Schroders’ Bone: Central London offices – stick or twist?

Bone Patrick Schroders

2013 was another bumper year for the central London office market. Improved economic sentiment lifted rental values whilst capital continued to flood into the market, driving down yields.

But have we had too much of a good thing? Yields in core markets are back to peak levels and prime rents are approaching previous highs. And with central London notoriously the most cyclical property market, is now the time for investors to start taking their chips off the table?

With prime rental levels in the West End back to £120 psf and the City moving past £60 psf, some core markets are starting to look a bit ‘frothy.’ However, if we look at ‘average’ IPD rental values we see that the recovery is at a far more embryonic stage (see Figure 1). In real terms, West End rental values remain 23 per cent below their previous peak, whilst City rents are 25 per cent below 2007 levels. This would suggest that if the supply/demand characteristics are favourable, there is the capacity for a sustained period of rental growth.

London offices 1

Limited new supply and strong occupational demand

A casual glance at the London skyline reveals some pretty dramatic changes taking shape. Whilst the Shard, the Walkie Talkie and the Cheesegrater have been notable additions to London’s office stock, away from these large tower developments very little else is being built. As Figure 2 demonstrates, we have seen low levels of new supply for the best part of a decade. We are expecting a spike in 2014, but the development pipeline then falls back sharply in 2015 and 2016.

So with a rather benign supply outlook, are we confident about future demand? There are a number of reasons to be optimistic that 2013 represented the beginning of an upswing in rents. It is no secret that London has been at the forefront of the UK economic recovery, with the capital’s share of the UK’s economic output growing to 21.9 per cent in 2013, the highest on record.

We expect London’s economy will continue to power ahead. Creative talent from across the globe is increasingly clustering in the largest and most 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.

A safe haven for international capital

With prime yields in some markets now back down to 2007 lows, it would be remiss not to question the sustainability of current pricing. However whilst yields look low when compared to historical levels, they look fairly priced if we consider rental growth prospects, the expensive pricing of competing global property markets and London’s pricing in foreign currency (figure 3).

Indeed in dollar terms, London values are currently 19 per cent below their 2007 peak, putting values in line with markets such as Paris (-20 per cent), New York (-15 per cent) and Milan (-24 per cent) and a long way below the likes of Munich (+4 per cent), Stockholm (+6 per cent) and Hong Kong (+45 per cent). If we factor in stronger growth prospects and London’s position as the most liquid property market in the world (source: JLL), then it is no surprise that it remains the first port of call for a number of international investors (table 1).

London offices 2

Stick

This is not to say there are no risks. A sudden appreciation of sterling may deter foreign investors from allocating more equity to London, whilst the desire for trophy assets in the capital may fuel a development boom further down the line. However, we believe that the strong performance of the London office markets is set to continue. We are still in the early stages of the rental recovery, London is well positioned to benefit from future growth across a wide range of industries and the supply outlook looks relatively benign.

In short, now is not the time to be taking your chips off the table.

Patrick Bone is head of UK property research at Schroders