With rents rising fast and professional fees under pressure, are central London occupiers fending off an impending affordability crisis? Fast forward to 2017 and the business rates revaluation could be the final straw
Lawyers are anxious, accountants a bit twitchy. The reason? It’s simple economics. If your costs are going up faster than your income, you have a problem. Sooner or later something has to give. And with professional incomes under pressure and London occupational costs rising, analysts are beginning to wonder what will give and when.
Data from separate studies by PwC and CBRE shows the problem. According to PwC, the hourly fees charged by lawyers are in reverse. The top 10 law firms saw hourly rates drop by 8.1% and others in the top 100 have seen hourly fees fall by between 0.4% and 9.3%.
This does not mean law firms are on the brink of collapse – profitability is up. But that is because the fall in fee income is being offset by charging more billable hours – about 7% more, on average. Yet there is a limit to what productivity improvements can deliver. PwC’s conclusion is that pressure on fees is undiminished, yet profits per full equity partner are still between one-fifth and one-third behind the 2008 figures. More recent data suggests top-line revenue this year is up by just 2% – making bottom-line profit even more vulnerable
CBRE’s analysis points in the same direction. The top 100 law firms occupy 10.4m sq ft of central London offices, and it is costing them a small fortune at a time when pressure on their margins is intense. The CBRE Legal 100 benchmark analysis reveals that the total volume of space occupied has fallen by 3% over the past three years, despite a 21,200 increase in headcount. The average area occupied reduced by 5% to 490 sq ft per fee-earner.
However, realising significant cost savings at a time of rising rents has been achingly difficult. Rising rents mean they are paying about £22,400 a year in rent for each fee-earner. Add rates, service charges and other occupational costs, and the received property industry wisdom that property costs are negligible compared to staff costs begins to seem wishful thinking.
CBRE says take-up by law firms fell by 8% in 2014 and was 16% below the 10-year average. It expects below-trend take-up from the law firms will continue.
Similar (if less acute) problems afflict other parts of the professional sector, especially for mid-tier firms. Corporates are enjoying mixed, generally rather flat, top-lines and bottom-lines. With the exception of tech and telecoms businesses, there is not much to cheer and in some sectors – notably oil and energy – quite a lot to moan about.
And where are rents going, as central London occupiers see their incomes wobble or flatline? In the City they are rising steadily – predicted to grow by 12% in 2015, 8% in 2016 and will be pushing £80 per sq ft by January 2017, says Colliers International. The West End will tip over £130 per sq ft in the same period. Another two or three years of rental growth is due before the market peaks, says Colliers chief economist Walter Boettcher.
Meanwhile, anyone with a rent review due in the next three years can expect a nasty surprise – some figures suggest landlords are gunning for an average 48% increase at rent reviews. Further away, the looming 2017 rating revaluation is certain to deliver expensive uplifts in occupational costs to many central London occupiers. Some suggest it adds up to an affordability crisis. (see below). Add in the above-inflation trend on service charges and it is enough to give the C-suite pause for thought on its real estate needs.
The conclusion some close observers reach is that the answer to “when will something give?” is 2017-18, and the answer to “what will give?” is that occupiers will chase cost savings and efficiencies in their real estate with a new sense of purpose. More – and more extensive – back-office relocations out of the capital are likely.
John Kent, executive director at CBRE, says the massive surge in the supply of serviced office space – up by 67% since 2005, according to Deloitte – is an early sign of occupiers adjusting to the pressure of rising occupational costs. “Occupiers will go for more short-term and serviced office space, more home working, more investment in technology,” he predicts.
Tom Carroll, head of occupier research at JLL, says massive rethinks of corporate real estate portfolios are on the horizon.
“Rising property costs are a concern for occupiers. There is a clear disconnect between rents and occupiers’ incomes. We surveyed 500 property directors and 77% said pressure to reduce property costs was coming from above. Any idea that cost reduction is off the agenda, now the recession is over and the economy is growing, just isn’t the case,” he says.
Carroll rejects the idea that the big tech companies are in a small class of occupiers for which expense is no object. “Yes there is lots of cash on some corporate balance sheets. But they still want efficiency from their property portfolio. The time when some sectors could afford to be relaxed about their real estate are gone,” he says.
Relocations within London, more efficient use of existing London floorspace, and serious efforts to move staff to other UK or overseas locations are inevitable, says Carroll.
Does this mean the London office market faces an affordability crisis? Guy Douetil, managing director at Colliers International, thinks not. Not for now. “We have been advising a Thames Valley company buying London tech businesses, and the tech businesses are not moving out to the Thames Valley HQ, despite the massive difference in cost,” he says.
Richard Proctor, head of tenant representation in the City office at Knight Frank, says London rents can rise a little further without causing a crisis.
“OK, so it costs £20,000-£25,000 a year per person to rent in the City, but that is still low compared to salary, pensions and training. Inevitably some occupiers have to find space in new locations where they can keep their outgoings steady, but at the same time other people are moving into central London because they have to be there,” he says.
For proof, Proctor points to Amazon, which famously stuck it out in Slough for years but is now heading for new offices at Brookfield’s Principal Place in Shoreditch, E1, a year after taking new 210,000 sq ft offices at Sixty London, EC1.
He says: “Amazon talked a good game about the frugality of being based in Slough, but if you have a staff attrition rate of 20%, and you are losing good people to rivals in London, you say enough is enough and pay £60 a sq ft at High Holborn. Clearly every occupier has a budget, but the immediate concern is not price, it is what the building can do for their business.”
There is no affordability crisis, says Proctor, and there won’t be so long as occupiers keep pressing for improved productivity from their floorspace. “The escape valve is not price, it is the size of office suites,” he says. In the next two to three years we will find out if he is right.
Affordability crisis?
Over the past four months London landlords have been quoting an average of a 48% uplift in rent at lease renewal, according to rates and rates reductions specialist CVS. The looming 2017 business rates revaluation could also hurt London occupiers, based as it will be on values at 1 April 2015.
“Given the general increases in rental levels, London offices can expect to see some of the largest increases in business rates when the new list comes into force,” says head of business rents John Hayward.
It is bad news, too, on service charges says CVS. “They are rising well above inflation levels,” Hayward adds.
