We are moving through a period of weak economic growth, rising inflation and upward pressure on the base rate. The UK offices market has traditionally reflected conditions in the wider economy, with rental values rising after growth in GDP and vice versa. However, as the office market becomes increasingly resilient, will the economy continue to dictate values in 2023?
It has long been accepted wisdom that movement in the UK office market lags the wider economy by between three to six months. We have seen this repeated in the last few cycles: using City Core office prime rents as a proxy, we can see that values fell by 33% in just two years in the wake of the early 1990’s recession; rents fell by more than 30% after economic growth slowed after the dot.com boom; and in reaction to the Global Financial Crisis (GFC) in 2008 we saw the City prime rent fall by 35%. The consistency and extent of these declines is clear.
Over the last few years, the UK has endured a prolonged period of uncertainty from the EU Referendum, through Brexit, the Covid-19 pandemic, the war in Ukraine and the cost of living crisis.
The Covid-19 pandemic prompted the deepest recession in more than three centuries, so our accepted wisdom would dictate that we should have seen a corresponding fall in prime headline rental values. However, this was not the case as shown in figure 1.
CITY CORE PRIME RENT PERFORMANCE POST-DOWNTURN
Source: Avison Young
“We are seeing a clear differentiation between demand for the best versus the rest, which is being reflected in what both investors and occupiers are willing to pay to secure their preferred options. Sustainability, amenity and connectivity are now equally as important as specification for most decision makers, and we expect this to continue into 2023”
Dominic Amey, Principal, Central London Investment
The UK has always been a fundamentally solid business location, with a strong macroeconomic and regulatory environment, international business language, access to talent, infrastructure and reputation. These traits are embedded in the UK’s major office markets and have remained constant through the downturns but have not been adequate to protect them from rental growth cycles.
So, what has changed, and how will this affect rental performance going forward?
There are three factors that have exerted influence on the current market to help maintain prime rental values. These are:
Flight to quality
Office demand is increasingly focused on best-in-class space, due to a desire to meet CSR targets surrounding sustainability, to attract and retain the best talent, and to occupy real estate that aligns with a company’s brand. This has resulted in the bifurcation of the office market; prime headline rents are outperforming rents for secondary and tertiary stock. There is a supply versus demand imbalance over the last four years compared to the supply position after the GFC, with tenants in competition for many top-quality assets.
This has been exacerbated by the lack of debt availability for speculative office development since the GFC and will continue to be an issue in the foreseeable future particularly given the rising cost of borrowing, high build costs, softening yields and challenged scheme viability. We expect to see an increase in pre-letting activity in 2023 as rising construction costs weigh on speculative development and occupiers look to the pipeline to ensure they are successful in securing their preferred options.
Changes in lease structure and occupier strategy
Pre-GFC it was common for occupiers to acquire an excess of office space on the expectation of future headcount growth. This is one of the main causes of the dramatic fall in prime headline rents in the early 2000’s after significant volumes of unoccupied, high quality second-hand space were released back to the market after the dot.com bubble burst. The widespread introduction of flexible space to the market and the adoption of options on additional space in traditional leases has reduced the threat of large-scale release of tenant space during downturns and helped to maintain steady prime rent levels.
Specifically in London, the financial sector has traditionally been the largest acquirer of office space and was typically the sector that drove rental growth.
However, the influence of the financial sector in London has weakened; due to north-shoring, off-shoring, Brexit and advances in technology the sector has been less active in the commercial real estate market. Over the same timeframe, the professional sector has grown significantly, and we have also seen particularly large acquisitions from tech sector occupiers. The tech sector is less vulnerable to shocks in the wider economy and in some cases, firms thrived during lockdown. The result is a much greater diversification in London’s and increasingly the Regions’ take-up profile, leaving the market less exposed to individual sector slowdowns.
Despite the market’s growing resilience, there are weaknesses that should be recognised. Demand for lower quality space is likely to remain benign in 2023 as smaller occupiers either wait in place for more favourable market conditions or turn to more flexible options to help them navigate uncertainty. This will continue to drive the bifurcation of the market that has already begun.
In addition, the ever-growing trend of agile working will drag on take-up levels for all grades of stock, although data suggests the return to the office is strengthening, with UK-wide National Rail and some of London’s underground stations now enjoying daily usage approaching, and in some cases exceeding, pre-pandemic levels.
However, despite the challenging market conditions, we have already seen strong prime rental growth in 2022 and we expect prime headline office rents in the UK to remain resilient as we move through 2023 as demand for best-in-class space remains strong.
“While there are challenging headwinds, the UK office market is looking resilient compared to previous property cycles. This resilience, particularly around evolving occupier demand and a drive for best-in-class space, will help support values as we navigate towards the economic recovery next year”
Charles Toogood, Principal & Managing Director, National Offices and Lease Advisory Team