2022 vs. December 2021). Rent indexation, coupled with high utility bills, may lead tenants to consider alternatives to moving to another location (especially relevant for those who cannot transfer the rising costs in full to final purchasers).
On the part of lessors, this means increasingly fierce competition for attracting tenants. Unleased areas are expensive for the owners of the building, so we can see promotional offers every now and then (first month for free, some next few months with a significant discount, etc.). It is also necessary to take into account the expected entry of new offices to the market this year. The market is expected to see segmentation between new, energy-efficient offices and those built earlier — at a time when energy consumption was not paid attention to.
High energy prices have also raised the issue of “measuring” the energy efficiency of buildings. Upon reviewing marketing materials, it appears that virtually every office in Riga is the most modern, the most energy-efficient, or the most environmentally friendly. But what does that really mean? A simple benchmark is BREEAM or LEED certification, which means that an independent auditor has delved into a particular object and has provided his or her assessment. Tenants have a poor understanding of how the particular assessment was formulated, which criteria are considered, and what the difference between BREEAM “pass” and BREEAM “outstanding” is.
In the coming years, the financial sector will play an increasingly tangible role in sustainability and energy efficiency. Banks that have joined the Net Zero Banking Alliance have already announced their sustainability objectives, including for the real estate segment. There will also be increasing pressure from supervisory authorities, so banks are already asking more and more questions related to energy efficiency when financing commercial properties, and they are demanding more energy certifications. For owners of energy-efficient buildings, this could mean better financing conditions, but for so-called “old” projects without specific sustainability ambitions, the trend is likely to be reversed.
Attracting service centres — what will we be better at?
It is pleasing to note that new office complexes are being built in Riga as well and that Riga is beginning to reduce the year-ago backlog from Vilnius and Tallinn in this segment. The expected additional 140 thousand sq.m. is a significant amount for our market, so changes are expected in the office lease market. A major challenge is the attraction of new tenants, which presents an opportunity for Riga City management, the Latvian Government, and the LIDA to show their power.
It is not news that Latvia and other Eastern European countries see global business service centres as one of the drivers of the development of their cities and economies. The arrival of each such centre means thousands of jobs, and demand for office space, apartments, and daily services. For several years we have been watching foreign companies transferring various types of services to the Baltic States. It’s quite simple math here: renting a class A office in Stockholm is 3 to 4 times more expensive than in Riga, and remuneration in this sector in Riga is at least twice lower.
It would appear that Riga and Latvia in general have every chance of becoming a leader in attracting business centers in Europe. A potential success story in Latvia is greatly complicated by the fact that it competes not only with Lithuania and Estonia, but also with Poland, Hungary, Romania, and Croatia, where office leases and salaries are comparable to those in Latvia. For example, comparing the costs of employees in the IT sector in Latvia (around 20 EUR per hour, source: Colliers) with an average cost indicator in the Eurozone (above 40 EUR per hour), it can be seen that by offering educated human capital, Latvia has a good chance of competing. But when we compare ourselves with other Eastern European countries, these advantages are lost. This means finding other factors with which we can excel.
In Latvia, the number of business service centres has not changed in recent years (50 centres), but the number of people employed there has increased from 15 thousand people in 2020 to 17 thousand in 2021, according to data from the International Business Services Association.
Foreign companies base their decision on specific calculations, and both the tax system and labour availability play an important role in determining their decision. If Latvia can compete successfully with the first, there are problems in terms of labour availability. Therefore, our “formula” of competitiveness is an education system in which we train a competitive workforce, attracting educated employees from other countries, as well as active communication from Latvia about our offer to global business service centres.
Interest rates can influence investment decisions
There will not be many announcements about the start of construction this year as lending rates have also gone up. A developer expecting a return similar to that of a few years ago would have to get much higher rents at current construction costs. In the absence of such opportunities in the market, developers will have to lower their return expectations. However, with interest rates on the rise, they have several alternatives available to them. Why should a real estate investor accept a 6% return, laboriously raise capital, and constantly negotiate with the developer and tenants or buyers when he can, for example, buy a Latvian bond with a 10-year maturity and a 4.6% yield and live relatively comfortably? Investor activity in the real estate segment will continue, but investors will pay more attention to risk diversification.
Although the factors described above will affect market activity, there is no sign that investment or the progress of new projects will come to a standstill. It is important to remember that real estate projects usually take several years to develop, so the market is already assessing the potential development and conditions of the post-war economy.
