The Competitiveness of London s Business Property Offer

Transcription

1 The Competitiveness of London s Business Property Offer CB Richard Ellis Limited St Martin's Court, 10 Paternoster Row London EC4M 7HP Tel: +44 (0) March 2010

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3 CONTENTS FOREWORD...1 EXECUTIVE SUMMARY...3 INTRODUCTION AND SCOPE...7 London as an International Financial Centre...7 Importance of Property in Relation to London s Competitiveness as an IFC...7 The Impact of the Credit Crunch on London s Office Market...9 Scope of Study...10 Structure of Study...11 Market Definitions...12 OCCUPANCY COSTS...14 Introduction...14 Measurement...14 International Financial Centre Comparisons...15 Are Rent Changes Correlated Across the Top-Ranking IFCs?...17 Cost Pattern within London...18 Rent Pattern across IFCs...20 Hedge Funds and Top Rents...22 Availability by Rent...22 OCCUPIER CHOICE...25 Introduction...25 Availability...25 SUPPLY RESPONSIVENESS...30 Introduction...30 London Office Supply...30 International Financial Centre Comparisons...31 Tall Buildings...32 Development Volatility...34 REAL RENTAL CHANGE OVER TIME...36 Introduction...36 London...36

4 International Financial Centre Comparisons...37 LOOKING FORWARD...39 The Outlook for Rental Values...39 Property Taxation...39 Supply Capacity and Development Activity...41 Infrastructure...42 New Locations...45 CONCLUDING THOUGHTS...47 APPENDIX A REGRESSION ANALYSIS...50 APPENDIX B CORRELATIONS IN IFC RENTAL CHANGES...51

5 FOREWORD Stuart Fraser Chairman, Policy and Resources Committee City of London This report, undertaken for us by CB Richard Ellis, reviews the current and future competitiveness of London s business property, making comparisons with other international financial centres. The report provides a valuable insight into the commercial property offer that makes London work well as a current location for international firms and what we need to do to adapt to the future. London s pre-eminence as a world class financial centre is due to a rich mix of inter-related factors including its access to markets, the quality of its regulatory framework and the depth of its financial expertise and knowledge. London also provides an extremely competitive property offer for financial and business related services. The locations of choice for large financial occupiers are the City of London and Canary Wharf. Both have rents significantly below London s top office rents and are competitive with other leading financial centres. London office rents have fallen by 54% in real terms over the last 30 years which partly mirrors a well-established trend in most international financial centres. In particular, City of London and Canary Wharf rents have fallen more rapidly than in other major financial centres such as Tokyo, New York and Frankfurt. London also has a wide spectrum of office space available at different rental levels in different parts of the Central London market adding to its competitiveness. The London property offer has grown significantly over the last 20 years and the future expected pipeline provides a match to future expected growth requirements, especially as improvements in transport infrastructure make outlying areas more attractive to those occupiers needing swift access to the centre but seeking a lower cost solution to their property requirements. Although London has good current availability for modern large floorplates, the report suggests it is less responsive to meeting new demand for larger units. This is due to existing planning constraints and lack of speculatively built product in this range effectively giving a long lead time into development. With a number of significant transport schemes due to complete within the next decade in London, the authors identify an extraordinary potential for these to reshape the pan-london office market. They are likely to unlock development opportunities in a wide range of locations, 1

6 from the well-established markets such as the City of London and Canary Wharf to emerging locations such as Stratford and Paddington. London s position as a global financial centre depends on its retaining a fully friendly environment for international business - a fair, consistent and predictable tax policy and supervisory environment, and access to open markets in the UK and globally. Property is an important component of its commercial offer. The forces that have driven London s office market growth also generate pronounced cycles in development activity. There is every reason to think that these forces are likely to persist in the future. London s property market has evolved progressively in the past 25 years so that the planning framework provides less of a rigid constraint on office supply than it once did. This should be further encouraged with a high priority attached to further reducing planning uncertainty and shortening timescales between approval and development wherever possible. Stuart Fraser London March

7 EXECUTIVE SUMMARY London s pre-eminence as an international financial centre (IFC) is due to a range of complex inter-related factors ranging from the regulatory framework to the depth of London s financial expertise and knowledge. London s property offer is not considered an important pull or push factor; however, it is becoming more important as competition amongst IFCs increases. The purpose of this report is to assess the competitiveness of London property offer against other IFCs. Occupancy Costs Given London s standing along with New York as one of the two truly global financial centres, the city s office market compares favourably with other leading financial centres in cost terms. The City of London was ranked 9th most expensive compared with other global office markets according to a recent CB Richard Ellis rent survey. In contrast, the West End was ranked the most expensive office market. Importantly, it is the City of London and Canary Wharf that are the locations of choice for most financial occupiers, although the West End is an important location for some specialist financial occupiers such as hedge funds. Cost patterns within London are markedly different. The top grade A rent in the City of London was per sq ft at the end of 2009, while the equivalent rent in Mayfair and St James s was per sq ft. The competitiveness of London s property offer extends to the high proportion of available space on offer at relatively low rents. An analysis of grade A availability in Central London shows that the majority of grade A space is on the market at a quoting rent of less than per sq ft and around a third at a quoting rent below per sq ft. In contrast, only 4% of units quote a rent above per sq ft. London s ability to compete on cost is highlighted by comparisons with other IFCs. London has a similar profile of availability by rent to Paris 71% of available units are quoting a rent of less than per sq ft in Central London (outside of the West End), compared with 73% in Paris and 86% in New York. Statistical analysis shows that rents in London are very competitive given its ranking as a financial centre and the size of its population. These findings suggest that the ranking of an IFC is a significant determinant of occupancy costs, particularly across European IFCs. Comparing predicted occupancy costs with actual values shows that for the 26 IFC markets, population and Global Financial Centres Index (GFCI) 6 ranking are good predictors of occupancy costs. On this basis, occupancy costs in London, represented by the City of London, are significantly lower than London s GFCI ranking and population would 3

8 suggest. On the other hand, occupancy costs faced by core West End occupiers are above predicted values. Occupancy Choice The availability of the appropriate size and quantity of space is another important consideration for occupiers when comparing locations. On this basis, London rates well on some measures and less so on others. As measured by the vacancy rate (which measures the amount of space available for immediate occupation), current office availability in Central London is nearly on a par with New York, lower than Hong Kong and Singapore and higher than Paris, Tokyo and Geneva. A review of how well IFC markets can respond to specific requirements shows that Shanghai benefits from the exceptional scale of its building boom and is able to offer a large number of options to suit different requirements from the smallest to the largest of occupiers. London compares well with other centres when looking at its capacity to accommodate a requirement for a 20,000 sq ft unit on one floor, but less well on bigger buildings. This reflects the recent surge in demand that has depleted availability of new stock. It is also a timing issue as it takes time to deliver new stock in Central London even when planning consent is in place; for some large developments from demolition of the existing building to completion of the new building takes 3-3½ years. Zurich and Hong Kong fare poorly on all availability criteria. In the case of Zurich, planning controls and the structure of current stock explain this, while the key issue for Hong Kong is the lack of land. A market s capacity to respond to demand through changes to supply is another measure of its competitiveness. Central London s stock level has grown by 14% since 1994, although this excludes large increases in stock levels during the early 1990s. This is largely due to development constraints in key markets such as the West End. In other Central London markets, stock levels have risen more quickly. The City of London and Canary Wharf markets have seen combined growth of 30%. By comparison, stock levels have increased much faster in some other IFCs, for example, Hong Kong, Singapore and Frankfurt have all experienced increases of 40% or more between 1994 and Since 1995, Shanghai s remarkable construction boom has seen its office stock level rise ten-fold, albeit from a low base. Real Rental Change Over Time Taking into account inflation, London has become a much cheaper location over the last 13 years. In nominal terms, rents in the City of London have rarely exceeded the peaks set in previous cycles, while nominal rental growth has been much stronger in the West End. 4

9 However, in real terms adjusted for inflation City rents have fallen by 25% and 9% in Canary Wharf since 1996, whereas West End rents have risen by 20%. This is a feature across most IFC markets over the last 13 years with Singapore, Shanghai and Hong Kong seeing large falls in real rents. Over this time period, Paris CBD and Zurich have shown relatively large increases in real terms. Concluding Thoughts London has a competitive property offer when compared with other leading international financial centres. Rents in the City of London and Canary Wharf, the locations of choice for large financial occupiers, are highly competitive with other leading financial centres. London office rents adjusted for inflation show that rents for the City of London and Canary Wharf have fallen significantly in real terms more than in other major financial centres such as Tokyo, New York and Frankfurt. London has a wide spectrum of office space available at different rental levels in different parts of the Central London market. The proportion of units on the Central London market (excluding the West End) at quoting rents below per sq ft is broadly in line with Paris and New York. The City of London and Canary Wharf have been major contributors to the rising Central London stock levels. London competes fairly well with other IFCs in terms of current availability. It has a good offer for modern large floorplates, e.g. a single floor of 20,000 sq ft. It is less capable of responding to demand for larger units from current stock, because of recent strong demand, and from future stock in the next 2½ years, which reflects the timing of supply. This highlights the aspect of London s property offer which is most problematic for occupiers in that supply is inelastic with pronounced volatility in both development and rental levels. This makes planning difficult and uncertain. It can have major implications for occupiers in terms of cost and choice at particular points in time. Looking ahead however, London faces a number of challenges and opportunities that will have a bearing on the competitiveness of its property offer. Rents in London are about to begin rising which will make it more expensive compared with other IFCs, although this impact will be lessened by similar pressure across other IFC office markets. The good news from a London perspective is that rents in the City of London and Canary Wharf have not increased in real terms over the last few rental 5

10 cycles, with significant increases in stock levels helping to contain rental pressures in both markets. The lesson for the future is that when markets can adjust supply relatively freely to accommodate demand, it relieves rental pressures and consequently restrictions on development have the opposite effect. London already has higher property tax and service charges compared with most other IFCs, which is an obvious disadvantage. Planned increases to business rates from the rating revaluation and the Crossrail levy, although having a marginal impact on occupancy costs for the City of London and Canary Wharf occupiers, will disadvantage London further. Over the longer-term, London has major potential supply capacity with a large proportion in new locations which will further expand the Central Business District. Significant transport improvements, including Crossrail, will help to unlock much of this supply potential. As a result, the market will evolve to a polycentric structure, helped by transport infrastructure improvements. These will enhance London s competitiveness in relation to property offer and provide occupiers with a greater choice of locations and cost levels. 6

11 INTRODUCTION AND SCOPE London as an International Financial Centre London, along with New York, is one of the world s two main financial centres. In recent years, London has continued to expand its role in globally traded services and now rests at the forefront of the world s financial centres: London is the biggest market in the world for derivatives traded over-the-counter. There are 250 branches and subsidiaries of foreign banks in London, more than in any other financial centre. The UK banking sector originates more cross-border bank lending than any other country. Around half of European investment banking activity is conducted in London. The London foreign exchange market is the largest in the world, accounting for 34% of global turnover, more than New York and Tokyo combined. London is one of the two largest fund management centres along with New York. It is the leader in the management of overseas clients non-domestic portfolios. The London Stock Exchange has a higher number of foreign listed companies than any other exchange. The UK insurance industry is the largest in Europe and second largest in the world. London is one of the two leading centres for international legal services, the other being New York. London is a major international market for accounting and related services. Core services include audit, tax advice, corporate finance and business recovery services. London s position as a pre-eminent financial centre has enabled it to enjoy significant economic growth over the last 20 years. Employment growth in London, driven largely by an expansion in financial and business services employment, has outpaced the UK and European averages. Importance of Property in Relation to London s Competitiveness as an IFC London s position as a major global financial centre relies on a number of distinct advantages. These are based to a large extent on a pool of specialised labour, an established financial infrastructure and a more accommodating regulatory system, the size and depth of its financial markets, as well as a convenient time zone that effectively bridges the gap between North America and the Far East. While London owes its importance as an IFC to a combination of these factors, its property offer has also played a role. Property is not a 7

12 primary driver that pushes or pulls in respect of relocation decisions or the choice to locate in London. In many instances, however, property constraints can impact on competitiveness and produce sub-optimal solutions for companies. An understanding of the location decision-making process helps in the understanding of the property s role in that process. Occupiers faced with a location decision consider a number of key factors. These have relevance depending on the stage of the decision-making process. At all stages, businesses are balancing the potential for cost savings alongside risk and uncertainty factors. At the start of the process, a business may simply select locations on the basis of a strict set of criteria. These considerations will include factors such as: timezone, corporate taxation environment, legal framework, infrastructure, market size, real estate and socio-political and financial risk factors. In terms of real estate, the main considerations are total costs (rent, service charge and taxes), vacancy rates, development pipeline and availability. Only once the decision has been made to consider a certain country do other factors come into consideration. Apart from location decisions, property-related factors have an effect on London s competitiveness at the margin. Companies depend on a supply of appropriate stock to operate efficiently. Anything that limits their access to appropriate and adequate space either via price or lack of supply will adversely affect their operations. For example, the inability of an occupier to obtain overflow or expansionary space close to a current location will create additional operating costs above and beyond those that would be incurred otherwise. The effects of this can influence how a company structures its operations and therefore result in higher operating costs. While not a primary location driver, property constraints affect perceptions and ultimately London s competitiveness. The competitiveness of London s property offer stems from a number of factors, particularly London s ability to provide occupiers with buildings that meet their requirements at a competitive price in their preferred location. The ability of the London property market to respond to the occupational demands of the financial sector for super trading buildings underlines this point. As investment banks grew through mergers and acquisition, larger buildings with large floorplates were required to meet the requirements of bigger consolidated firms and the technical requirements of screen-based trading. Demand was initially satisfied by relocations to fringe areas of the City of London and then to Canary Wharf. As planning controls eased in the City of London, it competed with Canary Wharf for larger occupiers. 8

13 This competition in the provision of space has helped to contain rental growth in the City of London and Canary Wharf, making rental costs very competitive compared with other international centres. The stock of office space in London has also responded efficiently to changes in demand in spite of the significant development constraints in some markets, particularly the West End. The Impact of the Credit Crunch on London s Office Market UK GDP turned negative in Q and recorded six successive quarters of decline to Q3 2009, with a cumulative drop of almost 6% in national output. The downturn triggered significant job losses, particularly among office-using sectors in Central London. Office leasing activity across Central London was the first to show signs of easing and subsequently the impact widened to encompass all UK office markets 1. The City of London market was particularly hard hit by the pullback in office demand from companies in banking and finance. Take-up of space in the City of London by this sector fell by more than 60% from 2.3 million sq ft in the year to Q to only 840,000 sq ft in the year to Q Tenant demand in the West End held up somewhat better in the early stages of the downturn, but sagged heavily as the recession took hold. Across the City of London and West End combined, exceptionally low levels of leasing deals were concluded in the two quarters following the collapse of Lehman Brothers in September Declining office demand coincided with a rise in the availability of new office space on the market in Central London resulting from the earlier upturn in development starts. Office availability rates in Central London rose in the downturn but by Q looked to be peaking at approximately 9.5% for Central London as a whole, somewhat higher in the City of London market, at 11.2%. This is a markedly lower availability rate than the peaks reached in previous downturns and reflects the much lower level of over-supply from new development compared with previous cycles. Rising supply and falling demand produced the inevitable reduction in rental values across the Central London market. Rental growth slowed or stalled in most parts of the market in Q4 2007, and the subsequent cumulative drop in prime headline rents in the City of London market reached 35.8% by Q West End prime rents were a little slower to fall but recorded a similar decrease of 34.4% by Q The decline in 1 For a comparative analysis of the impact of the credit crunch on IFC office markets, see: How Did They Fare? A Comparative Analysis of Office Markets in International Centres, February 2010, CB Richard Ellis. 9

14 Central London rents has been far in excess of that recorded in other UK office markets during the recession. Occupational and investment markets in London now look to have passed the trough of the downturn. Stock markets have rallied strongly from their March 2009 lows, business volumes in financial services are up and some banks are showing resurgent earnings. Office market indicators in Q showed a much more positive tone in activity and pricing. Tenant confidence recovered sufficiently to produce more active demand to take advantage of low rents and generous incentive packages. Occupiers taking large units of space in the City of London include Bank of Tokyo Mitsubishi, Nomura, Allianz and the Bank of China, together with several major law firms. Although seeing fewer large leasing transactions, the West End market recorded improved take-up. Total office availability has edged down since mid-year with recent leasing activity eating into the amount of new space on the market. Prime rent levels reached a turning point in Q with signs of uplift in top headline rents in the City of London and stabilization in the West End. Scope of Study As the London office market starts to recover from the effects of the credit crunch, there are increasing concerns that London as a financial centre is losing ground to other centres. Fears that the European Commission will introduce tighter and wider ranging financial services regulation along with concerns about changes to the UK tax system, from alterations to the non-domicile tax status through to the bonus tax and the increase in the tax rate for high earners, are creating the perception that the UK is becoming a more difficult environment for financial services companies. Against this background, it is crucial to highlight the advantages that London offers financial occupiers from a property perspective. The study aims to provide new perspectives on the competitiveness of London s property offer in comparison with other IFCs in the following respects: In various surveys of occupancy costs across global office markets, London generally features as one of the most expensive office locations. The reality, however, is quite different: there are a wide range of rental costs across Central London and the top grade A rents that make the headlines are not representative of London s property offer. A comparison of office occupancy costs across IFCs demonstrates the competitiveness of London s property offer. Equally important in terms of occupancy costs is the role that an IFC s ranking as a financial centre plays in determining occupancy 10

15 costs. A priori, we would expect that occupancy costs will be higher in proportion to a financial centre s global ranking and size to reflect the benefits to an occupier of being located in that market. If such a relationship holds, are London s rents higher or lower than would be expected from its status and size? How do actual and predicted rents on this basis compare for other IFCs? In a similar vein, it is important to understand how occupancy costs have moved over time in different IFCs compared with London. A distinctive feature of the City of London s property offer is that rents are currently no higher in nominal terms than in the mid-1980s and in real terms they are substantially lower. How does this compare with other leading IFCs? A competitive property market will see rents respond to changing market conditions. How does the cyclical variation in London office rents compare with movements in other leading IFCs? London is often characterised as a supply-constrained market due to land use planning. But it has significantly expanded its office stock in the past 20 years and development has responded strongly to periods of rising rents. How well does it compare to other IFCs in this respect? An important aspect of the competitiveness of London s property offer is the type of accommodation available in relation to business requirements. Does London have gaps in its offer? We will look specifically at London s comparative performance in the provision of large office buildings, especially tall developments, both for HQ offices and multi-occupation. In addition, the study looks forward to prospective developments in and influences on London s property offer to understand how London s property offer will change in the future. In this respect, it seeks to understand what factors will drive occupancy costs and the extent to which London s office supply capacity will be adequate and appropriate in relation to likely future needs. The study also considers the impacts that transport changes will have on the London office market and their potential to stimulate development opportunities across a range of markets. Structure of Study To align with these aims, this paper is structured in the following sections: An assessment of occupancy costs across major office markets worldwide, focusing on IFCs and detailed analysis of the relationship between occupancy costs and possible explanatory factors including the IFC rating. A review of availability of office space across a number of key IFCs (London, New York Paris, Zurich, Frankfurt, Hong Kong and Shanghai) and an assessment of each market s ability to satisfy 11

16 specific occupier requirements and, for New York, London and Paris, current availability by rent. An assessment of how responsive supply has been in the past across a number of IFC markets and a review of development volatility in London. A review of trends in real rents across Central London markets and a comparison across IFCs. A forward-looking assessment of influences and issues likely to influence London s business property offer and its competitiveness going forward on a 5-10 year horizon. Ending with some concluding thoughts. Market Definitions In this study we have drawn upon the proprietary data systems maintained by CB Richard Ellis on the Central London office market. The definition of the Central London office market area and its subdivisions used in our analysis is shown in the map overleaf. The area covered has very similar boundaries to the Central Activities Zone as defined in the London Plan with the addition of the area in the Isle of Dogs centred on Canary Wharf. Our Central London market consists of five main markets: the West End, the City of London, Midtown, Docklands and Southbank. Throughout the study when we refer to the London office market, it is the Central London office market that is implied rather than a Greater London office market. 12

17 Central London Office Market Source: CB Richard Ellis. 13

18 OCCUPANCY COSTS Introduction This section briefly outlines the measure of occupancy costs used in this study and then compares occupancy costs across a number of major office markets. It then turns to assessing the relationship between occupancy costs and potential explanatory variables, particularly the ranking of a financial centre. Occupancy costs account for a significant proportion of total business costs and are as a result the most significant aspect of competitiveness from a property perspective. Occupancy costs are influenced by a range of factors, most notably construction costs and location rent that is the payment for advantages of location and competition for the site from other uses. Measurement We have used CB Richard Ellis Global Occupancy Costs 2 data as a consistent measure of occupancy costs across markets. This calculates occupancy costs using three components: office rents, service costs and property taxes. In all instances, values are based on the costs levied on high quality grade A office space. Initially these are measured in local currency but for comparison are converted into US$. On this basis, the City of London is ranked 9th and the West End market is the most expensive followed by Tokyo and then Hong Kong. By comparison, New York is only ranked 24th. The data shows that London s two measurement points are widely apart. There are, however, measurement issues with the data when comparing occupancy costs across markets. The first issue relates to the definition of prime offices across markets. In most markets, prime space implies the best space available usually brand new space in good locations, with top specification. However, this is not consistently applied across countries. An average grade A rent is used in the US instead of prime which captures a much wider share of the market than elsewhere. One feature that emerges from this initial review of occupancy costs data is that major international financial centres (IFCs) tend to dominate, suggesting that there is a strong causal relationship between occupancy costs and status as an IFC. On the other hand, the fact that New York is only ranked as 24th in terms of occupancy costs indicates that other factors must play a significant role in determining occupancy costs; as indicated earlier, this may be partly a measurement issue. 2 Global Office Rents, November 2009, CB Richard Ellis. 14

19 International Financial Centre Comparisons The data appear to show a relationship between occupancy costs and a market s standing as an IFC. Indeed, in a recent book, Towers of Capital, Professor Colin Lizieri 3 has put forward the argument that the evolution of global finance and real estate investment has made IFC office markets more integrated with financial markets and more correlated with each other. According to this thesis, rent is the cost to occupiers of enjoying the benefit of an IFC location and that benefit relates to IFC ranking. Using CB Richard Ellis data on occupancy costs and GFCI 6 4, we can test this thesis by looking at the correlation between occupancy costs and the IFC s score as a financial centre. On this basis, we found a strong correlation of 38% between the GFCI 6 score of the top 40 IFCs and occupancy cost using City of London occupancy costs. There are a number of significant outliers including Mumbai, Tokyo and Hong Kong, which have much higher occupational costs than their rankings suggest. This points to other factors having a greater influence on occupational costs. A higher correlation is found for 26 European IFCs between occupancy costs and GFCI 6 scores on this basis the correlation is 44%, although Paris and Moscow are significant outliers. 3 Towers of Capital: Office Markets and International Financial Services, Wiley-Blackwell, The Global Financial Centres Index, September 2009, Corporation of London. The GFCI assigns a score to a financial centre based on a set of competitiveness factors derived from published sources and via a survey of respondents working in financial services and related activities. 15

20 Correlation of GCFI6 Ranking and Occupational Costs Top 26 European International Financial Centres Office Occupancy Costs US$/ SF/Annum 140 Moscow Paris 120 City of London GFCI6 Source: CB Richard Ellis Findings from a statistical analysis 5 provide evidence to show that the ranking of an IFC is a significant determinant of occupancy costs across European financial centres. These findings offer support to the thesis that IFCs have become more closely integrated. However, the findings also suggest that this relationship is not particularly strong at global level. Other factors probably of a more local than of an international financial nature play a more critical role in driving occupancy costs. Comparing actual and predicted values for the 26 European IFCs based on the GFCI 6 rating and population, it is found that predicted costs are close to actual costs for a range of financial centres. For the City of London actual occupancy costs are significantly lower than predicted values. Occupancy costs in Paris, Luxembourg, Zurich, Dublin, Milan, Athens and Moscow are considerably higher than their predicted values. 5 Details of the regression analysis are included in the Appendix. 16

21 Expected Versus Actual Occupancy Costs Top 26 European International Financial Centres $200 Actual = predicted West End Actual occupancy costs $150 $100 Paris Moscow City of London $50 Vienna $0 $0 $50 $100 $150 $200 Predicted occupancy costs Source: CB Richard Ellis and Corporation of London. In conclusion, IFC score and city size are reasonably good predictors of occupancy costs in European financial markets. London s occupancy costs when based on the City of London are significantly lower than its ranking as a financial centre and population would suggest. In comparison, the West End is considerably more expensive than predicted, a trait it shares with a number of European IFCs, including Paris where actual costs are more than 50% higher than predicted values. Are Rent Changes Correlated Across the Top-Ranking IFCs? The comparisons above look at occupancy costs in London and other IFCs at one point in time. Over time office rents change in response to the demand-supply balance in individual markets; however, there may be a degree of synchronisation due to the integration of financial markets. This can be tested by analyzing correlations in rental changes in IFCs over time. This is also relevant to the assessment of the competitiveness of London s office market. How does the variation in London office rents compare with that in other IFCs? For this analysis, we used quarterly prime rental growth rates for 10 top IFC markets 6 for two different time periods for which CB Richard Ellis has 6 London Central City, New York, Hong Kong, Singapore, Zurich, Tokyo, Chicago, Geneva, Shanghai and Sydney. 17

22 a consistent history. The correlations were run for a longer time period, covering Q through Q3 2009, as well the recent peak-to-trough period of Q to Q Rents were measured in local currency to avoid the effects of exchange-rate movements. 7 For the IFC markets, the average correlation in quarterly rental changes over the long history is 36%. London (City) has the highest number of significant correlation coefficients with other IFCs and is highly correlated (over 50%) with New York, Hong Kong, Singapore, Zurich and Tokyo. New York has the second-highest number of significant correlations and is highly correlated with Hong Kong, Singapore, Zurich and Tokyo. London is thus one of a highly inter-correlated group of markets with New York and the major Asian IFCs of Tokyo, Singapore and Hong Kong. The three Asian centres are also highly correlated with each other. Looking at the shorter time period from Q to Q the average correlation among the 10 IFCs increases to 52%. Correlation has been greater during the recent downturn when markets faced the global synchronization of the Great Recession. London s rental trends were most highly correlated with those in New York, Hong Kong, Singapore, Zurich, Tokyo and Sydney (all over 60%). During the downturn, Shanghai and Sydney have been pulled into a pattern of higher correlations with other IFCs, while Chicago and Geneva again emerge as the least-correlated centres. A competitive property market will see rents respond to changing market conditions. The correlation analysis shows that the cyclical variation in London office rents has significant commonality with movements in several other leading IFC s rental changes. In particular, in the recent downturn London fits a coordinated pattern of rental changes with New York and the largest Asian IFCs. In contrast, Geneva is an example of an IFC market showing low correlation with other centres and little rental adjustment in the recent recession. These findings support the argument that rents in international financial centres are relatively strongly linked to the prospects of financial markets and that these are strongly synchronised across several of the key financial centres. Cost Pattern within London As is clear from the previous analysis, there are distinct differences between occupancy costs in the West End and the City of London. These differences are not only observable in top grade A office rents, but also in business rates, which are linked to rental levels, and service charges. 7 Tables of correlation coefficients are included in the Appendix. 18

23 The headline figures most often cited when identifying the Central London market as the world s most expensive refer to a very small section of the West End core and in fact just a small collection of exclusive streets and squares within Mayfair and St James s. In total, the quantum of stock that, at any point, may achieve such high occupancy costs is much less than 5% of the total Central London market. The reality is that most of the Central London markets operate at a discount, sometimes as much as 50% for grade A space, to these very high rental levels. At the end of 2009, the top grade A rent in Mayfair and St James s was per sq ft. This rental value was more than 30% higher than the second most expensive West End submarket, North of Oxford Street West, and double the top rent in Soho. In the City of London, it is clear from the following chart that the range in which grade A properties are banded is much smaller than in the West End. Top grade A rents ranged from per sq ft in the City of London fringe (EC1) to per sq ft in the core City areas (EC2-4). A key feature in the evolution of London s office market in the past 20 years has been the emergence of new office markets providing expansion capacity for the core markets. The Southbank and Docklands markets offer high quality grade A accommodation at a discount to the City of London. Paddington and to some extent Midtown and Southbank perform a similar function for the West End. Central London Submarket Grade A Rents Quarter Four 2009 Mayfair & St James's North Oxford St W Knightsbridge West End Victoria Covent Garden Paddington North Oxford St E Soho City EC3 EC4 EC2 EC1 New Street Square Midtown High Holborn Fleet Street Southbank Docklands per sq ft Source: CB Richard Ellis 19

24 Not only do grade A headline rents across Central London vary significantly, but there is even greater variation in the rents at which transactions actually take place. Indeed while the top grade A headline rent in the West End was c per sq ft for most of 2009, only 11% of all transactions by total floorspace were at rents in excess of per sq ft. Indeed, the great majority of transactions (62%) that occurred in 2009 were at rents between and per sq ft; a much truer reflection of the representative rental levels faced by the majority of Central London occupiers seeking grade A space. Central London Transactions by Rent 2009 Grade A Deals, proportion by total sq ft 11% West End 17% Rest of Central London 4% 24% 11% 23% 38% 72% per sq ft Source: CB Richard Ellis Furthermore, there is a significant amount of office space classified as grade B or even grade C throughout the Central London office market. With varying levels of quality in terms of office space and a broad geographic spread across Central London on offer, there is a large amount of choice for the more cost-sensitive occupier. Rent Pattern across IFCs The wide variation in rents across the Central London office market mirrors the spread across global IFCs. Rents in the City of London and Docklands, the most likely destinations for larger financial institutions, are competitive with leading IFCs. The majority of Central London grade A rents are lower down the scale of occupancy costs in leading IFCs. Prime rents in Dubai, Paris, Zurich and Geneva are higher than those in Central London while those in 20

25 Tokyo are more than double the rate in the City of London or London s Docklands. While top rents in London s West End are the second highest in the world, these represent a very small proportion of market transactions. Looking at grade A rents in the second most expensive West End submarket would result in comparative rents falling to 4th place, below those in Paris. This suggests that London, in general, faces no greater obstacle in the cost of grade A headline rents than most other financial centres. This is especially true in consideration of London s size and financial standing, with many of the lower cost centres being notably smaller financial centres such as Chicago, Washington and Beijing. Global IFCs Top Grade A Rents 2009 Q3 Rental Values in US$ per sq ft $US per sq ft Tokyo London Mayfair Dubai Paris Zurich Geneva London City London Midtown Luxembourg Singapore New York Frankfurt Hong Kong Dublin London Docklands Washington D.C. San Francisco Shanghai Chicago Boston Beijing Source: CB Richard Ellis A number of factors influence this ranking. Firstly, with rents compared in a common currency such as US$, fluctuations in exchange rates will play a pivotal role. It is no surprise that, given the recent weakness of the US Dollar, there is a strong bias towards North American centres being comparatively cheaper. It is clear that London can provide financial occupiers with office accommodation at a broad spectrum of rental levels. While the West End core is among the most expensive, the other core markets provide office space at levels much more in line with the mean values across leading IFCs. Additionally, these values represent the rental levels for the best quality grade A space; there are numerous lower cost options throughout Central London. 21

26 Hedge Funds and Top Rents Banking and finance are the dominant sector of occupational demand in the City and Canary Wharf. Rental levels in these markets are therefore most representative of the occupational cost facing financial service firms in London. In the West End, financial sector demand is strongly focused on the core submarkets in Mayfair and St James s which have attracted a high concentration of hedge funds and private equity firms. These businesses have predominated among the tenants paying the highest West End rents, typically for smaller prestige quality offices. The top West End rents therefore reflect to a large extent what hedge funds are prepared to pay for a Mayfair office, which can be nearly double the top City rent. Interestingly, the willingness of hedge funds and high margin financial businesses to pay premium rents for prime, image-enhancing offices has been evident in certain other IFCs. In New York, Park Avenue and the Plaza District in Midtown Manhattan became hedge fund hotbeds, driving asking rents to $114-$124 per sq ft ( per sq ft) in the prerecession market at the start of 2008, well above the average of around $70 per sq ft in Manhattan. Similarly in Hong Kong s Central Business District, hedge funds and private equity firms, although accounting for a relatively small share of take-up, paid top rents for high quality space commanding good views in prestigious locations as much as 70% above the grade A average in 2008 and even higher than those seen in London s Mayfair. Availability by Rent An analysis of grade A office availability in Central London reveals that the large majority of space is on the market at less than 50 per sq ft. In fact, around a third of space available in Central London is on the market at a quoting rent below 40 per sq ft. Only 4% of units are quoting a rent of 70 per sq ft or more all of which are in the West End. A further 4% of units are quoting rents of per sq ft. 22

27 Central London Office Availability of Grade A by Rent % of total quoting rents City West End Rest of Central London Total Less than 30 psf 5% 1% 2% 8% psf psf psf psf 70 psf or more 13% 29% % 9% 25% 14% 11% 54% 5% 1% 6% 4% - 4% 4% - 4% Total 100% Source: CB Richard Ellis. It is worthwhile noting that if this was expanded to encompass availability of grade B and C space (grade A space accounted for 57% of available space at the end of 2009), then the proportion of space at lower rents would increase. The average quoting rent for grade B units in Central London is 30 per sq ft. The table below shows availability for all grades within a number of rental bands for London, New York and Paris. Units of floorspace with quoting rents below 40 per sq ft account for 71% of Central London availability (excluding the West End) and 39% of availability in the West End. By comparison, 73% and 86% of availability in Paris and New York respectively falls into this category. At higher rents, only 2% for Central London (net of the West End) is above 50 per sq ft, rising to 25% of current West End availability. In contrast, 9% of Paris availability is at this range. 23

28 Central London, New York and Paris Comparisons of Office Availability by Rent % of total of all grades of space quoting rents Paris New York West End Central London (excluding West End) Less than 30 psf 45% 56% 17% 42% psf 28% 30% 22% 29% psf 19% 12% 35% 27% psf 6% 2% 13% 2% psf 3% - 7% - 70 psf or more - - 5% - Source: CB Richard Ellis. To summarise findings: The West End has the most expensive space but Central London has a wide spread of office space at much lower rents than the oftquoted top headline. In Central London, space available by rent compares well with Paris: 71% of available units are quoting a rent of less than 40 per sq ft in Central London (net of the West End) compared with 73% in Paris and 86% in New York. 24

29 OCCUPIER CHOICE Introduction The capacity of a market to meet occupier requirements is an important test of its competitiveness. Therefore, this section looks at office space availability across a range of international financial centres, before assessing the ability of particular markets to accommodate specific occupier requirements from current and future stock. Availability Availability (supply) varies significantly across IFC markets. Data on the vacancy rate, which measures ready-to-occupy space shows that Singapore and Hong Kong have the highest vacancy rates, followed by London. Geneva is the most supply-constrained market with less than 4% of stock vacant and available for immediate occupation. While the vacancy rate provides a snapshot of a market s potential to accommodate occupiers requirements, it only tells part of the story. Vacancy Rates International Financial Centres, Q % of stock Paris Ile-de- France* Hong Kong Tokyo Singapore Geneva London - Central New York - Midtown Manhattan New York - Downtown Manhattan Source: CB Richard Ellis. * Paris includes Centre West, La Défense and Western Crescent. Rather than looking at overall availability or vacancy rates, a market s supply capacity could be assessed in other ways. With this in mind we sought to test the capacity of some IFC markets to meet certain hypothetical requirements by office occupiers. Basically we sought to assess how much choice in each city an occupier, particularly a financial occupier, would have at present, in terms of the number of available units and/or buildings that would meet the requirement. The limitation of this approach is that it reflects the position at a particular point in time. Therefore, the findings will depend very much on where the market is in the cycle. For instance, Central London has emerged 25

30 from the downturn much more quickly than other markets and demand over the last six months has absorbed a large proportion of available space, particularly in new large buildings. We sought to assess how well a market could meet the following hypothetical requirements (all for Grade A accommodation): 1. a large unit of 20,000 sq ft (2,000 sq m) on a single floor in a modern building ,000 sq ft (14,000 sq m) including a trading floor of 30-40,000 sq ft (2,800-3,700 sq m) from current availability or from the development pipeline within two years ,000 sq ft (46,500 sq m) including 30-40,000 sq ft (2,800-3,700 sq m) trading floors from current availability or from the development pipeline within two years. 4. an office with a 60,000 sq ft (5,570 sq m) trading floor from current availability or the development pipeline within 2½ years. In terms of units of 20,000 sq ft on a single floor, Shanghai with 435 units is significantly ahead of its nearest rival New York with 242; by comparison there are 134 such units in London and minimal availability among the other IFCs. Zurich and Hong Kong had no 20,000 sq ft units available. Increasing the size of the requirement to 150,000 sq ft with a trading floor of 30-40,000 sq ft reduces the number of available units quite dramatically. Once again, it is Shanghai (166 units) and New York (73 units) that can offer the widest range of options, with only London (9 units) and Paris (1 unit) from the other IFCs able to satisfy this type of requirement. Further increasing the requirements size further to 500,000 sq ft with a similar trading floor requirement means that only Shanghai (166 units) and Paris could accommodate the requirement (I unit). 26