Thinning pipeline sees London enter its next commercial property cycle

The Central London office market is cyclical. This adage has been the cornerstone of London office commentary and forecasts for more than thirty years, and it has been absolutely correct. 

Property cycles are fluctuations in activity measured by peaks and troughs in performance, and in Central London they have historically been triggered by major global economic events.

The 1990’s recession, the dot com crash, and the global financial crisis all sparked a fall in occupier demand, an increase in vacancy rates, and downward pressure on rents. However, the most recent increase in supply was not triggered by any particular economic event; it had already commenced before the EU referendum in mid-2016.

One of the key characteristics of the property cycles has been the relationship between peaks and troughs in office supply, and speculative construction activity. Speculative construction is counter-cyclical; as demand picks up, supply begins to fall, and developers commence schemes to fill the potential supply-demand gap due to their increased confidence.

Levels of supply of new and refurbished space began to fall rapidly in 2014, which prompted a reaction from developers. However, it was also the release of second-hand space to the market by occupiers moving into stock they had pre-let in the preceding years that contributed to supply’s rise.

Speculative office schemes under construction in Central London

^{Source: Knight Frank Research}

We now find ourselves in the next property cycle 

Although to an observer London may appear to be a sea of cranes, there is more going on beneath the surface that ought to be understood in any appraisal of the market. There are 259 development schemes under construction in Central London, however 187 of these are residential; only 72 can offer commercial space, and just two-thirds of these remain available to lease.

That being said, at the end of 2017 there was more than 6.9 m sq ft under construction speculatively, 20% above average levels. So what does this mean for the Central London office market?

In normal circumstances, the delivery of such a volume of stock to the market would be a cause for concern. However, more than a quarter of all office space currently under construction is not due to be completed until 2020 at the earliest, leaving around 4.9 m sq ft of new stock to be delivered to the market in 2018 and 2019.

The development pipeline for this period will only be able to satisfy little more than half of tenant demand, assuming average levels of take-up of new and refurbished space of 9.0 m sq ft.

We believe that this lack of quality supply will trigger the next wave of large pre-lets in Central London.

An historic analysis of pre-letting shows that at times of falling supply and strengthening market conditions, the pre-let comes to the fore. Supply has peaked in Central London, which has already prompted an increase in pre-letting.

An ongoing fall in supply will drive tenants to continue taking space out of the pipeline to ensure they secure their preferred options well in advance of their lease events. Large tenants cannot afford to assume that there will be speculative space available to satisfy their requirements.

As the pipeline thins and employment remains high, supply will fall.

^{Source: Knight Frank Research}

^{Source: Knight Frank Research}

^{* Data for 2017-2021 shows completed schemes and schemes under construction}

Who’s building London?

London’s commercial pipeline has historically been controlled by UK developers and funded by domestic capital. While overseas investors have dominated the market for built investment stock, there has been less appetite for involvement in development.

However, since the global financial crisis, bank funding for speculative development has been difficult to obtain, which has helped keep the pipeline under control. This has led to a significant shift in the type of money behind developments. Our analysis shows that the percentage of development over the next five years funded by UK money has fallen from more than 60% to around 32%, with a noticeable rise in the volume of space under the control of North American developers. This includes schemes yet to start on site.

One of the side effects of this rise in overseas money has been the lowering of returns for development projects in London; as ungeared returns of circa 10% become normal, London has become more aligned with other global markets.

Despite both this and Brexit, London has remained a relatively safe and attractive market, not least because of the currency advantage enjoyed by foreign investors. 

In last November’s budget, however, the Chancellor announced that from April 2019, most foreign investors will be liable to pay capital gains tax on UK property. From April 2020 they will also be subject to the recently introduced debt interest relief restrictions and loss relief restrictions, meaning that heavily indebted structures will be exposed to more UK tax. 

Importantly, this could be most keenly felt where an investor has already purchased secondary stock with a view to scaling up with a new scheme.

So what will be the effect on London’s development pipeline?

Knight Frank believes that there will be differences on a case-by-case basis. Larger overseas developers planning to build out and sell will, in all likelihood, already face corporation tax and could be largely unaffected by these changes.

Smaller developers or private investors may well benefit from accelerating the development process to add as much value to their site as possible before the March 2019 date, thus reducing the gap between ‘current’ value and post-development profit. 

In either case, although the changes could be significant, the advantages of owning and developing commercial real estate in London are likely to ultimately outweigh the negatives.

The Central London office market is currently undergoing a period of significant change – but with big change comes great opportunity. Our latest report provides occupiers and investors with thoughts and guidance for the year ahead as the Central London office market continues to shift.