Quality v Quantum – What’s Next for Occupier Demand?

Greater functional obsolescence will lead to a resetting of corporate HQs and a different dynamic in both the quantum and qualities of office space required.

Dr Lee Elliott – Head of Global Occupier Research

Dealing with functional obsolescence

The theme of physical obsolescence is well rehearsed in the London office market. Less appreciated or acknowledged, but arguably no-less impactful, is the growing sense of functional obsolescence. Corporate occupiers are increasingly recognising that their London office buildings – which typically constitute either regional or global headquarters – are often the product of a bygone age, no longer fit for purpose in a world of work shaken by the pandemic experience.

Indeed, the second edition of our (Y)OUR SPACE research, which surveyed almost 400 global corporate real estate leaders at the height of the Covid storm (January – March 2021), found that some 40% deemed it ‘likely’, ‘very likely’ or ‘definite’ that they would relocate their HQ facilities over the next three years.

The drivers of this relocation activity were telling. Cost sensitivity was, of course, a factor: headquarter buildings tend to be the more expensive offices in the most expensive sub-markets and are therefore in the crosshairs of any cost reduction initiatives. But almost as significant a driver was the recognition that a new world of work being ushered in by the pandemic experience had significant implications for both the quantum and qualities of floor-space that occupiers will need during the next cycle.

Quality and Quantum Drivers

Across the last twelve months, the Knight Frank Cresa Global Corporate Real Estate Sentiment Index has identified three key dynamics that will shape the future profile of occupier demand for London offices.

First, it shows that prospects for global economic growth have diminished over the last twelve months and have, in turn, led to reduced expectations around revenue, capital expenditure and headcount growth. This sentiment will act as a brake on expansionary demand over the first half of 2023. Throughout the year, London office demand will be primarily driven by occupiers responding to critical lease events. It is worth noting that there are 23.5m sq ft of lease expiries (484 occupiers) on office space of over 20,000 sq ft in London between now and 2027. It is clear that this structural demand will be sizeable and significant, exacerbated by an impoverished pipeline of quality new supply and the growing physical obsolescence already noted.

Secondly, most occupiers contributing to the index remain intent on redesigning and reconfiguring their office space, drawing particularly upon greater amenities and services to make their office more compelling to their staff. This will serve to sustain the well-trodden path to quality witnessed in the market over the last eighteen months and has real implications for the market offering emerging from landlords. This will require more than cosmetic meddling. Occupiers are seeking to enhance the physical environment while also generating a more vibrant workplace experience, one that is compelling to staff who now have some choice in where they work. Two clear outcomes are obvious here. One, the reconfiguration of office space to be less about individual, isolated workstations, or private offices, and more about driving connection, socialisation, and collaboration. Two, the use of a greater depth and breadth of amenities (both within the office and nearby) to provide staff with something they cannot readily access remotely.

The third dynamic apparent from our sentiment index is that the baseline for occupancy is being reset. The most negative sentiment across the entire index was in response to the suggestion that occupiers will return to pre-pandemic levels of occupancy, levels typically around 65-70% of office capacity. The genie of flexible working was released from the bottle by the pandemic experience, and it is not for returning. However, those early stage Covid projections of an occupier’s total floor-space reducing by 40 or even 50%, look increasingly wide of the mark. While the Martini Syndrome of working anytime, anyplace, anywhere, envisaged at the start of the pandemic, is not an outcome for most occupiers, an office first stance, combined with greater acceptance of flexible working is, and this will have implications for office occupancy and utilisation rates.

There is no right answer here. Each occupier will assess the quantum of space they require from a different starting point, considering their own pandemic experience, approach to flexible working and end goal. Some will contract and some will expand. What is universal, however, is that occupiers are seeking a step-change in the quality of space occupied to drive up utilisation. This serves to balance the needs of the business and employee. It represents a stronger return on investment for the CFO, whilst allowing the CEO to bring greater strategic alignment between workplace and workstyle, culture and connectivity, inclusion, and impact.

Market Implications

These dynamics have four clear and inter-linked implications for the supply side of the London market:

Purpose – Occupiers increasingly regard real estate as a strategic device. For landlords this necessitates the positioning of real estate less as a fixed physical product and more as a flexible solution to a range of strategic issues facing the customer, be that culture and brand, the attraction and retention of talent, or making inroads into important public ESG commitments.

Polarisation – This strategic imperative will extend the gap between the best office space and the rest. This polarisation is already becoming acute, and it will take some time for the overhang of space that is either physically or functionally obsolete to come back into productive use. For innovative landlords there will be opportunities to reposition well-located and fundamentally sound buildings through retro-refits and refurbishments which will also support the ESG agenda.

Pre-letting – Of course, this presents an opportunity for those landlords with development projects in progress or with planning consent. Occupiers, recognising the shortage of quality options, are becoming increasingly active further ahead of lease events to pre-commit to space, including for smaller units of space. This pre-commitment is often delivered at premium rental levels both to secure the option but also to allow the occupier to have greater input into the solution.

Partnership – This input serves to push the London market further away from its traditional adversarial relationships and towards a partnership between, in old language, landlord and tenant. This much heralded partnership footing is imperative to creating a market more responsive to customer need, one which can also deliver strong and sustained financial performance.