The London West End office market could benefit from strong growth in international business services, even if Europe were to fall back into recession. Mark Callendar and Jane Gravestock make the case
In comparison with the pedestrian recovery of the UK economy as a whole, the West End office market has rebounded healthily over the past two years. Agents' figures show that office lettings in the West End of London totalled 3.8m ft2 over the 12 months to June 2011, in line with the long-term average and almost double the trough reached in 2009. Admittedly these figures have to be treated with caution because they ignore the space that companies vacate when they move, but estimates indicate that net absorption has been consistently positive over the last eight quarters.
As a result, the West End vacancy rate has fallen rapidly from a peak of 9.2% in June 2009 to 5.2% in June 2011, according to Property Market Analysis (PMA), and is now below our estimate for the equilibrium rate (6.5-7%) normally associated with increases in rents. Furthermore, data on new requirements from tenants searching for office space suggest there is still significant demand for extra space, particularly from IT, financial and media companies.
At first glance, the vitality of the West End office market looks incongruous given the sluggish pace of the UK economy. However, the key to this conundrum is that the West End is not just a centre for UK business services, but is also an international hub. It is common knowledge that the City of London is an international financial centre. The Japanese have even coined a phrase, the ‘Wimbledon Effect', to describe how, despite there being few major British investment banks (analogous to the shortage of top British tennis players), the City has become a key venue for international banks.
However, what is sometimes forgotten is that both the City and West End are also major centres for international professional and business services. One circumstantial piece of evidence is that foreign-owned companies accounted for 50-55% of gross take-up in the City and 30% in the West End in 2009-10, according to PMA. By comparison, foreign-owned companies typically account for 10-15% of office lettings in Paris and New York. Moreover, a large proportion of the work done by large UK professional and business service companies is international and co-ordinated from London. For example, Allen & Overy reported that half of their legal work in 2010 involved three or more of their offices.
The international importance of London is further underlined by an analysis undertaken by the Globalisation and World Cities (GaWC) Research Network of universities. The ‘Global Urban Analysis' study of 175 international financial and business services companies looks not only where they are located but also at the importance of each office in terms of whether it is a global headquarters, regional headquarters, national office, or local representative office, and how they allocate work internally across their offices. The 175 companies have offices in 525 cities, and for each city the researchers multiplied the number of offices by their importance to arrive at a total connectivity score, indicating the capacity of the city to undertake international work.
As the table reveals London is a major international hub not only for finance, but also for accountancy, advertising, law and management consultancy and it consistently ranks above other European cities such as Paris, Frankfurt or Brussels. Business services firms in the City and West End are benefiting in particular from the growing reliance of multi-national companies on outsourced services and from the entry of those companies into new markets in central and eastern Europe.
The growth in international business services has probably been the main impetus behind the decline in vacancy in the West End office market over the past two years. However, perhaps counter-intuitively, another contributory factor has been an increase in the re-development of obsolete offices which were previously empty. We estimate the upturn in re-development has reduced the West End vacancy rate by 0.5% since 2009. While these schemes will of course return to the market in 2012-14, the increase in the total amount of office space in the West End will be limited to less than 1% between end-2010 and end-2015, according to PMA. By contrast, in the City, where there are fewer planning restrictions on high-rise development, the total amount of office space is forecast to increase by 4% over the five years to end-2015.
Predictably, the fall in the West End office vacancy rate to below its equilibrium rate has led to an early recovery in rents. The highest headline rents achieved on suites in the West End are now in excess of £100/ft2, and according to Strutt & Parker prime rents rose to £92.50/ft2 in June 2011, from a trough of £80/ft2 at the end of 2009. Admittedly, prime rents only refer to a very rarefied part of the market, but figures from Investment Property Databank (IPD) based on a broad mix of properties, also show a definite recovery, with average office rents in the West End increasing by 8% over the 12 months to June 2011.
Looking ahead, we would not be surprised if the recent turmoil in financial markets prompted some tenants to put new lettings on hold and if there was a pause in the rental growth for the rest of 2011. However, the drama in the financial markets will not trigger a recession and we expect that the UK and other developed economies will grow slowly during 2012 and 2013. This view is based on rising exports to emerging economies and higher business investment.
Consequently, we believe that any hiatus in lettings in the second half of 2011 should be temporary and that next year there will be a sustained improvement in tenant demand, which will push up prime and average office rents by 20-25% between end-2011 and end-2014. In nominal terms that would take prime office rents in the West End back to their previous peak of £120/ft2, although in real terms adjusted for inflation, they would still be around 20% lower.
Unfortunately, we cannot rule out the possibility of a double-dip recession in the UK and other developed economies, particularly if the euro-zone fractures. If that happens, tenant demand would fall sharply resulting in another downturn in West End office rents, particularly if the vacancy rate jumped back above 7%.
Another more specific threat to the West End is that cuts in government spending could lead more civil servants losing their jobs.
The main concentration of government offices is in Victoria, but they are also an important part of the occupier base in Covent Garden and St James. In total there are about 75,000 civil servants in the West End.
Our forecast assumes that the number of civil servants working in the West End falls by around 15,000 over the next three to four years and that the drop is more than offset by between 25,000-30,000 new jobs in business services.
However, there is a risk that the government decides to accelerate the relocation of departments to cheaper, more modern offices outside London, and that the cut in civil service staff in the West End is deeper than anticipated.
The medium-term outlook for the West End office market is still attractive. London is benefiting from strong growth in international business services, which should support a significant upswing in West End office rents from 2012 - assuming the UK and other developed economies continue to grow.
Moreover, if Europe did fall back into recession, the West End office market should be strong enough to weather the storm, given its current low vacancy rate and low future level of new development.
Mark Callender is head of property research, and Jane Gravestock is head of fund management for UK specialist funds at Schroders