Many readers will be familiar with our study of real estate spending as a proportion of employee salaries, which at 5-10% for London, may not be material enough to justify massive upheaval in firms’ real estate strategies. Its overall structural importance, and its underlying strengths, will not have changed as a result of the pandemic in the space of two to three years.įurthermore, we believe that many investors will be overestimating the impact that working from home and changes to the office environment will have on office space demand. It is the powerhouse of the UK and broader European economy and a major destination for investment capital, and has deep pools of high-quality talent, Europe’s best universities, the highest rate of graduates in Europe, more specialised businesses, and a competitive advantage in financial services as well as other industries. London is a global gateway city – by many measures THE global gateway city. £65 per square foot capitalised at 5% going to £50 per square foot capitalised at 5%, permanently in many investors’ minds, is a nearly 25% fall in capital values.īut is that narrative likely to be fully right? We don’t think so. Because in this scenario, the expectation is that rents are justified as they are, valuations will reflect these rents then capitalised at equilibrium cap rates. We believe investors will harness their innate desire to make sense of falling rents by creating a narrative around the fact that working from home and remote working will have permanently changed the demand for office space (a) in general and (b) in an “expensive” market like London, such that the new rents reached when the cycle bottoms are, or are at least close to, the justifiable long-term equilibrium rental levels. One of the most powerful human motivations is to make sense of the world, and to understand why things are as they are. Overall, the reduced demand from tenants and increased supply of new construction will contribute to lower office rents in the near-term.īut this is where we come to the prevailing market “narrative” and where we take a different view. And then there is the forthcoming wave of construction projects which are due to be completed over the next few years: as of Q1 2020, space under construction had risen by 30% in London, just as Covid-19 struck, to within 10% of all-time highs over the past two decades. It is also likely that “shadow space” (available space controlled by tenants looking to sub-lease) will be delivered onto the market to undercut landlords. “Thank you, Captain Obvious,” you may be saying.Īnyone with an ability to recall previous economic cycles will see that it is likely that tenants over the next couple of years will be dropping out of lease negotiations, re-negotiating the terms prior to actually signing or even reducing the overall amount of space they need in the first place. The continuing economic hardship will inevitably lead to business closures and reduced office employment, and a supply-demand imbalance augurs for lower rents. The Covid-19 pandemic has already reduced economic activity and placed substantial pressure on service sector businesses in London. What we do think we have a shot at predicting in the near to medium term is the movement in office space supply and demand, and the corresponding effect these factors have on forward rents. However, the long-term effects of these changes, after only six months’ worth of mostly anecdotes dressed up as data, are also very much unknown. It is likely that the growth in home-working and more flexible working arrangements will continue, as will the evolution of the demands from employees over the type of offices and spaces in which they wish to work. The pandemic has also changed the way people work. On the other hand, its status as a global city in an age of increasing global capital means that a structural shift downward in cap rates is likely to be ongoing, and where it stops is anyone’s guess. On the one hand, London is a volatile market and is not immune to economic cycles that create cap rate movement. A Returning Opportunity in the London Office MarketĪ recurring theme when we here at Castleforge attempt to prognosticate over the central London office investment market is that it is very hard to predict the trajectory of cap rates.
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