Standing tall: UK offices remain resilient, despite the country’s destabilising political environment
It is sometimes hard not to be distracted by all the noise around controversial political events like Brexit, especially when they are on your doorstep. As opinions become more polarised, it can be easy to lose a sense of perspective, which runs contrary to the increasingly global marketplace in which we all operate.
We were reminded of the importance of forming an impartial view of events such as Brexit when we accompanied some of our southern hemisphere colleagues on an investor trip to Southeast Asia recently. Rather than investors being put off completely by the ongoing Brexit debacle, we found that it had piqued some interest, albeit guarded, among those with a long-term investment mindset.
This interest has already manifested itself in the actions of investors from outside the UK, such as the recent acquisition by Citigroup of its headquarters in Canary Wharf in London and the closing of several Europe-focused funds with capital to deploy, some of which has been reserved for the UK.
Despite a slowdown in the economy post the referendum, some of the fundamentals remain positive. Unemployment is at the lowest level in a generation following a sustained period of job creation, and wages are slowly starting to rise. The working age population is also creeping up, supported by natural expansion and increases in the state pension age, despite lower levels of immigration than those seen in the past.
The UK also holds a leading position in several service sectors, including financial and business services. This is partly due, according to JLL’s Innovation Geographies report, to the country having access to the highest concentration of talent in the world due to its leading universities and highly-educated workforce.
Added to this is the favourable exchange rate for overseas investors and economists’ expectations that UK GDP will grow by 1.2 percent in 2019 and 1.1 percent in 2020, on par with the euro zone average.
In 2018, there were approximately £60 billion (€67 billion) of real estate transactions, 20 percent more than the 10-year annual average, with the office sector accounting for around 40 percent of volume. Despite the first half of 2019 Brexit-related bumps, £20.5 billion (€23 billion) has already been invested into UK real estate, £8.2 billion (€9.2 billion) of which went into the office sector — with more expected in the second half of the year (see chart below). As a result, even if you strip out the effect of some of the mega-deals, the strength of demand is evident to see, with significant capital allocated to the UK.
So why this continued interest? Firstly, the long-term fundamentals remain attractive. The UK real estate market offers size, diversity of product, depth of investors and breadth of occupiers, as well as an important level of liquidity and stock in large lot sizes — all underpinned by transparency. These are qualities that are not necessarily available in other European domestic markets. The low-interest-rate environment is also likely to be around for longer, as the Bank of England’s Monetary Policy Committee (MPC) will not want to raise interest rates until the Brexit route ahead is clearer, so no hikes are expected until May 2020, with only gradual rises expected thereafter. These conditions have drawn in cross-border investors, with Asian investors, for example, comprising the second-largest group purchasing UK assets over the past 12 months (see chart on page 33).
As would be expected, private equity money is more attracted to value-add opportunities with a focus on London, while longer-term capital is buying not only into the capital, but also into the growth story of the stronger performing regional cities.
While London still retains its crown in the UK office market, consistently attracting around 75 percent year-on-year of total capital inflows into the office sector, Manchester and Birmingham are attracting more attention, rounding out the top three spots.
If the lack of quality supply remains a feature in the major office centres such as London, a supply gap is likely to emerge in or around 2021 and 2022, which we expect to push overseas investors further up the risk curve into value-add/opportunistic and development opportunities in the regional centres.
By and large, fundamentals are robust with positive rental growth pushing through in supply- constrained markets. But, there is evidence of an emerging two-tier market as occupiers’ thirst for best-in-class space that delivers on quality, amenities and services to employees and provides for a work-life balance. These are increasingly becoming “must-haves” and not “nice-to-haves”. Developers are now having to balance rising construction costs with occupier demands for flexible, sustainable space and creating — or owning — these assets will protect and drive performance.
Vacancy in central London is 4.9 percent, having declined since the beginning of the year despite a slower first quarter in 2019 in terms of take-up, with the second quarter seeing a more robust performance. As a consequence, the first half for 2019 is in line with the 10-year average. While more stock is coming through with an estimated 13.2 million square feet (1.2 million square metres) under construction, this is unlikely to dramatically impact the level of availability as around 55 percent of this development has already been let, or is under offer.
Both the professional services and tech sectors are forecast to account for the majority of London’s GDP growth in the next five years, which should translate to further need to increase headcount and office space.
In the regions, 2.34 million square feet (217,000 square metres) of space was let in the second quarter across the UK’s “Big Nine” locations (Birmingham, Bristol, Cardiff, Edinburgh, Glasgow, Leeds, Liverpool, Manchester and Newcastle), bringing the half-year total to 4.3 million square feet (400,000 square metres) and 10 percent above the long-term average. Activity was heavily focused on larger deals, quality space in city centres and flexible space. The TMT sector was very active, while there was a retraction from traditional sectors such as financial, professional and business services.
The UK may not currently be for all investors, but there are opportunities to be had. For those that are taking a longer-term view of holding real estate and can see through the noise, supply constraints and a lack of speculative development remain key drivers of performance.
While there is a noted lack of product coming to market as Brexit unfolds, this may lead to a few more forced sellers. But with LTVs and debt low, and more international owners than before the GFC, this is likely to be limited, sustaining values.
Mark McLaughlin is managing director of Cromwell Property Group Europe.