Schroder Property
Central London Offices:
Stick or twist?
July 2014
Patrick Bone, Head of UK Property ResearchIntroduction
2013 was another bumper year for the central London office
market. Capital continued to flood into the West End and the
City, driving down yields and the pick-up in economic sentiment
fed through into improved demand, lifting rental values.
But have we had too much of a good thing? Yields in core
markets are back to their peak levels, whilst prime rents are
approaching previous highs. And with central London
notoriously the most cyclical UK property market, is now the
time for investors to start taking their chips off the table?
How far into the rental cycle are we?
One of the first questions to try to answer is how far has the rental recovery got to run? Prime rental values in core St James and Mayfair are almost back to peak levels, whilst in some markets such as Soho new rental peaks have been achieved.
Although some markets, particularly in the core, are starting to look a bit ‘frothy’ it is important to remember that by and large these are exceptional deals in a rarefied part of the market. Yes some occupiers in Mayfair and St James have recently taken space at £110 per sq ft, but the average rental level in the IPD West End sample is £40 per sq ft, whilst in the City it is still £34 per sq ft.
Indeed if we look at ‘average’ IPD rental values in real terms, then we see that the recovery is at a far more embryonic stage (see figure 1). In real terms, West End rental values have only grown by 7% since the bottom of the market in March 2010 and remain 23% below their previous peak. In the City, we have barely seen a recovery in real rental values at all, with average rents still 25% below their 2007 peak. This would suggest that if the supply/demand characteristics are favourable, then we should be set for a sustained period of rental growth.
2 50 60 70 80 90 100 110 Q 4 2 00 0 Q 2 2 00 1 Q 4 2 00 1 Q 2 2 0 0 2 Q 4 2 00 2 Q 2 2 00 3 Q 4 2 00 3 Q 2 2 00 4 Q 4 2 00 4 Q 2 2 00 5 Q 4 2 00 5 Q 2 2 00 6 Q 4 2 00 6 Q 2 2 00 7 Q 4 2 00 7 Q 2 2 00 8 Q 4 2 00 8 Q 2 2 00 9 Q 4 2 00 9 Q 2 2 0 1 0 Q 4 2 01 0 Q 2 2 01 1 Q 4 2 01 1 Q 2 2 01 2 Q 4 2 01 2 Q 2 2 01 3 Q 4 2 01 3
West End real rental growth City real rental growth
+11% -22%
-
23% Figure 1: The rental recovery in London still has a long way to goSource: IPD, Schroders, March 2014.
Encouragingly there is also significant capacity for income growth, particularly in West End portfolios. The chart below shows the reversionary potential of all the IPD PAS (Portfolio Analysis Service) segments. As the chart indicates, the level of income currently received by investors in the West End and City office markets is currently some way below the open market rental value. This suggests that there is significant reversionary potential for existing investors at future lease events. Figure 2: Reversionary potential (excluding voids)
Source: IPD, Schroders, March 2014.
7.6 19.5 -10 -5 0 5 10 15 20 25 Re s t of UK S ho p s Re s t of UK O ffi c e s R e s t of U K In dus tr ia l Re tai l W areh ou s es S o u th E a s te rn In d u s tri a l Re s t of S ou th E as t O ffi c e s S ho p pi n g Ce ntres S outh E as t Sh ops Ci ty O ffi c es W es t E nd a nd Mi d To wn O ff ic es % Reversion Over-rented Index, March 2001 = 100
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What drives rental performance in the City and the West End?
Before we can determine whether London offices look fairly priced, we need to understand the future prospects for rents. And to understand the prospects for rents, we really have to return to the
fundamentals of demand and supply. Historically, the City has been very much a supply driven market. Rental cycles have been very closely correlated with the development cycle (correlation: 0.84). So in periods where a large volume of new stock has entered the market, rental levels have fallen and vice versa. One key to understanding the prospects for City rents is therefore to forecast how much new space is coming on to the market.
Figure 3: City rental falls coincide with periods of high levels of development
Source: PMA, IPD, Schroders, March 2014.
The relationship between new supply and West End rents, in contrast, is virtually non-existent (correlation: 0.03). This reflects the strict planning cycle of the West End, which has historically curtailed the scope for new development. The majority of new space delivered to the West End office stock over the past thirty years has come in the form of redevelopment of existing buildings, with the overall level of stock not changing much over time. As a result, we tend to think of the West End as a demand-led market. Indeed every fall in rents in the past 30 years has coincided with either a recession, or some sort of ‘demand shock’ such as the dot com crash.
Figure 4: The West End is a demand driven market
Source: IPD, Schroders, March 2014.
-40 -30 -20 -10 0 10 20 30 40 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 0 2,000 4,000 6,000 8,000 10,000 12,000 Nominal Rental growth (%) Completions (m sq ft)
Completions IPD Estimated Rental Value (ERV) growth Forecast Correlation = -0.84 -40 -30 -20 -10 0 10 20 30 40 50 -6 -4 -2 0 2 4 6 8 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 ERV growth (%) GDP growth(%)
GDP growth IPD Estimated Rental Value (ERV) growth
Forecast
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Is the London office market at risk of over-supply?
A casual glance at the London skyline reveals some pretty dramatic changes taking shape. Europe’s tallest building, the Shard, now dominates the Southbank, whilst the Walkie Talkie and the
Cheesegrater have been notable additions to the City of London office stock. However, whilst these developments may be cause for concern, it is important to recognise that away from these large tower developments very little else is being built.
Figure 5: Rising levels of new supply in 2014, but falls back thereafter…
Source: PMA, Schroders, March 2014.
Figure 5 illustrates the historic supply cycle of the central London office market. The orange line shows annual levels of completions relative to the historic average. As the chart demonstrates, there have been very low levels of new supply coming onto the market since 2009, a testament to the long-lasting legacy of the credit crunch. Indeed apart from a small increase in 2008, the level of development has been very low for the past decade.
In 2014 we are set to see the highest level of new supply since 2003, reflecting the completion of the Walkie Talkie and the Cheesegrater developments. However, we do not believe this will be an impediment to rental growth. This is because 40% of the space coming on to the market in 2014 and 65% of the new tower developments has already been pre-let (source: CBRE, June 2014).
Separately, the development pipeline is set to fall back sharply in 2015 and 2016, suggesting the central London office market is not at risk of over-supply.
This is not to say that we should be complacent. Given the volume of equity chasing assets in the capital, there is a risk of a development boom further out, particularly if a number of sovereign wealth funds decide that they would like a trophy building in London. This risk is not without
precedent, particularly given that foreign capital has financed most of the major tower developments in this development cycle. However, even if developers are now slowly starting to respond to the improvement in market conditions, typically long lead times between development starts and completions means it will be at least three years before any meaningful amounts of new space are introduced. This suggests that in the medium-term at least, landlords can look forward to a sustained period of rental growth.
The supply picture looks even more benign if we factor in space removed from the commercial property market for residential conversions. Change of use legislation is making it easier to convert commercial property buildings into alternative uses and in doing so, keeping a lid on new supply. This is becoming an increasingly attractive option for landlords in London where the disparity between capital values for prime residential and commercial space continues to widen.
0 50 100 150 200 250 300 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 Forecast
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So with a rather benign supply outlook, are we confident about future demand?
Forecasts for future demand are dependent upon the performance of the wider economy and there are a number of reasons to be optimistic that 2013 represented the beginning of a recovery in rents. At a national level, most of the recent indicators of economic performance are becoming increasingly positive. Business surveys point to continued growth, employment continues to surprise on the upside and falling inflation and rising house prices are boosting consumer confidence.
It is no secret that London has been at the forefront of the UK economic recovery, with demand returning to pre-crisis levels in 2013. London’s share of the UK’s economic output grew to 21.9% in 2013, the highest level on record, and there are a number of reasons to believe that the London economy will continue to power ahead.
London’s growth prospects reflect its position as one of a select handful of global ‘super’ cities. London ranks as the leading global financial centre in the world, according to the latest survey of the global financial centres index, based on its transparency, legal systems and access to workforce. It is not just finance where London leads the way. London has, by some distance, the largest volume of legal sector office space in Europe, with most of the major law firms choosing to have their
headquarters in London. London is also a major hub for international media companies, ranking only behind New York for international publishing and TV companies and leading the way in online advertising spend.
The ability to access talent is one of the key reasons behind London’s elevated international status. Creative talent from across the globe is increasingly clustering in large, vibrant cities. Urban
economists have coined the term ‘economies of agglomeration’ to describe the benefits firms and individuals obtain by locating near each other, such as networking, the sharing of ideas, training and economies of scales. This suggests that the biggest cities will continue to grow, taking a larger share of economic output and drawing more and more talent from across the globe. London appears to be a case in point, with 40% of the capital’s workforce born overseas.
This ‘agglomeration’ effect is important for a number of reasons. Firstly the creation of clusters, which is helping to redefine London’s occupier markets. Historically insurance companies have clustered around the Lloyd’s buildings, whilst the investment banks are large occupiers of space in Canary Wharf. More recently we are seeing new clusters emerge. Silicon Roundabout in Old Street is becoming a hub for IT start-up companies whilst a cluster of medical research and development companies have taken space around the Francis Crick Institute near Euston. Going forward,
Google’s huge new campus development is set to have a transformative effect on the occupier base around King’s Cross.
Secondly, we are seeing increased examples of large corporations moving their headquarters to London. Young workers now want to live and work in close proximity and businesses are responding to these needs by taking space in popular urban areas such as Soho, Farringdon and Shoreditch. Coca Cola moving their headquarters from Hammersmith to the West End and Vodafone relocating from Newbury to Paddington are good examples. Whereas in the past businesses relocated to ‘spill over’ markets in the M4 corridor when the City and West End became too expensive, more recently we are seeing occupiers taking space in fringe markets in London. We believe some of these traditionally more peripheral markets, where rents remain affordable and occupier demand is improving, offer the strongest return prospects going forward.
A final occupier trend has been the willingness with which businesses are prepared to relocate to new villages within London. Tech companies in particular appear more focused on building quality and attracting staff than being wedded to a prestigious postcode. Instead of taking smaller offices in core areas, they are taking larger offices off more affordable rents, in fringe locations. This allows them to fit all their staff under one roof so that they can instil a common culture and set of core values, share best practice and encourage creativity.
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Figure 6 shows take-up by submarket between Q1 and Q3 2013. As the chart shows, in a number of markets such as the King’s Cross, north of Oxford Street and north of Soho, take-up was completely dominated by tenants migrating from other villages.
Figure 6: Occupiers shifting between submarkets
Source: Cushman and Wakefield, October 2013.
This is having an impact on performance. Whereas in previous cycles prime markets such as Mayfair and St James led the rental cycle and fringe markets followed, in this cycle we have seen some of the strongest rental performance from traditionally more peripheral markets such as Farringdon, King’s Cross and the South Bank. This suggests that those markets that record the strongest rental growth going forward are not necessarily going to be the same ones that have recorded the strongest growth historically.
Whilst London looks well positioned to benefit from this ‘agglomeration’ effect, its infrastructure will be key to delivering future growth. Crossrail, opening in 2018, will help to open up new office markets and improve the viability of locations to the east, but London needs continued investment. Two of the most pressing needs are housing and airport capacity. London’s population growth has not been met with a corresponding increase in its residential stock, driving up the cost of housing and making home ownership an increasingly difficult proposition for younger workers. Providing adequate housing provision will therefore be key to maintaining and attracting talent from across the globe.
Undoubtedly London will face increasing competition in the years ahead, particularly from the Far East, but it looks set to maintain a place in the ‘premier league’ of World Cities and we expect the gap between London and the rest of the UK to grow as London becomes increasingly integrated in to the fortunes of the global economy.
Where next for yields?
With prime yields in some markets now back at 2007 lows, it is reasonable to question the
sustainability of current pricing. The traditional way of estimating whether a property market is fair value, is to look at the spread of property yields over gilts. In truth, historically the correlation between these metrics has been pretty poor and this is because there is another factor at play, rental growth expectations.
0 10 20 30 40 50 60 70 80 90 100 Pa d d in g to n Nort h o f O x fo rd S tre e t Noh o Ki n g 's Cro s s So u th b a n k Doc k la n d s Cle rk e n w e ll a n d Sh o re d it c h So h o a n d Co v e n t G a rd e n M id to w n Cit y c o re M a y fa ir a n d St J a m e s Ham m e rs m ith Vi c to ri a
From within existing village Moving from other villages New operations Take-up by submarket Q1 to Q3 2013
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Figure 7: Estimating fair value for central London
Initial yield – 10 year Gilts Yield Gap
Source: FT, IPD, Bloomberg, Schroders, March 2014.
The chart above shows our estimate for fair value incorporating both the spread over 10 year gilts and rental growth expectations (previous 12 months rental growth + following 12 months rental growth). This analysis attempts to rationalise the fact that in a period of strong rental growth expectations, an investor will tolerate a lower spread over gilts and vice versa.
Any data point close to the line suggests that London yields look fairly valued, a large deviation above the line suggests that yields look cheap and below the line expensive. As the chart shows, London office yields started to get very expensive in June 2007 despite the strong rental growth coming through, with yields around 2% below gilts. Conversely, the analysis suggests that London yields looked cheapest in June 2012, when the large fall in bond yields meant that the spread over gilts was above 3%. Encouragingly the analysis suggests that yields currently look fairly priced, with a spread of around 1% over gilts compensated by expectations of rental growth of 8-10% per annum over the next two years.
This analysis may be useful for domestic investors, although it is important to recognise that the majority of buyers of central London offices over the past couple of years will not be pricing their risk-free rate off gilts. With over half of the City now owned by foreign investors and domestic investors only accounting for around 35% of transactions in 2013, it is increasingly important to factor in currency, overseas government bonds and the pricing of competing global markets. Are central London offices still an attractive option for foreign investors?
The aggressive pricing of prime properties in core markets is not confined to London. The economic instability post the global financial crisis has led to a ‘flight to quality’ across Europe, with
international investors focusing on core assets in the most liquid and transparent markets (see figure 8). Whilst prime office yields in the capital may look stretched relative to regional office markets in the UK, yields in competing European cities are close to, or in some cases already back to pre-crisis levels. -2 -1 0 1 2 3 4 -15 -10 -5 0 5 10 15
Mar '01 - Mar -'02 Jun '02 - Dec '04 Mar '05 - Jun '07 Sep '07 - Jun '10 Sep '10 - Sep '13 ERV growth (%) June 2012 June 2007 December 2013 July 2009 Correlation: 0.4155
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Figure 8: Low prime yields are not confined to London
Source: CBRE, Schroders, April 2014.
The investment case for London offices looks even more compelling if we factor in rental growth forecasts. Figure 9 plots forecast rental growth against the current prime initial yield. As the chart shows, the City and the West End are forecast to record the strongest rental growth over the next four years across all the major European office markets. Although some investors may be attracted by recovery plays in markets like Dublin and Madrid, City and West End offices still look well placed to deliver returns above most European office markets.
Figure 9: Factoring in ERV expectations, London remains an attractive option
Source: CBRE, Schroders, March 2014
3.0 4.0 5.0 6.0 7.0 8.0 9.0 % prime yield 2014 Q1 -2 -1 0 1 2 3 4 5 6 3 4 5 6 7 8 9
Prime initial yield (%)
West End
% Average ERV growth end 2013 to 2017
Zurich City Munich Stockholm Oslo Paris Lisbon Budapest Barcelona Milan Rotterdam Amsterdam Copenhagen Frankfurt Helsinki Dublin Warsaw Brussels Rome Berlin Vienna Hamburg
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Conclusion
Our analysis suggests that the case for sticking with London is well founded. As one of a select few ‘super’ cities, London continues to attract talent from across the globe and is well positioned to benefit from future growth across a wide range of industries. The continued agglomeration of labour and commerce in the largest conurbations suggests that London’s share of economic output will continue to increase in the years ahead. This positive assessment of London’s economic outlook underpins our forecasts for the continued strong performance of the capital’s office markets. Far from being at the top of the rental cycle we believe there is sufficient capacity for growth, with a benign supply outlook and improving demand from an increasingly diverse occupier base. These growth prospects are likely to fuel continued investment into London’s commercial property markets, with London remaining an attractive destination to place capital for both domestic and international investors alike.
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Important Information:The views and opinions contained herein are those of Patrick Bone, Head of UK Property Research, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.
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