Over the last few years a clear bifurcation has been developing in the central London market with tenants focusing on best-in-class newly developed or refurbished offices which enjoy high sustainability ratings under BREEAM, EPC and NABERS as well as offering a superior level of amenity, bike parking, changing rooms and an attractive working environment.
At the end of October availability was 25.1m sq ft of which 17.1m sq ft , 68%, was second hand. According to JLL, office take-up to September 2022 had been 7.88m sq ft, of which 57% had been prelet ahead of completion or in newly built or comprehensively refurbished office space. Of the 3.5m sq ft that was under offer, this percentage was 75%.
This focus of demand is reflected in rental growth for the best-in-class office space. But it is the opposite for the poor-quality, less sustainable second-hand space – for which agents are saying they cannot buy a viewing.
The same bifurcation has now appeared in the investment market with the recent increases in interest rates, rapidly rising building costs over the last 12 months and a greater realisation as to the extent of capex required to bring these poorer-quality buildings back up to best-in-class standard. Yields for genuinely best-in-class offices have moved out marginally whereas the “mutton dressed as finest lamb” have now been found out; yields are rising with price discovery continuing.
Last month a real estate analyst at Citi was reported as “expecting the values of office blocks in the capital to fall by 38% in the next two or three years”. A precise 38%! I believe he is half right because, as argued above, rents are falling for the poorer quality second hand space and yields are now expanding to reflect the new reality. Where he is wrong is that the evidence is showing strong rental growth for the best-in-class accompanied by a small adjustment in yield. There is a shortage of this space hence the rental growth and also, I expect, minimal further yield adjustment particularly as inflation is beginning to fall back along with interest rate expectations.
The evidence is showing strong rental growth for the best-in-class accompanied by a small adjustment in yield
Going forward I believe valuers need to reflect a greater likelihood of tenants departing the older office stock at lease expiry, along with sufficient capex to bring the building up to a lettable standard reflecting expectations of tenants for the higher-quality space.
There is a pull for tenants to move to the best space to attract and retain the best staff, encourage greater attendance at the office and to provide a dynamic and exciting workplace. A further pull is that every organisation now has their own sustainability objectives which are more easily met in newly developed or refurbished space. The push for tenants to move out of the older space is the ratcheting up of the Minimum Energy Efficiency Standard (MEES), whereby landlords should not be letting offices below EPC E from 1 April 2023 and below EPC B from 1 April 2030.
What does one do with empty office buildings that are not viable to be refurbished? Buildings like this are becoming the subject of increasing debate, with Will Arnold, head of climate action at the Institution of Structural Engineers, arguing in The Times that a new Grade III-listed status should be applied to almost any building earmarked for demolition.
According to Arnold, all efforts should be made to retrofit them unless they are structurally unsafe or given special dispensation by a local authority.
Buildings with “good bones” can and should be refurbished to best-in-class standard, for example our own building at 25 Charterhouse Square, which achieves the same rents as a new building. Other buildings are past redemption and no amount of retrofitting can make them fit for purpose; these buildings need to be demolished and rebuilt. Marks and Spencer in Oxford Street being a good example.
The argument should be “retrofit first”, not “retrofit only”, or central London will become a land of the dinosaurs with large empty blocks that should be knocked down instead of being left to rot.
The irony is that rents would soar in the few new office buildings it would be possible to build or refurbish, probably to the benefit of companies like Helical. But that would do huge damage to the UK’s competitiveness and productivity as we find our way in a post-Brexit world. Central London needs to evolve and grow within strong net zero parameters, but “retrofit only” is a step much too far.
Article written for and published in React News, 9 January 2023