The Bank of England also kept low interest rates making capital easily available, which helped investors fund their property purchases. The government also introduced REIT’s (real estate investment trusts), which considerably raised the profile of this sector. Also the tax efficiency of REITS broadened the range of investors leading to this asset being difficult to ignore. These factors were very encouraging and DTZ show us in 2006 £66 billion was traded in property. As the table shows below London is considerably the largest location for commercial offices investment.
Current commercial offices sector position – the effects of the credit crisis
The “credit crunch” has led to a downturn in the world economy. Many sectors are not growing; this is reducing the flow of income to companies. This has inevitably led to firms reducing in size or going into administration, thus reducing demand for office space.
As we have seen before, offices are the most volatile property type to economic boom or bust. The knight frank report show us three areas that affect commercial offices; investment market, demand/take-up and supply/development. The report of late 2008 tells us that, take-up fell by 22%, active demand fell by 18%, availability has increased by 35%, supply of new offices has dropped by 27%, prime yields are increasing and annual investment turnover reduced by 37% - all of which are compared to 2007.
The FOCUS Report of 2008 told us - Asking rent in central London for commercial offices had reduced on average from £34.64sqft to £30.20sqft. Available office space had increased by 10%. Lease lengths have shortened which was an indication that break clauses had increased in use. Investors were less inclined to invest in commercial offices due to falling rents and occupier uncertainty. The flexible UK lease structure is proving to be attractive to some investors but this method alone has not been enough to improve investor confidence.
In regards to London offices, they have had a dramatic drop in demand. Financial institutions were the majority in demand for office space supplied in London. Financial institutions have been hit hardest, from the restriction of credit, and so they have had to reduce their sizes i.e. reduce costs through redundancies and less property occupation, which led to a ‘flooding’ of available office space in the sector. This ‘flooding’ of the market has increased yields making investors reduce rents.
Although, recent outcome have shown us the UK economy is stabilising. Two factors which reiterate this are; FTSE 100 has grown to 5100 base points which is what it was at its highest peak in late 2007 and residential housing prices have begun to rise.
CBRE report 2009 Q3; tells us London office space take up has risen to 2.7 million sqft, rents are starting to stabilise, yields are beginning to reduce, and investment in central London rose to £2.7 billion – close to the figure in 2007. All of these factors are positives towards the office sector improvement. As predicted by CBRE in 2008, foreign investment will increase due to a weaker pound and low values for property, which is what has happened - as it is currently leading the investment turnover this year.
Knight Frank report Q3 of 2009 tells us demand for central London offices has continued to improve due a weak pound, signs of recovery in the occupier market have been improving investor confidence. Also prime yields have hardened which is a very important factor for the office sector as this means office values are beginning to stabilise/increase.
Future prospects with the commercial property sector
The global economy’s future seems to be stable and growth is starting to appear in USA, France and Germany. Growing economies mean growth in many businesses which lead to increase demand for employment thus partly demand for office space. Predictions of the UK economy have been fairly negative in terms of economic recovery although from present results such as ftse100 and house prices these claims are looking less valid.
The King Sturdge report of 2009 disagrees it argues rents are unlikely to rise until 2011, it mentions yields are stabilising but investor caution continues. It also states rents are set to fall further. But its predictions have not matched recent reality which shows earlier stability than expected and there are signs of growth in the some boroughs of London.
In the short term (next 5 years) the commercial office sector in London has been predicted to grow at the start of 2010 from the Q3 2009 reports. This is from the predictions that yields will reduce, meaning office values will begin to rise. This prediction is based upon UK economy strengthening hence the office sector will begin to be attractive to investors, as previous market trends have shown us capital value and rent rise faster than many other property types (residential/leisure/public) - during economic growth. Although the market is still oversupplied and is seen to be until the start of 2011, as previous empty offices will begin to be re-let.
Harris, 2005, believes the changing nature of businesses is requiring greater flexibility in the use of space and time, allowing for rapid response to operational needs. Harris also goes onto say; the location of offices has become far less constrained as a result of information technologies – enabling work to take place in wider variety of locations. This still means there is and will be demand for offices but offices of a richer texture of office environments. Meaning speculative development will have to take into account offices of a high quality and functionality, resulting in higher costs and probably lower profit.
Office space occupation would be higher if was not for the car, the car encourages decentralisation of employment. Future of London is unknown as technology increases to improve at a fast rate, which could lead to decentralisation of the workplace.
Sector risk analysis
“Risk is uncertainty regarding the expected future rate of return from an investment”
Risk is perceived in terms of security of capital, security of expected income and liquidity. There is systematic risk which affects all investments, such as: economic cycles, interest rate fluctuations, this cannot be diversified away. Non-systematic risk is investment specific and for property this includes: tenant risk, sector and geographical risk, structural risk, legal risk and planning.
An encouraging factor in the past for increased investment in property was availability of credit. This has now been greatly constricted, making it difficult for developers to find investors to fund a new build. This issue may mean there will be a lack of new offices in 2010. This can lead to an undersupply in the market greatly inflating rents. Speculative development could become a real issue by disencouraging tenant occupation in London due to rental values being too high.
Another risk is the departure of foreign investment; this would be an issue because it is accountable for much of the demand for office investment in London. Foreign investment has increased due to the reduction in the value of the pound and the reduction in prices for property. This is a very likely risk as the pound will eventually increase in value making investment in the UK less appealing to foreign investors. This risk can be mitigated by UK institutions being the predominate supplier in investment reducing reliance on foreign investors.
As mentioned by Harris, 2005, technology has been a large factor towards the office sector. It has led to greater requirements of offices for flexible businesses. Improved information technology could soon make location less relevant to businesses.
Over the past two years marker rental values have dropped and many leases are upward only meaning many leases are now over-rented. This may mean many tenants could default on rent or use the break clause. This would be a huge effect on the office sector and reduce investor confidence by tenants being of higher risk than before from difficulty to pay rent. This would make this asset class less attractive compared to gilts, bonds, stock market etc.
Deflation could occur, which would make paying rent difficult for tenants and investors would find credit difficult to pay back. The quality of this investment class would not be competitive and GILTS would be safer and greater return option.
Sector and geographical risk: ‘Lumpiness’ of property investment accentuates this type of risk; International diversification can ameliorate some of this type of risk.
Tenant risk: Non-payment of rent or other contractual obligations
Structural risk: quality of build
Conclusions and Recommendations
To conclude on the sector itself, recent reports on outcome suggest the sector is stabilising. As referenced before the sector is highly volatile towards economic cycles. And elements such as FTSE100 and residential prices increasing tell us the UK economy is coming out of recession. This being the case, it will mean great positives towards the office sector, such as being safer investment, stronger tenant covenants, capital and rental growth. Recommendation would be to see the outcome of 2Q1 2010 reports to fully determine whether the UK economy is out of recession. If it is the office sector would be give high turnover due to its volatility of economic boom.
To conclude on London as a geographical location, from previous market trends this is the best location in terms of investment for commercial offices. It far outweighs all other cities in the UK in terms of the amount of transactions and the growth patterns. The literature states the reasons for why London is the most successful city in the UK is in terms of commercial office investment from these factors; transport, central government, bank of England, headquarters for media etc. These factors are both appealing to the occupiers and investors; even though office rents are considerably higher the amount is acceptable due to the above factors. Many tenants are willing to pay high rent and this means greater returns for investors. The first recommendation is to invest in London for commercial offices – it has high returns, a wide variety of tenants and it’s a safer investment compared to other cities.
The next conclusion is focusing on whether to invest in a second hand property or a new development. From what the reports have predicted they suggest the current empty second hand offices will be taken up very quickly within the next two years due to high demand from a growing economy. Because the current market is still oversupplied this tells us then that investment into development of new offices should only be done unless the build will be completed in mid to late 2011. Thus recommendation would be to invest once 2010 Q1 report suggests UK is out of recession and invest in a new development to be completed by start of 2011. This is because many tenants will be looking for new offices and there will be very little on the market. This can give a high value to a new build from a lack of supply, and tenant specialist requirements.
References
Harris, R. (2005) Property and the office economy. London: EG Books
Schiller, R. (2001) Dynamics of Property Location. London: Spon Press
CBRE report 2008 Q4 / 2009 Q3
FOCUS 2008 report
King Sturdge 2009
Knight Frank report of 2008 Q4 / 2009 Q3
DTZ report 2009
Market Research - Commercial Office Construction Market Report UK 2007 from AMA Research
Office of National Statistics. (2009a) National Income, Expenditure and Output [online]. Available from: http://www.statistics.gov.uk/pdfdir/oiebrief0809.pdf. [Accessed: 14th December 2009].
