Picking a number from a hat, rolling a dice, finger in the wind? Finding the right price for a new or refurbished South East office scheme has rarely been harder.
Go back 13 months and it was easy. In 2014 the only way was up. Step back to 2010 and it was even easier – the price was whatever the occupier (any occupier) would pay.
Today, both early-days number-crunching appraisals and close-to-market quoting rents involve more uncertainty. What economists call “price discovery” has in some cases turned into hunt the thimble.
Rising construction costs are putting the most pressure on pricing decisions. Costs have rocketed, rising from around £150 per sq ft new build in 2013/14 to £190 per sq ft today. At its root is the well-advertised shortage of skilled trades which has forced a rise in labour costs.
Rob Joyce, London director at Graham Construction, has been working on Boultbee Brooks’ redevelopment of the White Building, Reading. The project adds 23,000 sq ft to create a 93,000 sq ft block.
Joyce says that a market in which developer clients held the whip has been replaced by one that is more balanced. Contractors can – if they want – hold out for better prices and less risky contracts.
“Contractors are more risk-averse because, in today’s market, they can afford to be. That’s because there is more work around,” he says.
The growing prevalence in the South East of two-stage contracting – which pushes design-related costs out of the initial tendering process – has probably pushed final costs up, he says. “The final cost often bears no relationship to the initial cost, as provided by the developer’s quantity surveyor – and that’s because we often don’t get enough design information,” he says.
“We’re seeing new-build construction costs rising from £150 to £190-£210 per sq ft.”
Investment committee appraisals – and ultimate quoting rents – are therefore under pressure. Today a rent of £25 per sq ft is probably necessary to make new build work in the South East, if the land cost is low or zero. If the developer paid a packet for the land, then it’s going to be £30 per sq ft or more.
In some markets rising construction costs mean curtains for speculative schemes. If a profit margin of 20% is assumed – and it usually is – then rising costs can squeeze a scheme off the drawing board.
Rupert Shelton, director at Palmer Capital, says: “In poorer markets where the cost/value equation is insufficient to trigger development, the only traditional way around this is to pre-lease to tenants at a “building cost” rent. In other words, the only way of making development viable in such circumstances is to pitch the rental level at an economic rent rather than a market rent. This creates an artificially high level, but props up the development appraisal and means that development can sometimes happen where the tenant’s business case for a new building is so compellingly strong that they need to find a way of making it economically viable.”
But where there’s no eager tenant in view, forget it.
The alternative is to slash building costs. Emma Goodford, partner at Knight Frank, warns that trying to control construction costs by opting for low specification office space is a risky approach.
“Yes, you can control costs through design – not everything has to be bespoke, it can come off the shelf. But tenants are discerning and you can value-engineer your building to the point where schemes become indistinguishable and they won’t work,” she says.
Goodford says the appraisals she has seen show construction cost inflation in double figures – not yet high enough to make an enormous difference to quoting rents in the stronger locations.
Given rising construction costs, some markets will be tough to price accurately, says Charles Dady, head of business space at Cushman & Wakefield.
“There are markets where it is going to be a push to bridge the gap between the economic rent and the appraisal, at least this year,” he says.
Behind the problems caused by rising construction costs lie another pricing conundrum: the risk that occupiers’ and landlords’ expectations about rental growth are drifting apart. Buoyed by the investment market and continued yield compression, landlords are in a chipper – perhaps cocky – mood.
Angus Malcolmson, director at Bilfinger GVA, says the rapid yield compression of the investment market is changing the way developers and landlords think.
“When they see the value of an empty building rise it makes them more comfortable holding their position on the quoting rent. They feel they can keep the building empty for longer, and be more picky about the tenants. Because the values are rising they don’t feel under commercial pressure,” he says.
Malcolmson suspects this confidence doesn’t push rents up much, or at all. Others aren’t so sure.
Simon Fitch, director at BNP Paribas Real Estate, points to Rockspring and Exton Estates’ Velocity development at Brooklands, near Weybridge, completed in 2013. “A speculative scheme that sat vacant for two years, but is now mostly let, and arguably they have done better on rents by waiting than they would have done if they’d let immediately on completion. Yield compression means it is less of an issue for developers if the building is vacant, even taking into account costs like empty buildings’ business rates,” he says.
The scheme now has around 25,000 sq ft vacant having been bought by Orchard Street for £56.1m, a yield of 5.7%.
In the end, local factors will always be the final decider when it comes to pricing.
Savills director Tom Mellows says: “Normally £30 per sq ft is the tipping point of viability, but if the fundamentals of the property are right, and supply is low, you can speculatively develop at lower appraisals.”
“I don’t think occupiers are as hung up on pricing as all that. For them it’s about other issues. Within reason, they don’t care about the rent,” says Mellows.
Yet in Milton Keynes it’s a different story. “A few pounds on the rent can make a big difference in this market,” says Roger Yates, Bidwells’ chief in Milton Keynes. A new part-speculative part-prelet office scheme in the city – with Grant Thornton already signed – will test whether that is still true (see box).
It has never been easy to price in a changing market. Rising supply-side costs, and changing expectations, make it more complicated than ever. In today’s South East office market it is harder than ever to be sure that the price is right.
Grant Thornton
When Grant Thornton wanted new Milton Keynes offices it knew it would cost. Although the accountancy business prefers not to go into details about the talks behind its 20,000 sq ft prelet with local developer Frontier, it is believed it allowed the headline rent to creep up from £22.50 per sq ft to £23.50 per sq ft. Rising construction costs are said to have been significant in a market which has struggled with rents above £21.50. Build costs at the 40,000 sq ft Victoria House are a modest £150 per sq ft – which allowed for flexibility in the appraisal.
