A 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. On the one hand, London is a volatile market and is not immune to economic cycles that create cap rate movement. 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.
The pandemic has also changed the way people work. 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. 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.
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. The Covid-19 pandemic has already reduced economic activity and placed substantial pressure on service sector businesses in London. The continuing economic hardship will inevitably lead to business closures and reduced office employment, and a supply-demand imbalance augurs for lower rents.
“Thank you, Captain Obvious,” you may be saying.
Anyone 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. 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. 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. Overall, the reduced demand from tenants and increased supply of new construction will contribute to lower office rents in the near-term.
But this is where we come to the prevailing market “narrative” and where we take a different view. One of the most powerful human motivations is to make sense of the world, and to understand why things are as they are. 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. 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. £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.
But is that narrative likely to be fully right? We don’t think so.
London is a global gateway city – by many measures THE global gateway city. 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. 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.
Furthermore, 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. 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. On the contrary, comments by Microsoft CEO, Satya Nadella, and Netflix CEO, Reed Hastings, have stressed their concern regarding the health and wellbeing of their employees and also the limitations of working from home on productivity and innovation – the lifeblood of economies and businesses. Let us not forget that London (and all other cities) have been dealing with shrinking real estate requirements per employee for nearly a half-century now, with the average square footage required per employee falling by half from 1990 to 2015, and yet many office owners have made fortunes over that time period.
And finally, the cost of building new stock in London is at a level in which permanently lowered rents will deter investors and developers from replacing old stock or building anything new. Just like it did in previous cycles, the cut-back in building will stabilise rents and then create rental growth from the bottom.