London Office Crane Survey Winter 2022 Caution during the flight to quality
With all of the turmoil over the past six months, and with the Bank of England forecasting a prolonged UK recession, it is hardly surprising that inflation and higher interest rates have taken their toll on London’s office market. Read full introduction
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New starts, at 2.5m sq ft, while up 6% over the previous survey, remained somewhat below the ten-year average of 2.9m sq ft. Moreover, completions, while also well up (71%) on the previous survey, at around 3m sq ft, were well below the 4.6m sq ft expected by us, largely due a shortage of materials and continuing supply chain disruptions. Meanwhile, the shift to refurbishments continues. They account for 26 out of 31 new starts, or 1.7m sq ft, around two thirds of total volume started. This uptick in refurbs undoubtedly reflects concern from local authority planning committees and occupiers about how embodied carbon is lost in the demolition process. But it may also be a symptom of developer caution – refurbs tend to be smaller, cheaper and quicker than new starts. This caution appears to have several causes. On the supply side, labour and material shortages, higher interest rates and material price inflation are playing havoc with pricing and tendering. On the demand side, the Bank of England is also warning of a recession lasting between five and eight quarters – if it's the latter, that would be the longest since the second-world war according to the FT. Combined with this cyclical downturn, developers now anticipate a structural decline of a full ten percent in the volume of space required per head, due to an increase in home working that was catalysed by the pandemic lockdown experience. With completions lagging our expectations, we now expect 2023 to be the 'year of the catch-up' in the London market. We then expect 2025 to be the 'year of the investor', as a potential rebound from the current recession, coupled with a supply squeeze, will create a new wave of opportunity for developers. In the UK's tight labour market, and with flexible working now embedded, developers, transport bodies and local authorities are combining to make offices a destination. In addition to high standards of sustainability, occupiers now want offices that are bright, airy and attractive, and surrounded by shops, bars, gyms and restaurants. This is undoubtedly an exciting time to be in real estate in London. We look forward to discussing our latest survey, and your thoughts on the market, with you over the coming weeks and months. Siobhan Godley Partner, UK Real Estate Leader
Key findings Welcome to our London Office Crane Survey Winter 2022 hub. Here you can access all of the latest commentary and data pulled together by the team at Deloitte. This time out we are focusing firmly on the data, and to make our key findings easier to navigate, we have grouped them into a series of important industry themes. We invite you to explore the thinking housed in each section, using our findings to inform your view of this fast changing market, and our interactive map to dig deeper into the different areas of London covered by the survey.
About the survey What? A report that measures the volume of office development taking place across central London and emerging London submarkets. Where? London, covering the central office markets: The City, West End, Docklands, King's Cross, Midtown, Paddington and Southbank, and emerging submarkets: Vauxhall-Nine Elms-Battersea, Stratford, and White City. Who? Developers building new offices or undertaking significant office refurbishment of 10,000 sq ft +. When? This survey covers the period from April 2022 to September 2022. How? Our team of researchers have walked the streets of central London to monitor office construction. Data on office construction in the emerging London submarkets is collected through online sources. This research is then verified against data provided by developers and input from our in-house property experts.
Theme 1: Development “The volume (in sq ft) of new Central London office construction starts increased slightly since the last survey, but it still remains below the ten-year average. Refurbishments remain a strong feature of this, representing over two-thirds of the volume (in sq ft) started” Sophie Allan, Director, Real Assets Advisory The tilt towards refurbishment continues, with fresh signs of new build growth in Q3 2022. Developers expect the shift to hybrid working to drive down the overall requirement for office space by 10% per head in the long term. But a tilt to refurbishment and 'flight to quality' will drive stronger demand for Grade A space. With the London office development pipeline forecast to grow next year, we believe 2023 will be the post-pandemic ‘Year of the Catch-up’ on completions.
Mathew Evans-Pollard Partner, Head of Development & Assurance, Development Lead +44 (0) 20 7303 3735 mevanspollard@deloitte.co.uk Sophie Allan Director, Real Assets Advisory +44 (0) 20 7303 3192 sophieallan@deloitte.co.uk
Volume of new starts increases slightly compared with last survey, but remains below ten-year average Central London: Volume and number of new starts per survey Source: Deloitte 31 schemes with a total volume of 2.5 million square feet (sq ft) were started between April and September 2022. This represents a 6% rise in volume over the 2.3 million sq ft started during the previous survey, but remains below the ten-year average of 2.9 million sq ft. Average new scheme size rose to 79,000 sq ft from 69,000 sq ft in our previous survey. This is largely due to the 556,000 sq ft refurbishment of BT's former headquarters at 81 Newgate Street, started in Q2 2022. Notably, the three largest schemes in our latest survey account for 41% of the total volume of new starts. There are 26 schemes currently in demolition/strip-out, with a total volume of 4.3 million sq ft. These are expected to start construction during the next survey period, between October 2022 and March 2023, and will probably drive a significant rise in new start volumes in our next survey.
Two major new build starts provide major uptick over Q1 2022, but refurbishment activity continues to dominate Central London: Volume of new starts - new build vs. refurbishment Source: Deloitte Refurbs remain a strong feature of new construction activity, with 26 of 31 new starts categorised as refurbishments, comprising a total volume of 1.7 million sq ft. This includes the refurbishment of BT's former headquarters at 81 Newgate Street, which on its own accounts for 556,000 sq ft. Elsewhere, over the past year, we noted the absence of larger new builds over 300,000 sq ft. None were recorded during the latest survey period, although two new build starts of over 200,000 sq ft helped bring the total volume of new build starts to 781,000 sq ft. This figure will likely continue to increase in the short term, with eight new builds each bigger than 300,000 sq ft currently in demolition. Nevertheless, over the longer term, we anticipate increasing drag on new build activity. ESG considerations have made local authorities less likely now to grant future demolition permits. In addition, the relative risk of new build projects versus refurbs may render the latter a more attractive proposition as the UK economic picture darkens. Following the UK pandemic lockdowns, another trend has been for developers to refurbish more large schemes of 200,000 sq ft and above, driving a relatively steady volume of refurbishment activity between surveys. During the same period, the volume of new build starts reduced, with fewer very large schemes of 300,000 sq ft and above commencing. Caution over working patterns leads to shift to refurbishment and established neighbourhoods, as hybrid working drives increasing demand for Grade A office space Central London: Volume of new starts by submarket Source: Deloitte With 18 new starts at a total volume of 1.1 million sq ft, the West End saw the highest number and volume of new starts this survey. By contrast, the City had about 0.8 million sq ft of starts this survey across six schemes, with 81 Newgate Street accounting for more than half of this amount. Midtown had about 0.3 million sq ft of starts across four schemes, while the Southbank saw about 0.1 million sq ft across three schemes. Docklands, King's Cross, and Paddington saw no new starts this survey. This lack of activity is not unusual however, since these markets (especially King's Cross) tend to see short bursts of activity when large new schemes (usually new builds) are started. The age of many buildings across the core sub-markets of the City, West End and Midtown is expected to fuel the trend towards refurbishment as the concept of "stranding" of buildings (because they are unable to meet more stringent climate and wider ESG demands, leading to a devaluation of the assets) becomes more embedded within asset management strategies. Continuing shortage of materials and supply chain failures push more completions out into 2023 Central London: Total volume of space completed per survey Source: Deloitte Completions are up by 71% over our last survey, with about 3.0 million sq ft delivered across 29 schemes during the latest survey period. However, we noted in our previous survey that we expected at least 4.0 million sq ft to complete during this period. Volumes were lower than previously expected as 20 schemes totalling 1.6 million sq ft were delayed by one-to-two quarters. This pushed projects into the next survey period and continues the trend seen in our last survey. If completions are on schedule, more than 6.0 million sq ft should be delivered in the next six-month survey period. Nonetheless, given what developers have told us about the continuing disruption caused by material shortages and supply chain failures, we expect the market will undershoot this figure once again. Completions have exceeded new starts, leading to a slight decline in volume under construction Central London: Total volume under construction per survey Source: Deloitte As of 30 September 2022 there are 108 schemes under construction across the Central London market, with a total volume of 12.8 million sq ft. This represents a 5% decline over a total construction volume of 13.5 million sq ft in our previous survey. We do not believe this indicates weakening activity, since the total volume of new construction starts is higher this time around. Rather, the drop in overall volumes is due to the total volume of completions exceeding that of new starts. This trend of declining 'under construction' volumes against a backdrop of rising new starts is also likely to continue in the future, driven by the ongoing shift toward refurbishment. Planners' increasingly favourable view of the 'reuse and recycle' approach that refurbishment provides, may make it more attractive than a new build solution, where the perception is that the carbon cost is greater. Refurbishments may also be quicker to deliver, adding to their attractiveness. Developers grow more cautious on leasing market conditions Developer Survey: 'Compared to six months ago, how do you currently perceive the leasing market?' Source: Deloitte Following a sustained period of optimism, developers are beginning to grow increasingly cautious about the state of the London office leasing market. Only 36% reported improving leasing demand over the past six months, compared to 45% who reported softening demand over the same period. Interestingly, this caution comes against a backdrop of recovering leasing activity following the sharp declines seen in the wake of the pandemic. This upswing in demand began in Q3 2021 and continues into this latest survey period. Nevertheless, in the face of intensifying UK and global economic headwinds, developers are clearly becoming more cautious about whether this nascent recovery in leasing demand will be sustainable over the longer term. We would also note that a reduction in supply could temper any downward trend in rental values, arguably providing a more positive medium-term stimulus from a rental growth perspective. Developers expect the ongoing shift to hybrid working will reduce overall requirements for office space by 10% per head over the long term Developer Survey: 'What impact will homeworking have on the amount of office space tenants will be taking long term?' Source: Deloitte Developers told us they expect firms will require less office space per head going forward. The majority (70%) think demand will decline by 10% in the long term, a trend we believe is driven by an accelerating shift to hybrid working. Tenants are increasingly seeking better quality office space with higher sustainability and wellness ratings. This is evident in our latest leasing data, with the largest leasing deals focused on space in recently completed, under construction and soon to start schemes. We expect overall demand for Grade A space to increase over the long term, despite reduced total office requirements per occupier as a result of this overarching trend. Legal sector pre-lets largest proportion of space in current ongoing construction projects Central London: Percentage of pre-completion lettings by sector Source: Deloitte Our data shows that 31% of volumes under construction as of 30 September 2022 had already been let to tenants. The legal sector (comparatively small compared to all real estate occupiers in London) has seen the largest proportion of under-construction pre-lets, representing one-third of total pre-completion let volumes. Of this letting volume, we note that Kirkland & Ellis secured 218,581 sq ft at 40 Leadenhall in June 2022. This was the largest legal leasing deal signed during the survey period. However, looking at all current ongoing construction projects, we would also note that this deal is still overshadowed by Linklaters’ leasing of 379,000 sq ft at 22 Ropemaker in February 2020. By contrast, the share of pre-completion letting volumes taken by financial services firms has shrunk by almost half in under five years, as the effects of cost-cutting and Brexit combined to reduce the sector’s London footprint. Looking at all office leasing deals for spaces above 50,000 sq ft across Central London, not just those under construction, we see that most deals were struck by financial services and legal firms here too. These deals were concentrated in the City and West End areas of Central London. Also, in the majority of cases, the stated reason for these deals was a desire to move to accommodation with stronger ESG credentials, supporting employee wellbeing and the brand image of the occupier. Emerging submarkets see no new construction activity over the past six months Other submarkets: Total office space under construction Source: Deloitte With no new starts, and only one completion in White City during this latest survey period, the total amount of under construction activity in our emerging submarkets has dropped by 9% to about 1.4 million sq ft since the previous survey, when the total stood at around 1.6 million sq ft. Vauxhall-Nine Elms-Battersea (VNEB) has only one scheme expected to complete next survey, which should add about 30,000 sq ft to the emerging submarkets. The remaining schemes in VNEB and Stratford are expected to deliver in late 2023 and 2024. Gateway Central and 1 Wood Crescent in White City are on course for completion in the next survey period, adding 390,000 sq ft of office space to the emerging submarkets.
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Theme 2: ESG “With tenants seeking better quality accommodation offering demonstrable ESG credentials, developers are focusing increasingly on the refurbishment of existing stock as a means of addressing 'stranding risk'. Net zero targets and legislation to support the commercial case for net zero development remain unclear and it remains to be seen whether the current macroeconomic headwinds will stifle progress. However, with both occupational and investor stakeholder pressure mounting we expect the shift towards greater alignment from developers with the ESG agenda to continue.” Philip Parnell, Partner, Head of Valuation and Real Estate Climate & Sustainability Lead Developers want greater clarity around net zero targets and legislation to support the commercial case for net zero development. More than three-quarters of developers say their new developments will be net zero by 2034.
Philip Parnell Partner, Head of Valuation and Real Estate Climate & Sustainability Lead +44 (0) 20 7303 3898 pparnell@deloitte.co.uk Jo Hills Director, Real Assets Advisory +44 (0) 20 7303 2098 jhills@deloitte.co.uk
Developers become more cautious about when climate targets will be achieved, with most anticipating reaching net zero on new developments beyond 2030 Developer survey: 'By when do you think all your new developments will be net zero?' Source: Deloitte 54% of developers in our latest survey expected their developments would achieve net zero emissions only after 2030. This compares to 70% who foresaw net zero emissions before 2030 in our Winter 2021 survey, just a year ago. We believe this downgrading of expectations is due to developers gaining a better understanding of what is required to achieve net zero, even though a universally accepted definition of the term remains on the ‘wanted list’. This may be a result of experiences gained in recent developments, and underlines the challenges associated with achieving net zero. When asked about changes the government and the wider industry need to make to achieve net zero developments, most developers wanted greater clarity around net zero targets and legislation to support the commercial case for net zero development. As noted in our previous survey, the lack of clarity regarding what ESG standards to adhere to, and what it means to achieve net zero, is further amplifying the caution of developers and increasing their perception of business risk.
Theme 3: Investment “The investor community is focused not only on traditional economic factors but now on the changing workplace environment and the need to meet growing ESG demands of both its tenants and stakeholders” Tony McCurley, Senior Advisor, Real Estate Looking further ahead, we believe 2025 will be the 'Year of the Investor' as a rebound from recession coupled with pressure on stock creates fresh opportunities.
Tony McCurley Senior Advisor, Real Estate +44 (0) 20 7007 0614 tmccurley@deloitte.co.uk Lauren Raw Manager, Family Office Real Estate Investment Advisory +44 (0) 20 3741 2131 lraw@deloitte.co.uk
Delayed starts to raise expected supply in 2026 Central London: Future office development pipeline Source: Deloitte Looking at the schemes with planning permission and those in demolition/strip-out gives us a useful view of the likely future supply of office space in Central London. The latest data shows an additional 15.6 million sq ft of new office stock is expected to be delivered between 2023 and 2027, all of which is yet to begin construction. Following post-pandemic delays, 2023 could be the 'Year of the Catch-up' delivering the highest volume of new office space for twenty years, although that would presuppose no major completion delays over the coming year, an optimistic assumption given current macro trends. Looking further forward we expect 2025 will be the 'Year of the Investor', as the real estate industry potentially rebounds from the UK recession and as pressure on stock stimulates rental growth, creating a wave of fresh opportunity for developers. In our previous survey we also noted that 80% of London office stock was graded 'EPC C or below'. Developers, we said, would need to build or upgrade approximately 15m sq ft per annum of office space. This would allow them to meet the government's proposed 'EPC B or above' standard by the 2030 deadline, while maintaining current levels of stock. On current trends we are set to fall short of this level. And, with developers projecting a 10% reduction per head in leasing demand overall as a result of hybrid working and other factors, this could lead to an acute supply squeeze going forward.
Growing pessimism from developers over short-term pipeline outlook Developer survey: 'Compared to six months ago, how do you expect your pipeline to change in the next six months?' Source: Deloitte 55% of developers expect their development pipelines will decrease over the next six months. This is a markedly more pessimistic outlook compared to the expectations expressed in our Summer 2022 survey, where 65% expected their pipelines would increase in the short term. Ongoing construction delays, rising costs, and financial and economic uncertainty are all likely to be driving the more pessimistic pipeline outlook of developers that we observe over both the short and longer term. This, we believe, will provide opportunities for investors to acquire sites at lower prices as existing asset owners feel macro conditions bite. Against this backdrop, real estate lending appetite is waning, with the market expecting lending rates either to drop over time or, at worst, stabilise at elevated levels. This has led some lenders to temporarily withdraw from the market. Elsewhere, others who lend against land are actively seeking repayments now to protect against future drops in land prices. While some lenders will remain open for business, they are likely to exercise greater prudence in initial advance rates in the absence of predictable outcomes. Going forward, we anticipate development lenders will be more cautious on Loan to Gross Development Value (GDV) as they become more wary of predicting commercial rents and exit yields for trading to investors. As a result, we expect investment yields in the City in particular to move much higher in response to this market.
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Theme 4: Cost "We have seen since mid-2022 a material slowdown in investment, development and construction activity as the participants re-examine project viability in the light of continuing tender price inflation in supply chains and, in particular, material cost increases. General contractors are being pressured for cost certainty, yet are working with multiple sub-contractors on various packages and hence have limitations to controlling pricing. Developers and investors have less conviction on viability and exit yields now that interest rates have significantly raised both the cost of funding a development and changed the relative value dynamics of risk free asset classes. A resetting of the RE investment arena is ongoing and transactions will resume. Fresh confidence now requires a more prudent set of underwriting assumptions reflecting a more normal long term average interest rate backdrop and bringing a closer alignment of buyside / sellside expectations. Clearly a more stable political environment is always preferred, but the RE investor market has shown time and again that it can adapt well to macro events. The era of ultra cheap debt is now over." Chris Holmes, Partner, Head of Real Estate Debt Advisory Cost continues to be the number 1 drag on construction activity, according to UK developers. Rapidly increasing debt funding costs will weigh further on scheme viability where sites are already held. This, together with inflation in tender prices, will exert downward pressure on future land prices.
Chris Holmes Partner, Head of Real Estate Debt Advisory +44 (0) 20 7007 2873 cpholmes@deloitte.co.uk Sophie Allan Director, Real Assets Advisory +44 (0) 20 7303 3192 sophieallan@deloitte.co.uk
Pricing expectations still remain high over next 12 months Price Expectations over next 12 months; Inside M25 Weighted by Market Source: Deloitte We see strong consistency in pricing expectations between our two surveys, across office, residential and fit-outs, with residential showing slightly higher pricing expectations than office. Separately, 80% of respondents expected prices would continue to rise. A further 60% of respondents also expected price rises to be permanent and to become embedded in the market.
Costs and funding seen as the biggest challenges to construction by developers Developer survey: 'What are the biggest challenges to development today?' Source: Deloitte Developers continue to rate construction cost as their top challenge, though the number seeing this as the greatest challenge is lower than in our previous survey. Availability of funding has also jumped in importance, with more than a quarter of developers citing it as a worry, compared to none in the previous survey. The increasing cost of materials, coupled with rising energy tariffs, is driving up the cost of construction. With no let-up in sight, we anticipate that construction costs are likely to remain a major challenge over the near term. Rapidly increasing debt funding costs will also continue to weigh on scheme viability where sites are already held. This, along with inflation in tender prices, will continue to exert downward pressure on land prices going forward. Energy costs showing marked increase as a proportion of underlying cost drivers If you have expressed a change in your prices over the last 12 months, we would like to understand what has driven this change. Source: Deloitte Energy prices are having an increasing impact on the cost of construction, placing third in our list of drivers of price changes, behind labour and materials The construction industry is approaching the situation pragmatically, balancing business resilience against the need to secure an appropriate level of turnover. They are also increasingly asking for pre-construction service agreements so that they can develop designs at a much earlier stage than usual. Being able to confirm designs earlier allows trades to place orders sooner and mitigate pricing risks that could arise during construction. Minimum bulk orders and the high priority placed on standardisation of components has also helped reduce pricing risk, as has the use of alternative material suppliers. Expectation of future workload growth falls Workload: Considering your workload today, how do you think this will differ in 12 months' time? Source: Deloitte Expectations are still positive for growth in overall workload, although they are markedly down from our previous survey. Since then, we calculate that the average expectation of workload growth has dropped by half, from 6% to 3%. However, feedback gathered from our survey suggests that the building trades have 60% of their work over the next 12 months already accounted for. In previous surveys this figure was typically around 50%. Expectations of price rises are consistent between our two most recent surveys What is your view as to how your prices will change over the next 12 months? Source: Deloitte On average, building trade respondents expect their prices will rise by 10.8% over the next 12 months, consistent with the level seen in our last survey. Superstructure trades describe lower volatility in the market, although predicted rises are still above long-term norms. Services on the other hand have been most affected by recent currency fluctuations. More widely, rising input costs have led to increased levels of insolvency among sub-contractors. This has reduced the number operating in the market, leading to increased prices. The remaining sub-contractors are also more cautious now in their estimating and pricing. UK CFOs cite energy supply, geopolitics and rate rises as key risks, according to Deloitte CFO survey Risk to business posed by the following factors Weighted average ratings on a scale of 0-100 where 0 stands for no risk and 100 stands for the highest possible risk Note: *"Higher energy prices or disruption to energy supplies" is a new risk to business added in the 2022 Q3 CFO Survey Source: Deloitte Respondents to Deloitte's latest CFO Survey rated external uncertainties at their highest levels since the pandemic. This is in large part due to the current economic outlook, characterised by factors such as declining growth, geopolitical tensions, and the anticipated UK recession. With the war in Ukraine threatening Europe's energy supply, unsurprisingly CFOs rated higher energy prices and disruption to supply, together with rising geopolitical tensions, as the top two risks to their businesses. The prospect of further interest rate rises and higher inflation follow close behind as the economic headwinds facing businesses grow. These factors are likely to impact construction directly. For example, according to the latest S&P Global/CIPS UK Construction Purchasing Managers' Index, higher fuel prices are already leading to sharp rises in input costs across the sector. The rapid reversal of monetary policy and increase in interest rates towards longer term averages took many real estate investors by surprise. Interest rates, and the cost implications of managing rate risk over business plan horizons via hedging, have become strong focus areas for investors. This follows a long period in which stability was taken for granted, and investors did not need to worry about interest rate risk or hedging strategies. Volatility arising from the rapid transition has generated greater uncertainty, negatively impacting many business plans, especially development projects. This is also starting to feed into new site entry prices and is creating a sense that current land costs are now too high.
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