Despite what you might have read elsewhere, the picture in London’s West End office market remains fairly confused. While there are signs that recovery from the latest cyclical downturn in the leasing market is under way, it is not a strong or wholesale recovery. Away from the leasing market, demand from investors for West End offices remains exceedingly high. We question whether the yields being paid by some investors are taking into account realistic views on the potential for rental growth over the next five years.
On the leasing side the story is positive, though perhaps not unreservedly so. The relationship between supply and demand started to move in landlords’ favour during 2004, with the total amount of space leased returning to its historic average of 3.6mft2. More importantly, the vacancy rate has fallen steadily, from a peak of 8.3% in January 2004, to its current level of 6.2%.
Behind these figures there are some indicators that point to the ‘recovery’ being less than widespread. On the demand side the total for 2004 was heavily skewed upwards by one large deal – the Metropolitan Police’s acquisition of more than 400,000ft2 (37,000m2) at Empress State House in Fulham. Leaving that deal aside, the total space leased last year was around 40% below trend. This below-average level of demand has continued into 2005, with space leased in the first quarter being 28% below the historic quarterly average. This reflects the story our brokers are hearing ‘on the street’ that tenant activity is more restrained than it was around the middle of last year. This trend particularly applies to the larger requirements.
We expect demand to pick up after the General Election in May, and the second half of the year to be much stronger than the first. However, we are forecasting that the total space leased in the West End office market in 2005 will be lower than the 3.6mft2 achieved in 2004.
On the supply-side the future looks more optimistic, driven by recovering take-up, further withdrawals of tenant-controlled space, and a restrained development pipeline. The latter of these factors shows the most significant change on previous cycles. The volume of speculative office development in the West End of London has been relatively low throughout the 1990s and the 2000s. This has been the result of a combination of developer restraint and lender caution.
We believe that trend will continue over the next five years, and this will ensure that the next growth period in the West End office market will not see the unrestrained levels of speculative development that precipitated the crash in the early 1990s. For example, we are currently monitoring 1.51mft2 of West End office developments that are due for completion between 2005 and the end of 2007. Only 42% of the space is being built speculatively. This is extremely low in comparison with the average annual level of completions in the West End of 1.7mft2.
As a result of the combination of these factors we forecast that the West End vacancy rate will fall to near 1999 levels by the end of 2009.
So what does all this mean for office rents in the West End? Recent headlines about a 20% increase in prime office rents in the West End in 2004 have been very misleading. Certainly the top rent achieved in the West End office market has grown from around £65/ft2 at the end of 2003 to £80/ft2 at the end of 2004. However, lettings in a couple of prime Mayfair office buildings are not representative of the state of the market. As the chart below shows the best that can be said of the recent trend in average Grade A and Grade B rents is that they have stopped falling.
Looking ahead we do not expect to see any rental growth from the £80/ft2 achieved this year. Indeed it is possible that the best rent achieved this year might be lower than last year. As the supply/demand balance continues to move in favour of the landlord we expect to see rent-free periods shortening and the strongest rental growth taking place in those markets and categories of property that were most heavily discounted in the recent downturn. These recovery plays will include sub-markets such as Soho, where top rents are £20/ft2 lower than they were in 2000. Average Grade A product in the core market is currently being marketed at a 40% differential to prime.
It may come as a surprise to some that over a period when UK commercial property rents fell by around 30%, investment yields also fell by, on average, 200 basis points. This is what has been happening over the past three years, and the West End office market has been at the sharp end of this trend. Investor demand has been at hitherto unequalled levels, and the total invested in the West End office market in 2004 was a record £3.6bn. Even with this volume invested last year the breadth of investors – from domestic to international and private to public – meant that demand exceeded supply and initial yields of less than 4% were being achieved on West End office investments.
The quandary facing investors in West End offices now is finding the value. With no sign of abatement in demand for the best quality product, investors are being forced to look at the secondary market where the prospects for rental growth are harder to read.
We believe demand for West End office investments will continue to exceed supply for the remainder of 2005, and this may drive some further hardening in yields – particularly on secondary product. However, some segments of the market are now well into the territory where buyers should be examining the difference between price and value. If the speed of the forecast rental recovery surprises on the downside, then some deals of the past 12 months might start to look overpriced.
Ultimately we believe prospects for the West End office market over the next five are positive, but fairly unexciting. Tenant demand will recover, though a boom is unlikely. Vacancy rates will fall, driving upward rental growth on scarce product. Investors who have bought less well-secured properties at keen yields will be bailed out by this combination of factors. Those who have stuck to long-term secure income streams will continue to do well.
For the chartists, now is certainly the time to consider speculative development (so long as you don’t all do it at once!), and for those who have product to sell – now is very much the time to sell.
Mat Oakley is a director in Savills’ European commercial research team