Our Thoughts
Thu, 31/08/2023 - 12:00
· 5 min read

Why central London will dodge the dreaded doughnut

’US cities must beware the ‘donut effect’’, the Financial Times warned in May.

The article by Rana Foroohar unpacked findings of a post-Covid economic hollowing out of city centres as former residents opted to live and work in the suburbs and exurbs. The evidence for the piece was gathered and published by the academics Arjun Ramani and Nicholas Bloom of the National Bureau of Economic Research, who used commercial and residential rents to suggest that, where households had left city centres during the pandemic, most had moved to the suburbs of the same city. Businesses and real estate demand had in turn shifted away from CBDs to suburban “outer rings” resembling doughnuts, leaving worrying prospects for commercial buildings in large cities.

US cities were the focus of the study, but the underlying causes can be found in London or indeed many other large cities in western economies – namely the rise of hybrid working and the movement of city residents to areas with more space and greenery. Yet, there are few signs that the doughnut is taking hold in London. Ridership of the tube, for example, is down just 13% compared to pre-COVID levels, compared to an average of -35% across the US. Meanwhile, rents in London’s West End hit £140 per square foot during Q4 2022, an increase of 19% compared to the same period a year earlier.

Whether these differences will endure is subject to considerable uncertainty, however London is uniquely positioned to dodge the dreaded doughnut due to a mixture of economics, infrastructure, architecture and green building legislation.

“One of London’s key differentiators from some US cities is the sustainability angle, particularly MEES [Minimum Energy Efficiency Standards] and the increasing real need for corporations to be in a best-in-class energy efficient building,” says Charlie Tattersall, associate director, capital markets research. “For many of these companies, if they want to get finance, if they want to take on new institutional clients, they have to show robustly how they are reducing their emissions from both their operations and their buildings.”


Amenity-rich locations

The UK’s Minimum Energy Efficiency Standards, which are currently moving through a series of debates in parliament, will render any commercial property with an EPC rating lower than B unlettable by 2030. The US does have comparable legislation in some states and tax benefits are on offer for building owners to get green certified, though it’s a patchwork that varies heavily by location. “The pressure on occupiers to occupy more sustainable buildings is also more intense in Europe, where the European Commission has led the world in regulating and legislating the world of ESG. The direction of travel in the US, where ESG remains a politically contentious issue, is less clear cut” Tattersall says.

The drive for sustainable buildings isn’t the only way occupier requirements have shifted. Companies are generally rationalising their office space, with some opting for a smaller amount of higher quality, flexible space, often in prime buildings. Character-rich buildings with smaller floorplates in amenity-rich locations are in vogue.

That’s where London’s West End really comes to the fore, says Mhairi Thomson, associate director, office research. The average floor plate in the West End, which is popular with hedge funds and companies in the creative industries, stands at 6,807 square feet. That compares to 29,299 sq ft in New York City.

“Occupiers are really resistant to committing to huge floor plates,” Thomson says. “It just isn’t feasible in the context of hybrid work, even for very large companies.”


Flexible space

The drive for smaller amounts of unique, flexible space is underpinned by the shift in workstyles. It’s tricky to compare occupancy levels in US and UK cities due to differences in data gathering. Office occupancy in the US is improving but remains less than 50% of pre-pandemic levels, according to Kastle data that measures key cards and fob activity. Occupancy in larger southern markets like Houston and Dallas is running higher than northern markets such as San Francisco, New York and Chicago, according to Transwestern.  

UK office occupancy stands at approximately 44%, according to data from Remit Consulting that measures total occupancy. That’s more than half of the pre-pandemic occupancy rate of 80%. The West End leads that index, with an occupancy rate of 47.6%.

Ease of travel may explain why occupancy levels are higher in London. While the research into which cities are failing or thriving post-pandemic is still nascent, one variable that seems to matter is ease of transit, Tracy Hadden Loh, a fellow at the Brookings Institution told the FT’s Foroohar. “This may be one reason why downtown London and Paris seem vibrant compared to many US cities,” she added.

Indeed, spikes in interest among office occupiers have become increasingly prominent along London’s Crossrail route, particularly at Tottenham Court Road, Canary Wharf and Liverpool Street, Thomson says. Developers have sought to capitalise on wave of new demand, and several large projects boasting the highest sustainability ratings are emerging, particularly around Tottenham Court Road.


Interest rates

To be sure, the London office market remains vulnerable to higher interest rates. The Bank of England in June raised base rate to 5%, highest level since October 2008, and the UK’s inflation problem appears to be particularly sticky relative to both the US and the Eurozone. Office capital values are likely to continue to soften for several more months at least, according to Tattersall. Meanwhile, not all submarkets enjoy tailwinds that are fuelling rental growth in the West End, and property owners in locations like Canary Wharf are pivoting to new sectors such as life sciences to curtail rising vacancy rates.

However, the economic outlook for the centre of the city and its office buildings appears radically different to that of several large US cities, underpinned by structural themes that will outlast the prevailing period of higher interest rates, Tattersall says.

“The resilience of central London is what makes the current moment so different to 2008 or the early nineties, which were characterised by oversupply of space and sudden structural breaks in risk appetite, with profound implications for liquidity,” he adds. “The fundamental lack of best-in-class space and diverse sources of finance are part of what makes this a very different situation. There remains a reasonable rationale for investing on the capital side once the outlook for inflation and interest rates becomes clearer.”

Why central London will dodge the dreaded doughnut