The City Office Market
3 Years Supply of City Offices... and Growing?
2008 has been a historic year in the City of London Office market; a year of extreme reactions to global problems. Recorded take up in 2008 was 4.2 million sq ft compared with 6.0 million sq ft in 2007, a fall of 30%, and 7.2 million sq ft in 2006. This is directly attributable to the reducing requirements for space by the financial industry as businesses continue to go bust, contract and consolidate existing space, and put expansion plans on hold.
Whilst take up has fallen steadily since the second half of 2007, the rate of decline has accelerated notably during the final quarter of 2008 with just 0.4 million sq ft leased compared with 1.2 million sq ft for the final quarter of 2007. By the end of 2008, CoStar Research was recording 13 million sq ft of space available or under construction, an increase in supply of 8% from the end of 2007 and a massive three-fold increase from the end of 2006, when 4.8 million sq ft was being marketed.
The average quarterly take up rate over 2008 implies there is at least 3 years supply of office space currently available in the City. Adding in the rate of delivery of newly vacated space and the forecast construction deliveries, will see this figure continue to rise throughout 2009.
Contrast in Deals
The largest single deal in Quarter 4 2008 was 33,809 sq ft taken by Fortis Bank at 63 St Mary Axe, contrasting with the largest deal in the first quarter of the year of 201,559 sq ft taken by Addleshaw Goddard Ltd at 1 Moor Gate. In the fourth Quarter of 2008, the average deal size was 3,555 sq ft, with 75% of deals being less than 5,000 sq ft. Our research also shows a dramatic increase in the willingness of landlords to offer more favourable lease terms. Concessions, such as higher frequency break clauses and longer rent free periods, are now commonplace to secure a letting.
City Skyline Still Dominated by Cranes
The CoStar 2008 1st half Central London Report carried the headline ‘... Twice the supply and half the demand'. This became further exacerbated during the second half of 2008. There is currently 8.7 million sq ft of completed space available in the City with an additional 4.3 million sq ft under construction; a level of new supply not seen since 2004. In 2009, 2.7 million sq ft of the space under construction is scheduled to complete, with the majority in the second half of the year. This includes Ropemaker Place where there are currently no prelets agreed for the 575,000 sq ft development. A further 2 million sq ft is currently scheduled to hit the market in 2010, of which 1 million sq ft is already under construction. It remains to be seen whether construction commences on the remainder in 2009.
Rental levels will continue to be subject to downward pressure as the market adjusts to increasing supply and contracting demand. Somewhat surprisingly, the average asking rent of all office space offered in the City in 2008, at £33.89 was only 3% lower than £35.08 for 2007. We would expect that figure to fall further through 2009.
This is not an attractive market into which to deliver new, high-quality office space, especially if funding is provided through debt agreements made a year or more ago. Furthermore, the Chancellor has fallen well short of providing any form of assistance through tax relief. So throw empty rates into the mix and the outlook for medium-term investor cashflow also looks bleak.
Pressure Mounts as Yields Rise and Rents Fall
The City Office market has been particularly impacted by the economic downturn and the continued uncertainty in global financial markets due to the occupier demographic. Long established business models, that have served the City well for decades, are now being questioned with many proving less than sustainable during this historically severe downturn. The businesses to emerge strongly will be those whose strategies have built in downturn contingencies and those capable of implementing the structural and organisational change required to survive in the emerging new world.
From an investment perspective, falling rents and occupier uncertainty in the City are putting returns under immense pressure. A market once driven by cheap available debt and continual capital appreciation, is now firmly entrenched in a sustained period of rising yields and falling rental growth. Income risk premiums continue to move out to reflect the uncertainty facing many industry sectors; the uncertainty associated with a serious financial crisis and an underlying economic recession. The result will be driven by basic economic fundamentals, leading to falling rents and more flexible lease terms for occupiers. This is substantiated by our own deal research that shows a higher incidence of break clauses in new leases. In 2007, 32% of new leases granted in the City contained a break clause, in 2008, this rose to 51%. We are also observing smaller space commitments being let on shorter leases, a continuation of the downward trend in lease lengths in the UK.
Whilst more flexible lease terms may prove more sustainable for businesses in the future, by relaxing some of the burden of a traditional restrictive commercial lease, it is the UK lease structure that to date has proved so attractive to investors. Falling rents and increasing vacancy rates have further implications throughout the financial sector, in particular the CMBS and ABS markets where debt secured against property assets rely upon the rental income stream to service the debt repayments.
