The office real estate market has received more than its fair share of column inches. National, international and trade publications have reported obsessively on the return – or not – of workers to the office and the impact that this has had on the sector.
Office occupancy in prime central London, where most of the listed real estate investment trusts (Reits) are invested, is pretty good. A brief wander around the many salad bars of St Paul’s provides some inkling of that. On Tuesday, Wednesday and Thursday, the queue for food near the Bloomberg Arcade is vast. On Monday, it’s moderate while on a Friday, a hungry journalist can saunter right up to the counter. In short, people are back, just not every day.
If you don’t believe the anecdotal evidence, then look to the statistics. Knight Frank data put the overall London vacancy rate at the end of the third quarter of 2024 at 9.4 per cent. The figure is 7.8 per cent for the West End and 8.9 per cent for the City and Southbank. However, not all office space was created equal. The vacancy rate for “true Grade A quality offices,” the highest quality, is 1.8 per cent in London and below 0.5 per cent in the City and West End core submarkets.
So working from home has not killed the office. However, it has reshaped the drivers of the market. Values, meanwhile, are shaped by a number of factors. In a 2024 research report examining office yields in European cities, the academics Omokolade Akinsomi, Samuel Duah and Matthew Clance found that prime rent levels, foreign investment, as well as macroeconomic variables such as employment, all had a significant bearing on office yields. Foreign investment, a significant driver of the London investment market, is examined opposite.
It’s (sort of) the economy, stupid
In short, office rents, much like their residential equivalents, are linked to the overall health of the economy. In theory, as the economy adds jobs, companies seek new office space, increasing demand and pushing up rents. Gross domestic product (GDP) has therefore been used as a determinant for office demand. However, an increase in the former does not automatically lead to a rise in the latter. Job growth in key sectors is also important. Estimates for December 2024 suggest that payrolled employees decreased by 0.2 per cent month on month, with flat growth in November. But London’s economy is its own beast, and prime central London is dominated by the services sector, so investors should look at that, too. This sector saw a 0.4 per cent increase between November and December 2024.
Even then, economic data is far from a perfect predictor. And the link between economic indicators and office demand has weakened since the pandemic increased the prevalence of home-working, says Marie Dormeuil, head of European market analytics at Green Street. “Historically, demand for office space would have been closer to office-using job growth, but because of the changing office use following the pandemic… space requirements are no longer growing as much as GDP growth because companies are able to be more productive and reduce their space,” she says.
However, headcount is an important factor. The Budget’s £25bn increase in national insurance contributions has led businesses to retreat from hiring and step up redundancy plans, according to the Chartered Institute of Personnel and Development (CPID). That said, much of the take-up in London has been driven by the legal sector, and this side of things appears to be booming, with the top 10 UK law firms charging clients almost 40 per cent more per hour than they were five years ago, according to PwC’s annual law firm survey. No surprise then that London’s legal sector has accounted for 20 per cent of the prime office space take-up since 2019.
Banks are also an important occupier, and this is part of the reason why return-to-office mandates have been followed so closely. JPMorgan’s instruction for staff to return five days a week has led it to seek more office space. The bank is said to be taking overflow space at Credit Suisse’s former Canary Wharf HQ while it assesses options. Not all peers are following suit: Citigroup has committed to allowing its employees to work from home at least two days a week. There are also challenges on the horizon. HSBC is pulling out of key areas of investment banking in the UK, Europe and the Americas, Citi is undergoing an overhaul of its private banking business while Deutsche Bank is restructuring. In all cases, this could lead to a shrinking workforce, putting a question mark over office occupancy.
Artificial intelligence, like the pandemic, has the power to reshape these industries by removing the need for repetitive, low-value work. If this were to translate into office jobs, then occupiers might shrink their office footprints further. However, analysis published by Green Street suggests that London would escape some of this impact as many of the at-risk positions are “already often performed from secondary locations”.
Tenant demand
At a more micro level, demand for offices at the occupier end is driven by tenant demand. Like their counterparts in the residential sector, corporate occupiers have their own specific list of requirements, including location, amenities and ESG credentials. Since the pandemic, these have become even more important as businesses try to entice their staff back into the office. This favours prime, well-located stock with strong ESG credentials. A lot of Derwent’s (DLN) and Great Portland Estates’ (GPE) buildings fit the bill here.
“Talent attraction and retention is very important, so they [companies] need to have great office space that meets their needs,” says Ellie McArdle, partner at Knight Frank. Location, including proximity to clients, is important, as are amenities such as bike racks, showers and gyms.
A limited supply pipeline
Office supply is far from elastic. It takes years to get planning consent and years for construction to complete, meaning developers need to be certain of demand before they even think about shovels in the ground. This, combined with high financing and construction costs, is why there is a shortage of top-quality offices in central London. While it might be at odds with some apocalyptic headlines about a glut of office space on the market, areas such as London and the West End are short of top space.
Add to this the fact that developers put off building in London after the Brexit vote, and it’s not hard to see why there’s a shortage around the corner. Knight Frank research shows that there is 12mn square feet of space currently under construction on which completion is anticipated by 2028. Just 7.5mn square feet of this falls into the “prime” category, leading to a shortfall of “almost 8mn square feet given the current average levels of new and refurbished take-up”. All of this means that rents are, for now, likely to continue going up. This favours existing landlords such as Derwent, and developers such as GPE, which raised £350mn last summer to fund its office development plans.