For professional investors and advisers only
Schroder Property
Central London Offices:
Stick or twist?
July 2014
Introduction
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.
Patrick Bone,
Head of UK
Property Research
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.
Central London offices: Stick or twist?
Figure 1: The rental recovery in London still has a long way to go
Index, March 2001 = 100
110
100
-22%
90
80
+11%
-23%
70
60
Q4 2000
Q2 2001
Q4 2001
Q2 2002
Q4 2002
Q2 2003
Q4 2003
Q2 2004
Q4 2004
Q2 2005
Q4 2005
Q2 2006
Q4 2006
Q2 2007
Q4 2007
Q2 2008
Q4 2008
Q2 2009
Q4 2009
Q2 2010
Q4 2010
Q2 2011
Q4 2011
Q2 2012
Q4 2012
Q2 2013
Q4 2013
50
West End real rental growth
City real rental growth
Source: 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)
19.5
Reversion
7.6
Source: IPD, Schroders, March 2014.
2
West End and
Mid Town Offices
City Offices
South East Shops
Shopping Centres
Rest of South
East Offices
South Eastern
Industrial
Retail Warehouses
Rest of UK
Industrial
Rest of UK Offices
Over-rented
Rest of UK Shops
%
25
20
15
10
5
0
-5
-10
Central London offices: Stick or twist?
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
Nominal Rental growth (%)
40
Completions (m sq ft)
12,000
Correlation = -0.84
30
10,000
20
Forecast
8,000
10
0
6,000
-10
4,000
-20
2,000
-30
-40
0
1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
Completions
IPD Estimated Rental Value (ERV) growth
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
ERV growth (%)
GDP growth(%)
8
Forecast
6
4
2
0
-2
-4
Dot com crash
-6
1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
GDP growth
Source: IPD, Schroders, March 2014.
3
IPD Estimated Rental Value (ERV) growth
50
40
30
20
10
0
-10
-20
-30
-40
Central London offices: Stick or twist?
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…
Completions relative to historic average (100 = average)
300
Forecast
250
200
150
100
50
0
1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017
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.
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Central London offices: Stick or twist?
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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Central London offices: Stick or twist?
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
From within existing village
Moving from other villages
Victoria
Hammersmith
Mayfair and St James
City core
Midtown
Soho and Covent Garden
Clerkenwell and
Shoreditch
Docklands
Southbank
King's Cross
Noho
North of Oxford Street
100
90
80
70
60
50
40
30
20
10
0
Paddington
Take-up by submarket Q1 to Q3 2013
New operations
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.
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Central London offices: Stick or twist?
Figure 7: Estimating fair value for central London
Initial yield – 10 year Gilts Yield Gap
Correlation: 0.4155
4
July 2009
June 2012
3
December 2013
2
1
0
-1
June 2007
-2
-15
-10
-5
0
5
10
15
ERV growth (%)
Mar '01 - Mar -'02
Jun '02 - Dec '04
Mar '05 - Jun '07
Sep '07 - Jun '10
Sep '10 - Sep '13
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.
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Central London offices: Stick or twist?
Figure 8: Low prime yields are not confined to London
% prime yield
9.0
8.0
7.0
6.0
5.0
4.0
3.0
Peak/Trough last 5 years
2014 Q1
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
% Average ERV growth end 2013 to 2017
6
West End
5
City
Munich
Stockholm
Berlin
Oslo
Paris
Vienna
Hamburg
Frankfurt
Helsinki
Copenhagen
Amsterdam Milan
4
3
2
1
0
Dublin
Brussels
Warsaw
Rome
Lisbon
Barcelona
Zurich
-1
Budapest
Rotterdam
-2
3
4
Source: CBRE, Schroders, March 2014
8
5
6
7
8
9
Prime initial yield (%)
Central London Offices: Stick or twist?
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.
.schroders.com/ukstrategicsolutionwww.schroders.com/ukstrategicsolutions
_________________________________________________________________________________
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,
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For professional investors and advisors only. This document is not suitable for retail clients.
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