The commercial office industry meets in gloomy mood this week, but if occupiers, developers and financiers work in partnership, they could open up the sector

mug rawlinson

The cream of the commercial office industry meet in Manchester this week at a challenging time for the industry. After an encouraging 2010, demand for new space faltered in mid 2011. Further loss of confidence led to some high-profile deferrals at the beginning of the year. The future project pipeline is looking much less healthy. The financial performance of office investment has also deteriorated - led by declining capital values. Furthermore investors in existing property continue to face their own finance challenges. According to recent research by De Montfort University over £100bn of existing debt is secured on property with a loan to value ratio of over 70% - debt that cannot not be refinanced on current market terms, which is likely to be “rolled-over” by the current lender.

The industry is firmly divided into haves and have nots. The London-based REITs such as Land Securities and Derwent London have recently reported solid results backed by new lettings and a continuing programme of development. By contrast, smaller scale and speculative developers, particularly those operating outside of London, struggle to find finance and the pre-lets necessary to unlock the money. De Montfort’s recent property lending survey reports that no lenders are prepared to provide project finance for speculative development - squeezing the market further while tenants delay their relocation decisions.

Over £100bn of existing debt is secured on property with a loan to value ratio of over 70% - debt that cannot not be refinanced on current market terms

In the short to medium term, outside of the property industry itself, this is a containable problem. Recent research by DJ Deloitte noted that rent levels in London have been sustained during the slump as a result of the maintenance of a balance between supply and demand. Both supply and demand are running at very low levels. 2011 saw the lowest level of completions in London since the early nineties - 65% below the long-term average - and the lowest level of take-up in a decade. But what happens when the economy recovers - can the clients of the industry be certain that the right sort of space will be delivered in the right location?

In London, there are signs of acceleration. According to DJ Deloitte’s May 2012 crane survey, office space under construction has increased by 28% in the past six months. However, volumes remain low in absolute terms. Although the West End of London is seeing a rapid increase in office construction, fringe markets such as Docklands and King’s Cross are seeing the first activity for some time. Outside of London it is difficult to generalise, but again levels of demand are down, and with new supply being constrained, rent levels are being maintained.

Current low levels of office construction - 35% below the UK long-term average - are a concern to the industry supply side. EC Harris research shows there is a pipeline of over 50 million ft2 of potential office development at different stages of design and procurement - equivalent to around seven years of take-up. Much of this will never get built, and given funding constraints, there is a possibility that, by the time occupiers decide that they need new space, competition will start to drive up rents - affecting the viability of the original decision to relocate. 

There is a pipeline of over 50m ft2 of potential office development at different stages of design and procurement - much of it will never get built

This challenge may be even more marked in the UK’s “buoyant” cities such as Cambridge, where above-average rates of office-based job creation is expected in new creative and technology-based industries. Centre for Cities and BCO Research has suggested that due to a lack of development activity caused partly by limited opportunities for pre-let, these dynamic locations have attracted less office space than they should have - potentially holding back a driver of future economic growth. These markets characterised by smaller occupiers with the need for flexible leases to accommodate growth, present great opportunity but are particularly difficult to support in the current market impasse.

So what steps could help to unlock this market? Clearly, reducing the cost and time of a development will help, so it is not surprising to see a rapid increase in the volume of refurbishment in the pipeline.  However, many occupiers will continue to want new space and with few developers active in the market, the risk is that the space will not be available in time when occupiers finally return to the market. How occupiers, developers, investors and lenders work together in partnership to unlock future investment or to upgrade existing buildings will be crucial not only to provide the quality, low-energy space that business needs to be effective, but also to maintain the diversity and dynamism of one of the construction industry’s most important sectors.

Simon Rawlinson is head of strategic research at EC Harris