- One-fifth of Canary Wharf offices empty
- London too dependent on flexible space, say analysts
Shares in the UK's four biggest London office real estate investment trusts (Reits) – Landsec (LAND), British Land (BLND), Derwent London (DLN), and Great Portland Estates (GPE) – sank last week after analysts at Jefferies warned that the market faced a “rental recession” due to a three-decade low in London office occupancy.
Not everyone is so downbeat, however. Other market experts argue that the quartet will be rewarded for investing in their London buildings with higher rents and valuations in the long run. Office owners have largely seen rents remain stable even while valuations have fallen.
The bear case from Jefferies' analysts Mike Prew and Sarim Chaudhry is that the amount of unlet London office space has reached a "tipping point" from which rents will fall. A fifth of Canary Wharf offices, 10 per cent of City offices and 7 per cent of West End offices are empty. The Jefferies analysts forecast that the post-Covid world of hybrid working will ultimately lead to a fifth less demand for London office space in the long term, drawing a parallel with the decline in shopping centre Reits from 2015.
Shopping centre owners' rent roll and value collapsed spectacularly in 2015, putting Hammerson (HMSO) into a spin it is still struggling to recover from, and killing off Intu entirely.
Based on its experience of previous recessions, Jefferies believes that a vacancy rate of around 8 per cent, which all three main London office markets have either exceeded or are close to exceeding, is enough to trigger a drop in headline rent. Throw in the increased need for incentives to get tenants into a building and general inflation, and it is difficult to see how the four office Reits will grow their net rental income in the coming years. Put into valuation terms, this means slashed target prices. Jefferies now sees 250p as fair value for British Land, down from 420p, and 465p from 641p for Landsec.
Jefferies is also bearish about the extent to which the London office market depends on flexible workspace providers, particularly the lossmaking WeWork (US:WE), calculating that leases to these tenants account for about a tenth of the central London office market. Jefferies said flexible operators had been “absorbing vacancies” and propping up rental demand, but that this demand would start to fall away. These tenants will struggle with a potential recession on the way and are likely to cut their leases, leaving London office landlords with even more empty buildings.
Higher, better, greener, stronger
The final bear point is the level of spending required to ensure buildings meet the higher, 'greener' standards both tenants and government regulation demand. Although the likes of Great Portland and Derwent have portfolios that almost entirely comprise new, top-of-the-range office buildings, Jefferies said British Land and Landsec own a lot of older, lower-quality buildings, alongside a portfolio of high-quality stock, which will require work.
Not everyone shares this pessimistic view. The same week Jefferies downgraded Landsec and British Land to ‘underperform’, Shore Capital upgraded them to ‘hold’ from ‘sell’, pointing out that the pair own many assets that are not London offices. Meanwhile, Stifel analyst John Cahill doubled down on his ‘buy’ case for both Reits.
Andrew Saunders from Shore Capital said the reality of the property market is "more than reflected in the current share price" of the four Reits, including the money British Land and Landsec need to spend on upgrading their portfolios. He added that there may be further net asset value (NAV) drops for the London office Reits, but could not see valuations getting as low as current discounts indicate. Landsec is currently sitting on a 35 per cent discount to net tangible assets.
He also said it is a mistake to look at vacancy rates in London overall – even on a sub-market basis – and apply that to the four London office Reits. First, none of those Reits own buildings in Canary Wharf, where the situation is most dire.
Second, Saunders argued that the Reit quartet operates in even more specific markets within the West End and the City where vacancy is low and demand high. Victoria, Fitzrovia, St James's and Mayfair in the West End, he said, are elite locations where there are few modern buildings available. “It comes down to distinct neighbourhoods and local markets,” he said.
"The bifurcation of the London office market will continue, with high-quality space supplied by LandSec and peers subject to high demand, in contrast to a poor outlook for the vast majority of the office subsector, which will not meet tenants' new high standards in terms of energy efficiency or appeal to staff," said Cahill at Stifel.
Saunders also said WeWork and its ilk cancelling leases could present an opportunity. All four Reits have their own flexible workspace brands under which they could soak up demand if and when flexible operators either in their buildings or nearby exit leases. “If you can’t beat them, join them – but do it better,” he said. Whether the London office Reits can do it better remains to be seen.
