WHATS HAPPENING TO OFFICE RENTS IN LONDON?

Rising Tenant Demand, Delayed New-Build Supply and UK Economic Recovery Leading to Strong, Long-Term Commercial Rental Growth in London Currently favouring landlords, this trend is set to continue for several years until supply and demand is re-balanced. The office development squeeze in Central London has fed into the emerging rent spike in Grade A space as tenant demand has surged vs the relatively fixed supply side. Grade A office rents are now at or above the previous peaks of 2007, before the 2008 debt crisis collapse. Adding to the problem are new planning policies that encourage the conversion of existing office buildings to residential and hotels, taking-out existing stock from the supply side.

LOOKING AHEAD ****The volume of planned new office developments is insufficient to satisfy the predicted increase in office tenant demand in the next 3-4 years at least.

Rents, therefore, look set to climb further. What does this mean for office tenants facing relocation, rent reviews, lease renewals and other accommodation expansion and property cost issues?

Over the next few years, as the Central London office market becomes increasingly less tenant friendly, market knowledge and specialist transaction negotiation skills will be the key to maximising rent discounts and rent-free period incentives and generally getting the best business value and premises value-for-money, for tenants from their exposure to property costs and liabilities.

The London offices market is really a series of more localised sub-markets where specific factors dominate in the medium term as development, business mix, infrastructure provision and housing may inject significant change to their established character, dynamic and economic base. Most office location decisions are locally based and sourced for a host of sound business reasons, mostly people and finance related, so it is vitally important to understand these sub-markets and their nuances in dealing with business property change (relocations and expansions) and property cost and value changes (rent reviews, lease renewals, property taxes).

These events are ever more frequently found through structural property issues like short leases, lease-break clauses, rent increases demanded by landlords and locality change (such as decanting office buildings in favour of residential conversion). However, the threat of change also brings opportunity to the wise and well-prepared!

HOW DOES THE LONDON OFFICE MARKET LOOK IN AUTUMN 2014 FOR TENANTS FACING CHANGE IN THE NEXT 6-34 MONTHS?

We have already issued a report on the Southbank (London SE1 business district) sub-market.

In this report we now look at the West End (London W1, W2 and SW1 postcodes), Mid-town (London WC1, WC2) and City (London EC2, EC3, EC4) core sub-markets.

In these reports we summarise recent market activities – office and business space lettings – and take a predictive look at where those rents might be headed in the short term.

However, what might be achieved in a particular client situation depends crucially to the particular brief and the skills and knowledge applied to understanding and delivering it. Ask-re is a chartered surveyor consultancy specialising in bespoke client solutions – especially in challenging situations of particular leases and issues where “Mr Market” is doing his best to favour landlords! THE LONDON “WEST END” OFFICE LETTINGS MARKET

Rents now vary between £55/£60psf in sub-locations such as Victoria, Marylebone and Fitzrovia and look to be heading toward £72.50 in 2015, £80.00 in 2016 and £85.00 in 2017. Our benchmark is Grade A, new build or top quality, for this headline guidance and there are many variants input into the findings put forward here. Top rents in prime sub locations are appreciably higher at £100+ already with the historic peaks regained on some transactions. One deal does not a market make!

THE LONDON “MID-TOWN” OFFICE LETTINGS MARKET

With a significant element of new-build not possible in the core West End sub-market locations, and from a generally lower rent price basis, Mid-Town offers an interesting and developing(!) mix of results from best new-build to multi-storey industrials now reinvented as trendy media business offices. Composing this into headline guidance: Rents are generally at the £50-57.50 level with “Kings Cross” as an interesting sub-market contributor of best new space evidence, standing £7.50psf higher than this benchmark. Projections for Grade A are £70psf in 2015, £77.50 in 2016 and £85.00 in 2017. Of course, all market summaries are just that and our guidelines are necessarily generalisations over multiple variants and nuances found in all property transactions. Whilst mid-market space can still be found at around £40 to £45psf, availability has dwindled whilst absolute best has exceeded previous peak prices, strong recoveries from the lows of 2009/2010.

THE CITY OF LONDON OFFICE LETTINGS MARKET

The City market remains a quirky curate’s egg of a market with a huge variety of specification and quality and size peppering the lettings. In comparative terms for this report, rents are generally fully up with events at £62.50 and heading for £65 and £70 by 2017, possibly £80. Massive new towers make an obvious impact in all senses but seem unable to attract rent-pricing at West End levels paid on equivalent space. Even Mid-Town shows headier pricing than the City.

CENTRAL LONDON OVER ALL?

The supporting sub-locations around these cores (West End, Mid-Town and City) are all at materially lower benchmark values and are projected to show flatter rental growth curves in the medium term ahead, confirming that the “flight to quality” continues but not wholly at the expense of the sub-locations.

RENT COSTS ISSUES FOR TENANTS

In static situations such as mid-lease rent reviews, or dilapidations negotiations at lease-end, generally rent price comparisons are the key concern affecting the financial outcome, usually achieved by market-informed negotiation.

Understanding and getting to the true comparative rent price (typically psf and never per m2) requires highly specialist skill, knowledge and experience including how to read leases, valuation science and knowing the market. Headline rents can never be trusted at simplistic face value. And valuation science alone does not give the real life ‘right’ answer. However, the ‘comparable’ rent from other transactions is always a good place to start in considering a particular rent review, lease re-jig or other negotiation of value within a contract or at the point of entering a new contract.

Getting behind the surface rent £psf is key. Factors affecting valuation include legal clauses and rules, permitted user variations, capital spent on facilities, rent breaks, taxation impacts, service charges and many others. Business space lettings, mostly offices, are almost always corporate and considered transactions but personal or special value situations do erupt and measurably move the numbers – depends who’s playing! Qualitative value is always a component of any deal and "in the price".

In terms of lease negotiations in the free market, incentives to enter transactions such as rent free periods and contributions to capital expenditures on fit-out, can crucially alter the apparent rent £psf being paid. A landlord’s claimed result is often quite different to the tenant’s analysis of what has been agreed to be paid.

In the autumn 2014 market for Central London office lettings, it is true that “rent-free” allowances are generally drying up to the point of almost elimination on smaller, competed-for lettings.

Looking back 12 months or so, rent frees have typically been 9-12 months on new 5 year leases and 18-24 months on 10 year terms with no tenant-only breaks. We have exceeded these terms for our clients in many cases.

However, looking ahead, all the indications are negative for this rent alleviation continuing. Each case on its merits but “automatic” 6 months or 12 months allowances are increasingly questioned. One deal we are doing in Q4 2014 will be a very hard-fought 2 ½ months! A year back it would have been 9-12 months! This compression is enhanced when availability dries up – vacancy levels being at historic lows in some spots.

Other than rent, the key property cost is business rates the level of which property tax is seriously punitive and a significant overhead. Business Rates taxes are generally at £18-£25psf for ‘typical’ business space in Central London and will exceed £30psf on Grade A space in the West End and £22-25psf in the City.

The Revaluation scheduled for 2017 may heavily impact market rents in 2017 and 2018 unless there is some reform and reduction from anticipated levels. Rateable Values are based on notional market rents with tax rate set by the Treasury, nationally. If the base date for Revaluation 2017 is 2015, a rent of £70psf set in 2015 implies £30psf tax in 2017, without system reform.

With service charges at £12-£15psf, total occupational costs for the 3 principal property overheads would then really be around £115psf all-up, off the headline £70psf rent in 2015. On 10,000sq ft and a 10 year lease, this could be a pain for a typical tenant taking a part-floor in a new core location building.

THE “MIDDLE MARKET” LAYER

Headline rents will naturally tend to lead-up Grade B and Grade C office rentals, if only because landlords are always keen to ‘pump’ their buildings – making rents rise is their raison d’etre! (Ours is to reduce excessive rents and negotiate better value for money packages for our tenant clients!)

Our final generalisation in this report is that whilst Grade A rents will ‘spike’ in the most favoured sub-markets and special situations then cool-off a little toward 2020 as new supply gets sucked-through, it is the Grade B office strata, the biggest part of the market,  where rents will be most elastic, coming off a relatively low base and being pulled strongly to the new peak rents increasingly being seen in many locations (including outside London). There will be a wide range of actual and comparative value to be negotiated-back to favour the well advised corporate tenant.

Office space tenants in Grade B and Grade C buildings should be especially aware and responsive to this forthcoming threat of strongly rising rents over the next 3-4 years toward 2020. The rise is already out there and happening and will get worse because of the structural deficit of constricted supply. After some very tough years, landlords are well-placed to benefit through their tenants’ growing business recoveries and successes, to pay substantial and growing rents right across London. We are well placed to blunt their ambitions in particular cases!