Why office rents in London hardly changed despite the slump in demand

  • 45 Walkie Talkies worth of empty space
  • Tenants demand more from their landlords

The laws of supply and demand are simple. An oversupply leads to falling prices. In the post-Covid London office market, however, things don’t seem so easy.

According to property data firm CoStar, the home office boom means the capital currently has 31 million square feet of vacant office space — the equivalent of 45 walkie-talkie buildings. That number is the highest CoStar has seen since data collection began in 2005. Not even during the 2008 financial crash did CoStar record a larger number of vacant office spaces.

But despite this abundance of supply, prime rents in London fell just 1 per cent from their pre-Covid-19 peak and are now just 0.8 per cent below pre-pandemic levels.

How have office landlords managed to keep rents so stable despite a lot of vacant space? The short answer is: office landlords – such as listed players British Country (BLND), Landsec (COUNTRY), Derwent (Crossdresser), Spiral (HLCL) and Great Portland Estates (GPE) – are forced to offer tenants more for the same rent.

“Previously you did the traditional ‘let it go and forget it,'” said Marcus Phayre-Mudge, a fund manager for a real estate equity investor TR Property Investment Trust (TRY). Now, however, tenant expectations are higher, he said.

The most blunt and popular of the incentives on offer are so-called “rent-free” periods, where rent is waived for a few months to get the tenant to sign on the dotted line. According to Carter Jonas data, this has happened much more frequently during the pandemic than in previous years – leading to severe distortion in rental rate numbers.

In other words, although the headline rent for leases in the London office market has changed little from pre-Covid, the rent-free periods have been getting longer, which in turn has meant that the actual rental income landlords received from these deals has fallen much more than the headline -Imply rent figures.

Carter Jonas incorporated these rent-free periods into his data to calculate what he called “effective net rent.” This character paints a completely different picture. Pre-Covid, effective net rents tracked headline rents almost closely, but after Covid hit effective net rents on a five-year office lease in London, headline rents fell 8 per cent from second quarter 2020 to second quarter 2021, agitated. This net effective rent has since returned to an average of 3 per cent below pre-Covid levels, but varies widely in different parts of the capital.

But even Carter Jonas’ net rents don’t tell the whole truth. This is partly because they only apply to the top end of the market – what office landlords refer to as prime space. If all of London’s office market were included in the data, net effective rents would be even lower, according to Michael Pain, Carter Jonas’ head of tenant representation.

What we are seeing is the emergence of what Pain and many others describe as a ‘two tier market’ where Class A space operates in a different world than the office market as a whole. Savills (SVS) calculates that 91 per cent of all newly let space in the City of London for the year to June was Class A, compared with 67 per cent for the pre-pandemic long-term average. In short, the offices across the capital that are gathering dust are the lower quality stocks, while the higher quality offices attract tenants willing to pay pre or near pre-Covid rents.

Pain has also observed instances where tenants were downsized from larger Class B spaces to smaller Class A spaces. The tenant saves money and the office market can post higher rents. “To sum it up, what we’re finding is that tenants are trading down in terms of the quantity of usable space, but the quality of the space is going up,” he said.

Listed landlords deal almost exclusively in Class A space, so Carter Jonas’ decision to only include Class A space in his effective net rents gives a fairly clear picture of their market.

However, Pain added that even this hides the fact that other concessions have been made. He said while some rent months were waived in the form of rent-free periods, other months – particularly during Covid – payment was merely deferred, with an agreement that tenants would pay the landlord back if they were able to. These deals are not reflected in the headlines or net effectives, which has meant that market rents have been kept at the same level while at the same time giving tenants some leeway.

In addition, according to Pain, more and more tenants, especially small and medium-sized businesses, are demanding fully equipped offices from their landlords so that they can move in ready from day one. In the past, tenants would prepay a third party for this work, but hiring landlords to do it instead can spread the cost over several years in the form of higher rents.

Another popular landlord concession costs absolutely nothing: more flexibility. While 25-year leases may have been common in the office market in the past, the rise and popularity of flexible working hours has seen landlords accept increasingly shorter leases. Data from BNP Paribas Real Estate shows that the average lease term for an office building in central London has fallen from 11.6 years in 2013 to 6.4 years in 2022.

As with office equipment, office agents are observing that this trend is more pronounced among small and medium-sized businesses. “The smaller occupier requires that level of flexibility,” said Ben Thomson, head of tenant representation at BNP Paribas Real Estate. “And Covid has only exacerbated that trend.”

Carter Jonas’ Pain added that tenants are typically willing to pay more for these shorter leases, which like everything else, helps keep rents high. This does not mean that long-term leases are gone, but they are negotiated in a more tenant-friendly manner. “Tenants who sign longer leases want a longer rent-free period,” he said.

There’s another incentive to keep rents high, but it doesn’t come from landlords. Since the pandemic began, the government has introduced a series of measures that have reduced business installments for companies to prevent them from going under. With businesses paying less money for business installments than they would normally, Pain said tenants were more able to pay market-level rents than they would otherwise have been able to.

While that combination of factors has kept the headline rent high for now, the jury is still out on whether it will stay that way. Phayre-Mudge’s TR Capital owns shares of some of the big public office leasing companies, but even he admits rents will fall if a recession hits – arguing that there is “a very strong correlation between job growth and rents”.

“So if we go into a recession, rents will fall. But it won’t be because you or I were smart enough to predict the popularity of work from home.”

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