The performance of the Central London office market is closely linked to the performance of the wider economy. It is now clear that the COVID-19 pandemic will precipitate a deep recession. CBRE is currently forecasting GDP growth of -3.5% for 2020. This would represent the weakest year for economic growth in the UK since 2009 (-4.2%).
In the immediate short-term, the market is likely to be severely disrupted by the change in society caused by the COVID-19 outbreak, limiting viewing opportunities as well as presenting other practical roadblocks. This will limit take-up in the near term, perhaps lasting until the end of Q3. Large occupiers who are driven by lease events and are therefore compelled to make a move remain active within the market despite the disruption. However, for smaller occupiers, or those whose requirements are based on expansion, the market has virtually ground to a halt.
In the longer term, the Central London office market is well positioned to weather the economic storm should the economy return to a degree of normality by the final quarter of the year. One of the key differences between the office market today and the office market in the pre-Financial Crisis period is the extent to which the occupier market has diversified. In the run-up to the Financial Crisis, the market was dominated by the finance and insurance sectors, representing 41% of take-up in 2006 (61% in the City). This left the market vulnerable when those sectors experienced a downturn. In the last 10-years, no single sector has accounted for more than 23% of demand, with a relatively even split between the financial sector, the creative industries and business services. This diversity of occupier type will provide the London office market with a large degree of resilience. In addition, we have seen a structural shift in the market towards new, high-quality buildings, enabling companies to densify their usage of the space and to carry out modern workplace strategies such as wellness. It is likely that in the aftermath of this current crisis, there will be an even greater focus on wellness, with “healthy” buildings likely to be in high demand.
In terms of rental values, COVID-19 is likely to cause downward pressure, but the impact is likely to be more muted than previous downturns experienced by the market.
Supply is low in London and the development pipeline is constrained. In September 2008 (when Lehman Brothers collapsed), 28% of the development pipeline was pre-let. As at the end of February 2020, 59% of the development pipeline had already been pre-let. Issues around social distancing at construction sites is likely to delay the completion of schemes currently under construction, and development starts are likely to fall given the uncertain economic outlook. This will further constrain the pipeline of speculative space in the coming months.
Options for firms looking for large, new, high-quality buildings is diminishing. At the same time, demand for those buildings, especially when driven by necessity, is likely to remain high. This could cause prime rents to perform better than in previous cycles.
There are potential downside risks for the London office market, however. Whilst the development pipeline is likely to remain constrained, predictions of falling office-based employment in 2020 (we currently forecast office-based employment in Central London will fall by 33,000) will lead not only to falling demand, but an increase in secondhand release space. Further additions to availability could arise should there be significant failure in the flex sector. Should a significant increase in vacancy occur at the same time as a fall in occupier demand, this is likely to lead to downward pressure on rents.