Office market update Autumn 2023

UK office vacancy rate continues to climb.

Weak demand and strong supply are resulting in an ever-rising vacancy rate for offices across the UK, which has hit 7.7%, up from less than 5% before the pandemic. The pipeline of office delivery suggests that this trend is unlikely to reverse in the coming years as this year is set to be the biggest for net new office deliveries since 2008. There is currently more than 100 million square feet of vacant office space in the UK, and this is set to rise to 130 million next year.

The picture becomes more nuanced in city and local markets, however, where local drivers are producing different trends. And the flight to quality continues, meaning the picture also changes for best-in-class office space where demand remains resilient in many areas. This is evidenced by the expanding yield spread between prime and non-prime office assets, which was at 160 basis points for South East offices in Q1 2023, according to Capital Economics.

The headline message for the UK office market is that the recalibration in this market due to working from home has not yet run its course. Some employers are asking workers to attend the office more frequently, with the chief executive of Zoom, the video conferencing provider, recently saying that working solely through video calls was bad for creativity, as he encouraged workers back into the office. Goldman Sachs, the investment bank, recently reminded employees that they are expected into the office five days a week. However, it seems unlikely that office attendance will return to pre-pandemic norms, with many firms settling on a hybrid model – indicating the need for less office space.

In addition to this, the economic outlook signals that office jobs could be affected by a weakening in the labour market, which will have a knock-on impact on non-prime office yields.

London office take-up fell to the lowest level in two years in Q2 2023, and net absorption across the capital fell into negative territory. This comes as more space is being released into the market, a trend which is only set to continue as pipeline work completes over the next year. The vacancy rate is now at a 20-year high of 8.8%, up from below 5% at the start of 2020.

Demand for Grade A office space remains positive, however, amid ESG considerations and also as businesses seek to entice staff back into the office.

As companies continue to review their need for space to accommodate new hybrid working and take advantage of the cut in costs from having smaller floorplates, the demand for office space will continue to be muted, delivering weaker rental growth. Regionally there will be disparities, as firms in cities outside London, with shorter commuting times and less expensive office spaces, may not feel the need to resize, which could deliver less negative results to rental income. In London, rents will also be linked to supply. The large pipeline of space coming online in the City will put downward pressure on rents, while in the West End, a relative lack of supply (vacancy rates are currently at 3%) will prop them up to an extent.  

Average rents across the UK have remained surprisingly static over the last three years, despite the large recalibration in the market. There is evidence however, that this is being achieved by increased incentives. Overall UK annual rental growth is 1.3% in the year to August, according to CoStar, but growth is set to shrink through the rest of this year, and into negative territory next year, before recovering in 2025/26. Rental growth in Manchester is higher than the UK average, at 3.1%, but average rents in the city are also expected to fall next year, as they are in London where rental growth has been more modest at 0.9% in the year to date. As ever, rental performance will vary by locality, with tightly supplied markets, such as the West End of London, likely to outperform.

Investment levels slide.  After a rise in investment in UK offices at the start of the year, investment slowed in Q2, with annual sales levels falling to £8bn in Q2, down from more than £25 billion around this time last year. Higher borrowing costs and uncertain sentiment are acting as a drag on prices and activity, especially for non-prime assets.

Investment levels in Manchester have also fallen to £191 million in the last 12 months, compared to 5-year annual average of £627 million, while in London sales volumes were also very muted in Q2 after a modest bounce back in Q1, with a total of £1.2 billion invested, taking the rolling annual total down to £7.5 billion, the most modest sum since the financial crisis.

In the capital, some investors are taking advantage of the lack of competition where they see opportunity for re-development, creating Grade A office space in locations which are still showing healthy levels of demand. A former police station on Tottenham Court Road and 141 Wardour Street were both purchased in Q2 for redevelopment – both close to Elizabeth Line and Central Line stations. Investors are also searching for opportunities for office-to-resi conversion, or other alternative uses.

Distressed sales may soon become a more regular part of this landscape as re-financing pressures mount for some investors. The disposal of the Sancroft building in the City of London for £315m and 20 Canada Wharf for around £160m are two examples of distressed sellers.

Outside London, the appetite for Grade A office space was illustrated by the sale of the Halo building in Bristol, for £72.3 million, at a 5.6% yield. This also suggested a stabilisation of yields in key regional cities.

All office yields have softened by 90 bps in the year to the end of Q2 according to MSCI, pushed up by higher-than-expected gilt yields and the recalibration of the office market.  The gap between prime yields and secondary stock/locations is also clear. For example, in the South East, the average yield on prime property is 6.5% to 7%, whereas secondary stock in less established location, the yield is around 10.5%. Average yields for prime central London offices are at 5.25% in the City. Yields in prime West End have softened to a lesser extent, at 3.75% to 4%, up from 3.25% – 3.50% in Q2 last year.

Higher financing costs are likely to act as a drag on investment activity throughout the rest of the year.

Key investment deals:

Property address	Town / City	Date	Yield (%)	Sale Price (£m)	Buyer
10-15 Newgate Street EC1	London	Q2 2023	–	£315m	Mitsui Fudosan Co Ltd
Old Broad, Lion Plaza EC2	London	Q3 2023	6.0%	£209m	Lion Plaza Propco Ltd
50-60 Broadway SW1	London	Q1 2023	3.8%	£100m	Investra Capital
1 Sovereign Street	Leeds	Q3 2023	7.0%	£38,5m	Citi Private Bank
The Halo, Temple Street	Bristol	Q2 2023	5.6%	£72.3m	CBREIM
St James Square, Dalton Place	Manchester	Q2 2023	5.8%	£30m	Karrev Real Estate Fund +1

Key statistics:

Offices Q2 2023 unless otherwise stated	Central London	Manchester	Key Regional cities
**	**Current Quarter (last quarter/5 yr av)	**Current Quarter (last quarter/5 yr av)	**Current Quarter (last quarter/5 yr av)
Occupier
Availability rate	10.7% (10.2%/9.4%)	11.1% (10.9%/10.2%)	9.7% (9.9%/8.9%)
Vacancy rate	9.8% (9.2%/6.6%)	8.8% (8.5%/6.9%)	7.9% (7.9%/5.8%)
Rental growth % annual	1.56% (0.87%/-0.0%)	1.3% (2.6%/3.4%)	1.7% (1.18%/3.7%)
Quarterly take up sqft	1.9m (2.1m/2.6m)	0.46m (0.21m/0.48m)	1.04m (0.86m/1.4m)
Prime headline rent per sqft Q2 2023	£130 psf (West End) £82.50 psf (City)	£40 psf	£42 psf (Bristol, Birmingham) £37psf (Leeds) £29 psf (Newcastle)
Average rent per sqft	£58.66 (£57.32/£57.00)	£20.53 (£20.21/£19.00)	£19.96 (£20.02/£18.52)
Supply
Completions (net delivered) sqft	-68,000 (734,000/741,000)	228,145 (0/146,125)	71,325 (542,474/64,223)
Total under construction sqft	10.0m (10.1m/8.1m)	1.6m (2.0m/1.8m)	2.9m (3.4m/4.0m)
Investment
Quarterly Sales volume £	£789m (£1.7bn/£1.9bn)	£40m (£1m/£138m)	£197m (£45m/£418m)
Average yield %	–	7.4%	8.1%
Prime yield % August 2023 (Q1 2023)	City: 5.25% (4% – 4.75%) West End: 3.75%-4.00%% (3.75%)	6.0% (5.75%)	6.00% (5.75%)

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