Interesting idea. I think the key risk to consider is that Dublin has one of the largest office supply pipelines in Europe. The question is whether vacancy goes to 10% - 12% and rents fall 5% - 10% like management thinks or whether vacancy goes to 15% - 20% like the GFC and rents fall 30% - 40%... That being said, thinking about it in your framework of forced purchasers and someone buying this due to its relative value to other European office REITs - I can see that. Kennedy Wilson, Blackstone, German capital - I could see all of them making a bid for this. How did you get to your estimate of the tax leakage on delisting?
Thanks for reading and commenting. I'm not sure I'd agree that Dublin has one of the largest office supply pipelines in Europe, but I think one also has to look at the supply/demand balance. Total supply is ~7.5m sq. ft. of which ~5m sq. ft. is under construction, and in turn ~2.5m of this is pre-let, leaving 2.5m of space under construction as unlet or speculative development. Current active demand today in Dublin is ~2.9m sq. ft (CBRE, April-21) so ~1.2x available (unlet) supply under construction. Beyond whats under construction, is hard to see how anything else gets built on a speculative basis, so I think that keeps a lid on oversupply. Furthemore, long-term average annual demand for the Dublin market is ~2.2m - 2.3m sq. ft. so as things stand there is no supply of new space beyond the next 2 years or so. Furthermore, prime rents are holding at ~€55 - €57 per sq. ft. which is a ~12% drop post-COVID so I think this holds from here. Finally, on vacancy secondary stock deemed not fit for purpose post-COVID world is where the vacancy is rising along with some elements of sub-letting, but prime office space designed for the post-COVID working environment (such as Hibernia's new developments) is in demand as evidenced by recent KPMG win. So vacancy really reflects certain types of office space as much as an overall reduction in demand. Quality space will remain in demand in my view.
On the tax leakage, I assumed a 20% tax on Tthe cumulative unrealised gain on portfolio of ~€442m over the historic book cost, on the basis that this would be treated as a deemed distribution to shareholders on de-listing.
Thanks for the clarification on the tax calculation and also appreciate your engagement with my attempts to break the thesis here - I think its very promising and I am trying to think through in depth how it could go wrong...
I think I broadly agree with your conclusion - that the best quality space will do fine and Hibernia either owns it or has it in their development pipeline (and the KPMG agreement really solidifies that pipeline), but working in this industry, I am very cautious about (A) extrapolating the past / using averages to predict the future and (B) the rose-tinted glasses of the brokerage industry, who provide the data!
My quibbles would be:
-5m sq ft development pipeline under construction is ~11% of Dublin CBD office stock (~45m sq ft) - yes about half pre-let but not all of that is businesses expanding - the space they vacate needs to be considered... Only cities in Europe with a larger pipeline now is Berlin with about 15% of stock under construction although London is also up there
-Demand in the form of take up figures don't reflect net absorption - a lot of that leasing is tenants leaving a building to enter a new one
-Since office markets are cyclical, using average demand over long time periods is not necessary that useful looking at periods after downturns. For example, while average has been ~2.2m, take up was ~1.5m for the 2010-12 period. Rents didn't start to really grow again until 2014 once the backlog of vacant space really got worked through and vacancy fell below 10% or so...
-Brokers and landlords do a lot of work to keep "prime rents" up through incentives, confidentially and whatever means necessary as market ERV determines what happens at review... As a result, they are almost always inflated figures and often lag the reality of what can be negotiated on an arms length basis in the market.
These quibbles are relevant in my mind as Irish lease reviews are not upward only like they are in the UK and other jurisdictions. Rents can be revised down to the ERV thus even though HBRN has a solid in-place lease term, a lower than expected trough in rents over the next 2-3 years could have a material impact on their rental income... If the trough is where rents sit today, it looks like HBRN will do fine and even well - if there is another 10% downside to rents (to the low 50s compared to low 30s and high 20s post GFC), this could start to have a significant impact on cash flows and the 30% discount to NAV might not be such a steal.
Quibbles aside, the biggest longer-term risk I see to CBD office markets (not just Dublin) is the impact of hybrid / flex working on demand over a longer period of time. Companies will continue to use office space but will it be the same as previously or 10%, 15%, or 20% less? Demand for office space per employee could be structurally lower in the future than it has been in the past - continuation of a trend we've seen over the last 3 decades and accelerated by mass adoption of the remote work tech that has been available for a while.
Thanks for the thought provoking ideas, analysis and thoughts. Will definitely be following your work and writing going forward!
Thanks for the comments, always good to hear the counterarguments to test the thesis. Your points are all fair and valid, but I'd mention a few points in response:
1. Supply & vacancy now vs. post-GFC 2009 market - on the cyclical point, I think one has to remember there was a massive oversupply of built and pipeline office space (of mixed quality) from 2009 - 2013, which we just don't have today. The vacancy rate so far is largely being driven by lower quality space (that no one will want post-COVID) and secondary locations, so the read across impact on rents for prime space is limited IMO.
2. Regarding demand, the low take-up in 2010-12 reflected the fall-out of a global recession, which was much steeper than the COVID recession (to date at least). As a result, corporates are now focused on re-opening etc again. In addition, demand now is still supported by growth companies that despite what they say in terms of WFH soundbites, are still looking for high quality space, and want staff back in the offices 60%-70% of the week, and as things normalise it may be just the use of that space that is different, but not the amount required, e.g. more collaborative space, break-out areas, amenity space etc.. Corporate surveys already indicate that generally occupiers are not going to downsize footprint significantly.
3. Thirdly, if rents do soften further, I think some of that impact will be offset by strongly supportive yields - the market here is more mature now vs. 2009, with a larger, educated pool of buyers comprising long-term foreign capital (as opposed to leveraged domestic speculators), which is supportive of yields and valuations. From speaking with market participants, the usual suspects in terms of French, German and other long-income buyers are in the market looking for assets, and once they can walk buildings again when travel restrictions lift, I'd expect to see a pick up in investment activity.
None of this is to say your concerns are not valid, but just that I do see mitigants to these risks as they relate to Hibernia's end of the market. Obviously Grade B office space is secondary locations are not a place to be now.
Interesting idea. I think the key risk to consider is that Dublin has one of the largest office supply pipelines in Europe. The question is whether vacancy goes to 10% - 12% and rents fall 5% - 10% like management thinks or whether vacancy goes to 15% - 20% like the GFC and rents fall 30% - 40%... That being said, thinking about it in your framework of forced purchasers and someone buying this due to its relative value to other European office REITs - I can see that. Kennedy Wilson, Blackstone, German capital - I could see all of them making a bid for this. How did you get to your estimate of the tax leakage on delisting?
Thanks for reading and commenting. I'm not sure I'd agree that Dublin has one of the largest office supply pipelines in Europe, but I think one also has to look at the supply/demand balance. Total supply is ~7.5m sq. ft. of which ~5m sq. ft. is under construction, and in turn ~2.5m of this is pre-let, leaving 2.5m of space under construction as unlet or speculative development. Current active demand today in Dublin is ~2.9m sq. ft (CBRE, April-21) so ~1.2x available (unlet) supply under construction. Beyond whats under construction, is hard to see how anything else gets built on a speculative basis, so I think that keeps a lid on oversupply. Furthemore, long-term average annual demand for the Dublin market is ~2.2m - 2.3m sq. ft. so as things stand there is no supply of new space beyond the next 2 years or so. Furthermore, prime rents are holding at ~€55 - €57 per sq. ft. which is a ~12% drop post-COVID so I think this holds from here. Finally, on vacancy secondary stock deemed not fit for purpose post-COVID world is where the vacancy is rising along with some elements of sub-letting, but prime office space designed for the post-COVID working environment (such as Hibernia's new developments) is in demand as evidenced by recent KPMG win. So vacancy really reflects certain types of office space as much as an overall reduction in demand. Quality space will remain in demand in my view.
On the tax leakage, I assumed a 20% tax on Tthe cumulative unrealised gain on portfolio of ~€442m over the historic book cost, on the basis that this would be treated as a deemed distribution to shareholders on de-listing.
Thanks for the clarification on the tax calculation and also appreciate your engagement with my attempts to break the thesis here - I think its very promising and I am trying to think through in depth how it could go wrong...
I think I broadly agree with your conclusion - that the best quality space will do fine and Hibernia either owns it or has it in their development pipeline (and the KPMG agreement really solidifies that pipeline), but working in this industry, I am very cautious about (A) extrapolating the past / using averages to predict the future and (B) the rose-tinted glasses of the brokerage industry, who provide the data!
My quibbles would be:
-5m sq ft development pipeline under construction is ~11% of Dublin CBD office stock (~45m sq ft) - yes about half pre-let but not all of that is businesses expanding - the space they vacate needs to be considered... Only cities in Europe with a larger pipeline now is Berlin with about 15% of stock under construction although London is also up there
-Demand in the form of take up figures don't reflect net absorption - a lot of that leasing is tenants leaving a building to enter a new one
-Since office markets are cyclical, using average demand over long time periods is not necessary that useful looking at periods after downturns. For example, while average has been ~2.2m, take up was ~1.5m for the 2010-12 period. Rents didn't start to really grow again until 2014 once the backlog of vacant space really got worked through and vacancy fell below 10% or so...
-Brokers and landlords do a lot of work to keep "prime rents" up through incentives, confidentially and whatever means necessary as market ERV determines what happens at review... As a result, they are almost always inflated figures and often lag the reality of what can be negotiated on an arms length basis in the market.
These quibbles are relevant in my mind as Irish lease reviews are not upward only like they are in the UK and other jurisdictions. Rents can be revised down to the ERV thus even though HBRN has a solid in-place lease term, a lower than expected trough in rents over the next 2-3 years could have a material impact on their rental income... If the trough is where rents sit today, it looks like HBRN will do fine and even well - if there is another 10% downside to rents (to the low 50s compared to low 30s and high 20s post GFC), this could start to have a significant impact on cash flows and the 30% discount to NAV might not be such a steal.
Quibbles aside, the biggest longer-term risk I see to CBD office markets (not just Dublin) is the impact of hybrid / flex working on demand over a longer period of time. Companies will continue to use office space but will it be the same as previously or 10%, 15%, or 20% less? Demand for office space per employee could be structurally lower in the future than it has been in the past - continuation of a trend we've seen over the last 3 decades and accelerated by mass adoption of the remote work tech that has been available for a while.
Thanks for the thought provoking ideas, analysis and thoughts. Will definitely be following your work and writing going forward!
Thanks for the comments, always good to hear the counterarguments to test the thesis. Your points are all fair and valid, but I'd mention a few points in response:
1. Supply & vacancy now vs. post-GFC 2009 market - on the cyclical point, I think one has to remember there was a massive oversupply of built and pipeline office space (of mixed quality) from 2009 - 2013, which we just don't have today. The vacancy rate so far is largely being driven by lower quality space (that no one will want post-COVID) and secondary locations, so the read across impact on rents for prime space is limited IMO.
2. Regarding demand, the low take-up in 2010-12 reflected the fall-out of a global recession, which was much steeper than the COVID recession (to date at least). As a result, corporates are now focused on re-opening etc again. In addition, demand now is still supported by growth companies that despite what they say in terms of WFH soundbites, are still looking for high quality space, and want staff back in the offices 60%-70% of the week, and as things normalise it may be just the use of that space that is different, but not the amount required, e.g. more collaborative space, break-out areas, amenity space etc.. Corporate surveys already indicate that generally occupiers are not going to downsize footprint significantly.
3. Thirdly, if rents do soften further, I think some of that impact will be offset by strongly supportive yields - the market here is more mature now vs. 2009, with a larger, educated pool of buyers comprising long-term foreign capital (as opposed to leveraged domestic speculators), which is supportive of yields and valuations. From speaking with market participants, the usual suspects in terms of French, German and other long-income buyers are in the market looking for assets, and once they can walk buildings again when travel restrictions lift, I'd expect to see a pick up in investment activity.
None of this is to say your concerns are not valid, but just that I do see mitigants to these risks as they relate to Hibernia's end of the market. Obviously Grade B office space is secondary locations are not a place to be now.