Why London office rents barely moved despite a collapse in demand

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

The laws of supply and demand are simple. An abundance of supply means prices fall. In the post-Covid London office market, though, things do not appear as straightforward.

According to data from real estate data company CoStar, the work-from-home boom means there is currently 31mn square feet of vacant office space in the capital – the equivalent of 45 Walkie Talkie buildings. The figure is the highest CoStar has been seen since it started recording the data in 2005. Not even during the 2008 financial crash did CoStar record a greater amount of empty office space.

Yet despite this abundance of supply, prime London headline rents fell by just 1 per cent from their pre-Covid peak and are now a mere 0.8 per cent lower than before the pandemic.

How have office landlords managed to keep rents so stable despite the acres of empty space? The short answer is that office landlords – such as listed players British Land (BLND), Landsec (LAND), Derwent (DWT), Helical (HLCL) and Great Portland Estates (GPE) – are being forced to offer tenants more in exchange for the same rent.

“You used to do the traditional ‘let and forget’ back in the day,” said Marcus Phayre-Mudge, fund manager of property equities investor TR Property Investment Trust (TRY). Now, however, he said that tenants’ expectations are greater.

The bluntest and most popular of the incentives on offer are what are known as ‘rent-free’ periods where by a number of months worth of rent are waived in order to get the tenant to sign on the dotted line. According to the Carter Jonas data, this happened a lot more during the pandemic than in the years prior – which had the impact of heavily skewing the headline rent figures.

In other words, although the headline rent on the leases in the London office market barely changed from pre-Covid, the rent-free periods got longer, which in turn meant that the actual rental income landlords received on these deals dropped much more than the headline rent figures imply.

Carter Jonas factored these rent-free periods into its data to calculate what it calls the ‘net effective’ rent. This figure paints a very different picture. Pre-Covid, net effective rents track the headline rent almost exactly, but after Covid hit the net effective rent for a five-year London office lease dropped 8 per cent from the second quarter of 2020 to the second quarter of 2021 as headline rents barely moved. That net effective rental figure has since returned to 3 per cent below pre-Covid levels, on average, but it varies wildly across different parts of the capital.

However, even Carter Jonas’ net-effective rent figures do not tell the full story. In part, this is because they only apply to the upper end of the market – what office landlords refer to as ‘grade-A’ space. If the whole of the London office market were included in the data, Carter Jonas’ head of tenant representation Michael Pain said that the net effective rents would be even lower.

What we are seeing is the emergence of what Pain and many others describe as a “two-tier market” where grade-A space operates in a different world from the office market as a whole. Savilles (SVS) calculates that 91 per cent of all newly leased space in the City of London for the year to June was grade-A compared with a 67 per cent long-term average pre-pandemic. In short, the offices across the capital that are gathering dust are the low-quality stock, while the higher-quality offices are attracting tenants willing to pay pre-Covid or near-pre-Covid levels of rent.

Pain has also observed instances of tenants downsizing from larger grade-B space to smaller grade-A space. The tenant saves money, and the office market can record higher rental levels. “To sum it up, what we’re finding is tenants trading down in terms of the quantum of floor space, but the quality of space is increasing,” he said.

The listed landlords deal almost exclusively in grade-A space, so Carter Jonas’ decision only to include grade-A space in its net effective rental figures gives a pretty clear picture of their market.

Yet, Pain added that even this hides the fact that other concessions have been made. He said that while some months of rent were waived in the form of rent-free periods, payment for other months was merely postponed – particularly during Covid – with the agreement that tenants would pay the landlord back when they were able to. These deals are not reflected in the headline or net effective figures, which has had the impact of keeping market rents at the same level while also giving tenants some slack.

In addition, Pain said an increasing number of tenants, particularly small to medium-sized businesses, are demanding fully fitted-out offices from their landlords so that they can move in ready to start work from day one. In the past, tenants would pay a third-party contractor up-front for this work, but by asking the landlords to do it instead the cost can spread across several years in the form of higher rent.

Another popular landlord concession costs absolutely nothing: greater flexibility. Whereas 25-year leases may have been common in the office market of the past, the rise and popularity of flexible working has meant that landlords have been accepting ever-shorter contracts. Data from BNP Paribas Real Estate reveals that the average lease length for a central London office building has dropped from 11.6 years in 2013 to 6.4 years in 2022.

As it is with office fit-outs, office agents have observed that this trend is stronger among small to medium-sized businesses. “The smaller occupier requires that level of flexibility,” said Ben Thomson, head of tenant representation of BNP Paribas Real Estate. “And Covid has only exacerbated that trend.”

Carter Jonas’ Pain added that tenants were typically willing to pay more for these shorter leases, which like everything else helps to keep the rents up. This does not mean that he has seen long leases go away, but they are being negotiated on more tenant-friendly terms. “The tenants who are taking longer leases want a longer rent-free period to do so,” he said.

There is one more incentive helping to keep rents high, but this one has not come from landlords. Since the pandemic began, the government has introduced swathes of measures that have reduced company’s business rates payments in order to stop them going under. With companies paying less money on business rates than they normally would, Pain said that tenants have been more able to pay market-level rent than they might have been otherwise.

Even though this combination of factors has kept headline rent up for now, the jury is still out on whether it will stay that way. Phayre-Mudge’s TR Capital holds equities in some of the big listed office landlords, but even he admits that if a recession hits rents will come down – arguing that there is “a very strong correlation between employment growth and rents”.

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


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