Office market update Q2 2023

UK office vacancy rate hits near 10-year high but prime space still at a premium.

Office take-up gained some momentum towards the end of Q1 as employees continue to return to the workplace in greater numbers. But overall demand for office space remains muted compared to historical norms. 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.

As a result, UK net absorption remained in negative territory in Q1, and the vacancy rate was at 7.6%, the highest level since 2014. It is tipped to continue to rise, hitting 9% next year, according to CoStar.

In central London, net absorption also fell into negative territory in the first three months of the year after rebounding last year, but again this is linked to the high levels of office supply in the capital, which accounts for more than half of office construction taking place across the UK. Available space in this market is 50% higher than early 2020. The vacancy rate in London is higher than the national average at 8.9% – up from 5% when the pandemic started.

Underneath the headline data however, the flight to quality continues, with the demand for best-in-class office space, in the best locations, being registered across all the UK’s major cities. Some companies are upping their requirements in terms of specification, but reducing their footprint (eg HSBC, Clifford Chance). However, there are other firms that are looking to expand their offices, especially in regional cities, with TV streamer Roku leasing 250,000 square feet in Manchester, Cardiff and Cambridge. The public sector has also been active in office take-up over the last few years.

Co-working businesses are also taking more space, tapping into the trend for hybrid working, and for firms looking for flexible space. But this trend itself is creating another split in the market – the difference between larger and smaller offices. Typically, smaller offices would have catered for the businesses now choosing co-working or flexible office spaces. Vacancy rates for sub-15,000 sq ft buildings is rising in London.

The demand for quality office space is also being driven by ESG considerations. Companies, their clients and investors, are all becoming increasingly aware of their own carbon footprint and operations. Legislation around MEES compliance will also accelerate the availability, and in some cases obsolescence, of older stock where retrofitting is not viable. From April this year all offices must have an EPC rating of at least E, rising to C in 2027 and B in 2030. This has meant that pricing of older buildings has come under greater downward pressure.

The WFH trend cemented during the pandemic is unlikely to fully unwind in the near or medium term. But there is evidence that more people are making the commute more often – with the Department for Transport data showing that national rail passenger numbers have reached over 100% of pre-Covid levels of the first time since March 2020. There have also been some high-profile comments from business leaders and policymakers calling for employees to return to the office, from Elon Musk calling working from home “morally wrong”, to Chancellor Jeremy Hunt saying that office working should be the default. Pushing the pendulum fully back to pre-pandemic norms is now unlikely, but with tougher economic conditions ahead, more businesses may start to ask employees to be in the office for 3 or 4 days a week.

After posting falls in 2021, office rents in London are rising modestly once more, but increased incentives are protecting this rental growth. Across the UK, rents are up 1.6% on the year.

Investment levels start to build  

UK office investment levels picked up slightly in the first three months of the year, from a 10-year low in Q4 2022. While the political upheaval of late last year which caused market volatility has settled down, the economic backdrop remains challenging, with rising inflation and interest rates, putting particular pressure on properties which need refinancing.

Office values continue to fall as the segment comes under pressure from hybrid working trends and heightened risk of obsolescence. Central London office values were down -0.9% in March and -1.9% over the last three months.

In London, investment levels also picked up pace from a very slow Q4 last year despite the ongoing disparity between the pricing expectations of vendors and purchasers. A notable deal was the sale of Winchester House, 1 Great Winchester Street, EC2 for £255m at a NIY of 5.3% to Castleforge Partners and Gamuda Berhad as a redevelopment play.  The property is currently let to Deutsche Bank on a lease due to expire in October 2023, when the bank is set to move to its new London headquarters at 21 Moorfields.

There were some notable deals during the quarter, for example the £190 million sale of 50 Finsbury Square at a yield of 4.4%, and the purchase of 60 Gracechurch Street by the Obayashi Corporation for £140 million (4.7% NIY) as a redevelopment play.

Yields have continued to soften across the board, with average yields for prime central London offices at 4.75% in Q1 2023 in the City, some 75 bps higher than last summer. 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. In other cities, prime yields are +100bp higher between 5.75% and 6%.

Key investment deals:

Key statistics: (Q1 2023 unless stated otherwise)

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