Strong take-up, falling vacancy rates, and 20% rises in average prime rents are all strong indicators that the central London office market is now firmly past the point of recovery and well into its growth phase. Somewhat inevitably this has led to a rise in questions about whether the market is overheating, and whether the investment market might be too far ahead of the leasing market.

The first question has to be whether the demand for office space in London can be sustained, particularly in the face of tenant austerity and rising occupational densities. The simple response to this question is an economic one – London is growing and will continue to grow. London’s population is forecast to grow from 8.4m in 2013, to 9.2m in 2023 – this is the equivalent of moving the whole population of Birmingham and Hartlepool over the next decade.

Will there be jobs for all these new residents? In the early phase of the economic recovery the relatively low wage growth will support headcount growth, but once more robust growth of 2.5% pa and above is locked in, it will be the expansion of higher value industries such as those in the TMT and Financial Services sectors that will support a sustained period of above trend growth in office-based employment in London. So, with Oxford Economics forecasting nearly 82,000 more office-based jobs in the City and Westminster over the next five years, we can probably be assured normal levels of take-up growth, particularly since we believe that occupational densities will stop falling as staff morale become of increasing importance to many employers.

The next key question has to be over the supply-side. Is the development market booming or about to enter a boom? Certainly the level of development and refurbishment completions in the City of London this year is well above average at 4.7m sq ft, though the pipeline in the West End is still firmly below average. Just under one third of 2014’s completions in the City have already been pre-let, and only 40% of the remainder are actual new developments. Against a background of even average levels of take-up, this is likely to be absorbed in 2014 and 2015. Furthermore, the development pipeline in 2015 and 2016 remains significantly below average.

The supply-side risk rises in the medium term, and the timing of this will depend heavily on how quickly lender’s aversion to speculative office development diminishes. Previous downturns have always been preceded by a three to four year period of above average lending to commercial property, and this cycle will probably be no different. However, while the London lending market is becoming increasingly competitive, the volume of debt targeted at 100% speculative development projects remains limited at the moment.

What will trigger a rise in lending activity? Probably a sustained period of above average rental growth. The longer that goes on, the easier it becomes to believe that this cycle is more stable than the last, and the lower risk development seems. Certainly all of the last three downturns have preceded by a period of three to four years of above average prime rental growth. Our current rental growth forecasts for both the City and West End only have one year of above average rental growth in the next five years, and this comes at the back of the forecast period.

The final question hanging over the central London office market is whether the investment market is too far ahead of the leasing market. Prime yields are firmly below average, and 2013 saw a record high level of transactional activity. Will the current wave of non-domestic investment targeted at central London drift away as the global economy recovers? Our view is that some of it might start looking for more opportunistic purchases elsewhere, but that generally London’s attractiveness to non-domestic investors has been on a steady upward path for the last 30 years. Back in the 1990’s the norm was for around 35% of total investment to be from non-doms, this has since risen to 45% in the early 2000’s, 60% in 2005-2010, and nearly 70% in the last four years.

Pricing is undoubtedly keen, and this has as much to do with the strength of demand as the fairly steady supply. Indeed, while the investment volumes reached record levels in 2013, the actual number of transactions has been on a gently declining trend since the mid 1990’s. Thus, with a relatively illiquid market, the current yield levels are probably supportable, so long as the outlook for rental growth remains positive.

In conclusion, we believe that the central London office market has definitely moved from recovery into growth. The supply and demand balance looks promising for some years to come, and this should support average, though relatively unexciting, levels of rental growth.

Taken from
Review and Outlook: Central London Offices - February 2014