Our Thoughts
Mon, 15/04/2024 - 12:00
· 5 min read

The London commercial real estate recovery is missing just one vital ingredient

Borrowing costs have dipped from last year’s highs, office rents are climbing in key submarkets, yields are stable, and supply remains very tight. So why aren't we seeing more deals?

London’s commercial real estate market (CRE) looks primed for a recovery.

Inflation may be running hot in the US, but in the UK, inflation appears to be under control. The drop in the Consumer Prices Index (CPI) to 3.4% in the year to February was better than economists had expected and adds some certainty to our view that the Bank of England will cut the base rate in June. Office rents are climbing in key submarkets. Values have stabilised. The supply of prime office space remains very tight.

Yet, some investors are hesitant. CRE investment volumes in central London surged 23% in the final quarter of 2023, but at £1.5bn remained 65% below the ten-year average. Our provisional analysis of Q1 reveals another encouraging increase to the region of £2.5bn, but we would consider that subdued given the scale of the opportunity at hand.


Time to re-enter the market

Don’t just take my word for it. “Now is the right time to re-enter the market, otherwise the current pricing opportunity could likely be missed” said Barings last week, on European real estate. Kathleen McCarthy Baldwin, Global Co-Head of Real Estate at Blackstone, shared a similar view on CNBC discussing real estate values bottoming out and the opportunities they are seeing to deploy $65 billion of dry powder.

What are many waiting for? A small proportion of investors appear to believe capital values will soften a little further. Another slice appears to be anticipating more bank-led sales at bargain prices, while others are waiting for stock levels to rise, given the fact that some potential sellers think they’ll get a better price later this year. Of course, many are waiting for the first rate cut for the signal to start to deploy. But, having sat across the table from dozens of investors in recent weeks, there is really only one important ingredient missing, and that’s confidence.

Everybody is looking at everybody else, effectively saying “you go first”. That’s understandable in these moments. It’s often only with hindsight that you can see when one cycle ends and another begins, and the trigger is often a spate of deals that turns sentiment and begins to build real momentum.


The process of price discovery is over

It is possible that some of those moments have already arrived.

Blackstone’s £230 million deal at 130-134 New Bond Street at sub 4% is a boon for the retail sector and reflects a core play with core plus returns potentially on offer. BT group’s £275 million sale of the BT Tower to MCR hotels is a huge display of confidence. Nomura’s £64 million purchase of 55 St James’s Street at 4.25% also suggests core money may be returning. Royal London’s £192.5 million purchase of a 50% stake at 1 Triton Square, earmarked by British Land for a life science and innovation hub, is a perfect demonstration of the beginnings of a shift in sentiment. We’re aware of more deals that are imminent – the types that will reinforce our view that the market is liquid, and the process of price discovery is over.

The city market is yet to see further larger ticket deals, but it has seen confidence in market sentiment expressed in a different way. Take the withdrawal from the market of 20 Old Bailey and 5 Churchill Square, which suggests that for some sellers pricing had perhaps drifted down too far, and there is a conviction that there are better values to be had later in the year.

Here is what these investors, and many like them, are seeing: prime yields in the West End and City markets are steady at 4 – 4.25% and 5.75% respectively. Prime West End rents are running at £150 per square foot (psf), 7% higher than a year earlier. We’ll see another 14% growth during the next three years, according to our forecasts, and deals are already being signed in the late hundreds in markets like Mayfair and St James’s.

Prime rents in the City stand at £75 psf and will climb by around 9% through to 2026, according to our forecasts. The best spaces already command £95 psf. Yields in both submarkets will come down in the second half of this year, and early movers that simply opt to buy and hold stand to make sizeable gains as borrowing costs fall. The outlook may be even brighter for overseas investors purchasing in sterling, which has outperformed all of its major peers this year.


A narrow window

That’s the broad investment case, but there are other angles that investors are seeking to explore. As of March 5th, the 15,000 square foot cap on converting office to residential via Permitted Development Rights (PDR) has been lifted, and there is now no requirement to show the building has been vacant for three months before submitting a planning application. Obtaining consent to convert offices into homes via this method takes between eight and twelve weeks, compared to the two years it would take via traditional planning,

There is no certainty that this policy will remain in place under a new government, so investors have a fairly narrow window within which to pick off offices in locations that would be better suited to other uses.

Meanwhile, Marks & Spencer’s High Court win against the government’s decision to block the redevelopment of its Marble Arch store could act as a confidence booster to developers who may more readily consider appropriate redevelopment instead of heavily compromised remodelling.

The implications for the latter might not be huge at this stage – the government can appeal the ruling, but it’s undoubtedly another fair wind in the sails of that hard-to-measure phenomenon that we call sentiment.

Confidence has been missing for two years but if you take our data, two consecutive quarterly increases in investment volumes certainly signals the return of confidence and the start of the recovery. The deals we’ve seen in the past eight weeks suggest we aren’t far from the beginning of a new investing cycle. In fact, perhaps it’s already here.

The London commercial real estate recovery is missing just one vital ingredient