The speculative office funding market is back, and more players are getting in on the action than ever before. But success will rely on a clear, realistic vision of occupational demand and rental prospects.
Speculative financing of office development is a risky enterprise - but it's back. A growing number of pension funds, institutions and banks are prepared to take a gamble on occupational demand in the UK, financing the construction of major office schemes without so much as a sniff of a pre-let in place.
Hopes of a recovery in the occupational market and the prospect of rising rents traditionally drive such a vote of confidence in the commercial property development cycle. Research conducted for Skyline by property services consultancy CB Richard Ellis shows that in central London today, 771,000 m² of office space is under construction. Two-thirds of this figure, 511,000 m², is being built speculatively. A year ago, just 418,000 m² was under construction, of which 251,000 m² was speculative; so the amount of speculatively financed office development in the capital has doubled in the space of 12 months. Outside London, there is also clear evidence that developers in the regional cities are beginning to enjoy the same feelgood factor.
In the past few months, some impressive office schemes have attracted funding and will be built, many of them in the City of London. But will the rents be as impressive? A rush towards speculative development is always tinged with the fear of oversupply. Plus, there is a worry that the UK's latest spec dev push is actually an unfortunate side effect of Britain's booming investment market.
Commercial property's attractiveness as an asset class has never been greater and investment yields on well-let, prime office properties in the South-east hover around the 4% mark. Investors are also aggressively targeting regional cities. In April, two prime office properties in Glasgow were sold at record yields of 4.75%. But low interest rates and money from domestic, foreign and private investors competing to secure property investments are squeezing out institutional buyers, which target higher returns.
Get in early
The logic is simple: if you can't get in at the end, get in at the start. Forward-funding a speculative office scheme will typically net an equivalent yield of 6% to 7%, assuming the scheme lets up. An increasing number of UK institutions are prepared to stump up the cash and take the letting risk, but investment specialist and Liberal Democrat peer Lord Oakeshott, who is managing director of fund manager OLIM, argues: "Too much of today's development is driven by the investment market, not the occupational market."
"Timing is everything in spec development," says Mike Hannigan, investment director at Standard Life. "London office cycles are short and sweet, but we feel the market is coming back."
Standard Life has an in-house development team, but it will not invest more than 10% of a given fund's value in speculative development in the office, retail and industrial sectors.
In February, Standard Life agreed a £50m package to finance Delancey's 40 Portman Square, an 11,000 m2, office-led development in London's West End. Delancey had already rejected offers from occupiers to take pre-lets at £65/ft2, as it believes a shortage of large floorplate schemes could lead to rents rising to as much as £90/ft2 when the scheme completes in 2008.
Too much of today’s development is driven by the investment market, not the occupational market
Lord Oakeshott, OLIM
Standard Life is financing three more office schemes in central London. The mutual's decision to fund 200 Piccadilly in 2004 was driven by the stunted development pipeline in the St James area, and a 4600 m2 pre-let to Apax Partners has now, in Hannigan's words, "de-risked the situation". The other two offices, both in the City at One Old Jewry and 22 Chancery Lane, will be completed at the end of next year.
Do your homework
"Although there is a lot of development happening on Cheapside, we are going to deliver those schemes at the forefront of the development cycle," says Hannigan. "Development yields are over 7%, compared with under 4% in the investment market. If you do your homework, the risk/reward premium is sufficient to justify spec development. The projects we finance are things we want to hold in the fund's portfolios. Should we call the cycle wrongly and rents are lower than we'd like, we still own a property in a prime location and we will get reversionary value as rents increase."
Morley Fund Management is another active fund when it comes to spec development. In April, Morley and German fund DIFA agreed to split the financing of Paddington Central, a 23,000 m² office scheme in west London from Development Securities. In the West End core, Morley has financed the construction of the Curve in Lower Regent Street, which was let under construction to King Sturge, and is funding a further office scheme with Grosvenor at 77 Grosvenor Street. "We are developing to create investment stock," says Richard Jones, Morley's head of life funds. "We do feel the West End has a restricted supply pipeline and think rental growth will continue."
Jones manages four of Morley's life funds and balances the exposure to different sectors, areas, tenant profiles and speculative development. "It's my job to make sure we're not overexposed to any one area," he says. "But I'd prefer to be exposed to shiny new West End buildings - even if they're empty - than poorly located buildings with a year left on the lease that need to be developed."
Outside London, Morley agreed the £40m forward-funding of PMB Holdings' Abbey Mill House in Reading last October. The 15-storey tower, due to be finished late next year, will be the city's tallest office building. "There has been virtually nospec funding in the Thames Valley in the past five years," says Ed Jones, property director at PMB Holdings. "However, there is only 4600 m2 of prime office space available in Reading's city centre and nothing in the pipeline capable of being completed before our scheme."
Believed to be funded off £24/ft², which is Reading's prime office rent, Jones says he would be "hugely surprised" if the finished tower failed to command significantly more. "Speculative development is calling the start of recovery in the occupational market, not the peak of the investment market," Jones argues. "If the occupational market wasn't there, we wouldn't be doing this and neither would Morley."
Britain's three biggest quoted property companies are internally funded, the fact that Land Securities, British Land and Hammerson are all developing speculative offices in London is seen as a bellwether for the market. British Land is on site with 201 Bishopsgate in the City, which will deliver 76,000 m² in 2008, and could start 122 Leadenhall, which will be 56,000 m², next January. Hammerson has started its first speculative London office development for four years at 125 Old Broad Street. Land Securities, meanwhile, is pressing on with New Fetter Lane, part of which is pre-let to Deloitte, and aims to spec 20 Fenchurch Street, dubbed the "Walkie-Talkie Tower", if planning permission is granted next year.
One of my concerns about banks providing finance is that they haven’t been doing it for 15 years and there are a lot of players out there who I don’t think have the skills
William Newsom, Savills
CBRE's figures for speculative development levels in the City are starker that the central London picture. Of the 297,000 m² under construction, three-quarters (223,000 m²) is speculative, compared with only 56,000 m² a year ago. "Speculative starts have exceeded 139,000 m² in the past six months, demonstrating developers' confidence in a rental upswing,' says Richard Holberton, director of research at CBRE.
Banks on the look out
But it is the banks' attitude to speculative finance that is really getting the market revved up. In January, Minerva secured a £275m senior debt facility from Deutsche Postbank and Nationwide to finance the speculative construction of the Walbrook, a 41,000 m² office development in the City. Barclays and HBOS are actively looking for speculative opportunities, and funding agents report that banks have lost out to funds on several of the London schemes mentioned in this article.
"Speculative development is the ultimate property risk," says William Newsom, head of valuation at Savills. "Talking hypothetically as a valuer, if one creates a building that no one wants to occupy, it is not worth anything. There's no point talking about yields, as there will be no rental income to capitalise."
Bank lending for speculative schemes is something that concerns him. "Aside from the obvious fundamentals - research into the marketplace, performance of the occupational market, location and getting the right planning permission - the skill set of the development team is of paramount importance to letability," he says. "One of my concerns about banks providing finance is that they haven't been actively doing it for 15 years and there are a lot of players out there who I don't think have the necessary skills."
Michael Brodtman, head of valuation at CBRE, is less worried. "The amount of bank finance being provided for speculative development is really very small, and remarkably so," he says. "Banks have an appetite for development funding, but there is such a lot of equity floating around, it hasn't been required."
Banks and institutions "are certainly very happy to take more speculative risk than they were 12 months ago", says Julian Stocks, head of capital markets at Jones Lang LaSalle. "The key question mark is where occupational demand will come from, as that's what everyone is banking on."
As more players enter the forward-funding market - Legal & General and Axa Sun Life are tipped to be on the brink of signing major speculative deals - there will come a point where the letting risk intensifies and the trend ceases to become sustainable. The development cycle is clearly heading for a boom, but how many of these schemes will fall victim to the inevitable bust remains to be seen. The last word goes to Stocks: "I don't feel the funding market is overheating quite yet. People do have longer memories than you might think."
Skyline May 2006
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