Leasing market to be underpinned by supply shortage and persistent demand for prime offices

• Premium office supply shortage points to continued growth in rents
• The proportion of the office space of the quality sought by today’s businesses is limited, so competition will continue to intensify around this small segment of the market
• Demand is also likely to be more qualified, considered and grounded in occupiers’ experiences from “the great global workplace experiment”
• 42% of tenant release space falls into the Grade B (or lower) category, meaning we expect it to be almost entirely discounted by occupiers, unless refurbished to a new modern standard

Backdrop

Leasing activity in London’s office market seized up in 2020 for obvious reasons, with most businesses postponing decision-making where possible. This was not unique just to London, with major cities like New York, Paris and Sydney all experiencing record low leasing volumes last year.

As it became clear that technology was enabling many to continue working remotely, businesses began to assess their occupational strategies with a view to factoring for more remote working. Indeed, major global occupiers from Facebook to BP and from Aviva to Schroders have already announced permanent changes to working patterns for staff, all of which incorporate a formalised element of working from home (WFH). While clearly not a new phenomenon, the formalisation and extension of existing WFH practices will be one of the lasting legacies of Covid-19 and a major factor in occupational strategising as we take tentative steps towards national inoculation.

Nearly a year since the UK first went into a Covid-19 induced lockdown and with the rollout of the first vaccines now well underway, what does the future hold for London’s office market? While the five-day commute was already being challenged, the forced period of working from home has proved extremely challenging for businesses and individuals with neither extreme necessarily providing the optimum balance. What forced working from home has done is pull the value of the office into sharper focus. Occupiers will be looking to adapt the workplace to cater to the key areas of collaboration, creativity and culture, all of which have proved so difficult to replicate remotely.

The market remains supported by strong underlying fundamentals, three of which are reviewed below:

1. Demand: As we commence 2021, prime headline rents remain relatively stable and steady, as they did throughout much of 2020. During Q3 last year, rents in the City core slipped to £70/sq ft and the West End core registered a decline to £110/sq ft, from £72.50/sq ft and £115/sq ft respectively. This left prime headline rental rates within touching distance of pre-pandemic record high levels, highlighting the resilience of rents for top quality space, albeit lease incentives continue to increase. For obvious reasons, requirement levels have remained subdued, but there is evidence to suggest that occupier demand is being deferred rather than eliminated altogether. In fact, during 2020 we recorded a 32-fold increase in lease renewals, hinting towards delayed decision-making by businesses.

“Pressure will grow on landlords to get into the service layer and/or operational performance of an asset.”

For 2021, we expect a steady return of demand as the year progresses, the vaccination rollout gathers pace and we move toward national herd immunity, which the UK’s Scientific Advisory Group for Emergencies (SAGE) believes can be reached by the summer.

Demand for office space is also likely to be more qualified, considered and grounded in occupiers’ experiences of the great global workplace experiment, spawned by Covid-19. And a continued and increasing proportion of that demand is set to take a flight to quality as businesses seek offices that engender their ESG intentions, offer the flexibility they desire and provide a rich workplace experience for its employees, putting growing pressure on landlords to get into the service layer and/or operational performance of an asset.

Read: Re-gearing points to deferred demand

2. Supply: Here we mean the very best offices: brand new, Grade A stock. And such offices remain in short supply across London.

If we look back to 2009, during the depths of the global financial crisis (GFC), 80% of the space under construction in the City core was being built speculatively. Currently the figure stands at around 10%, so a significantly lower quantum of uncommitted space is in the pipeline for this submarket.

The dearth of supply has been a key feature of London’s office landscape ever since the GFC, with the availability of financing being one of the limiting factors to development. We entered the pandemic with about half of all stock under construction already pre-let: at the end of 2020, that figure was unchanged. While leasing volumes have declined, pre-letting activity has persisted, with occupiers, particularly those in professional services and finance and banking, committing to space still under development and taking a longer term view of London.

A central issue that will transcend the pandemic revolves around the war for talent. Businesses were already responding to this challenge prior to the pandemic by seeking out higher quality office space, and the resilience of this trend over the last 12 months highlights the criticality of this issue. In fact, in PwC’s Talent trends 2020 report, 74% of the global CEOs interviewed were concerned about the availability of skills, with about a third of respondents saying they were extremely concerned.

“The proportion of office space considered to be of a quality sought by today’s businesses is limited.”

Given that about 36% of London’s office stock was completed after the year 2000, barring refurbishments over the last 20 years, the proportion of the market that is considered to be of the quality sought by today’s businesses is limited. As such, we expect competition to continue intensifying around this small segment of the market as occupiers vie for the best buildings as a means of attracting and retaining the best people, at the same time as signalling their intentions with regard to environmental, social and governance (ESG) criteria.

Read: Supply shortage set to define the 20s

3. Tenant release space: The potential glut of tenant release space has been a significant area of concern since the start of the pandemic. Excluding 2020, the volume of tenant controlled space on the market in any given year has been around 3.5 million sq ft. Since March 2020, 3.1 million sq ft of space has been released.

“Any impact of tenant release space on the market will clearly be driven by the quantum of space, but more importantly the quality of that space as well as the location.”

This is where the quality of stock released comes into play: just over 50% of tenant release space since the start of the pandemic falls into the Grade B (or lower) category. We expect much of this space to be discounted by occupiers, unless refurbished to a new modern standard. Furthermore, the increasing focus on prime office space that delivers on flexibility, quality, and aids ESG goals means poorer quality stock will face challenges in attracting interest. The alternatives are to risk the long road to obsolescence, or perhaps even a change of use.

That said and, as our analysis has shown was the case in the aftermath of the global financial crisis, the underlying supply shortage in the market will see much of the higher-quality tenant release space rapidly reabsorbed. Our view is that ultimately any impact of tenant release space on market rents will clearly be driven by the quantum of space, but more importantly by the quality of that space, as well as its location.

Read: Impact of tenant release space expected to be localised at a submarket level

Read: Why prime headline rents are set for continued growth

View our video: London Office Leasing - World Post Covid 

Part 2: Sector activity & ESG