Deal-making in London has an old-school feel at the moment.
Fewer glitzy brochures and videos are circulating. Instead, agents are having more quiet coffees spent hunched over dog-eared tenancy schedules as property owners fret over asset values. It’s all very 1990s.
The final quarter of 2022 was characterised by paralysis as the soaring cost of debt obscured the true value of London’s offices. Yields moved out sharply amid double-digit write downs. Less than £1 billion of stock changed hands, making it the worst quarter since 2008. Much of that is yet to be crystallised as assets get sold, but it looks likely that core values have fallen between 20% and 30%.
When will the bottom arrive? The data suggests it is close. I’d argue it’s already here.
Activity is fast approaching normal levels, with at least £2.5bn of deals forecast to complete before the end of the first quarter. Indeed, according to preliminary BNP Paribas Real Estate data, c. £1.2bn transacted across Central London office markets in January – 9% above the 10-year average for the month.
The outward shift in yields slowed dramatically in January as swap rates moderated from a high of 5.2% in late-September. We see yields peaking at c 5% in the City of London, from 4.75% at the end of Q4, and about 4% in the West End, from about 3.85% in Q4.
It’s hard to overstate quite how much economic conditions have shifted in just a few months. The Bank of England’s November forecast predicted eight successive quarters of economic contractions, the longest recession since the Great Depression. The economy would end the period 3% smaller with unemployment hitting 6.5%, the Bank said. All of that was predicated on the market’s expectation that the base rate would peak at 5.25%.
That’s likely to prove far too pessimistic. Our forecasts suggest that a 0.25% hike at the next Monetary Policy Committee meeting will be the last, leaving the base rate at 4.25% until at least the end of the year. Meanwhile, the odds of a so-called “hard landing” for the economy are shrinking every month.
Private sector companies surveyed for the closely watched S&P Global Purchasing Managers’ Index reported a rebound in activity during February, for example, ending six months of contractions. Lower economic uncertainty, easing supply chain problems and falling inflation had driven a turn in consumer demand amid a broad-based rise in business confidence, respondents said. The Bank of England’s central projection now has the economy contracting only slightly by Q1 2024, with the unemployment rate rising modestly to 4.3%.
An imminent dovish pivot now looks very unlikely, given the strength of the economic data, but swap rates have seen some improvement and conditions in occupier markets remain conducive to prime rental growth. Indeed, the central London vacancy rate declined to 8.2% in Q4, down from 8.9% in the previous quarter. Prime rents in the City stabilised at £72.50 per square foot in Q4, but a shortage of the best quality properties drove prime rents in the West End to £140 per square foot, an increase of 19% compared to the same period a year earlier.
Investors have a window of opportunity before traffic arrives later this year. A significant amount of capital, which we estimate from various geographies and risk profiles at circa £41bn of dry powder, is waiting to be allocated and there remains very little stock being publicly marketed – particularly the sustainable, Grade A space that investors want. That presents a huge opportunity for sellers.
For buyers, there are attractive deals to be done before competition picks up significantly - particularly for those with the skills to turn around buildings with ‘brown to green’ strategies that will mean implementing upgrades to meet the currently proposed EPC rules coming into force in 2027. The entrepreneurial investors will transact first, and indeed they already are, with others circling. Those with cumbersome board approval processes will likely need more evidence of “price discovery” before acting.
Granted, there are other variables impacting values. The tiering of offices based on their ESG credentials is already shaping the market and the influence of environmental and societal factors on values will only grow. But the question of when average values will settle in the broadest sense looks clear to me, and the answer to that is now.
Of course, there remains a gap between what some sellers want and what some prospective buyers are willing to pay, but in many cases that’s now as reality bites. And besides, that’s what the coffees are for!
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