The Carter Jonas Net Effective Rents Index
Changing market conditions are often reflected in the prevailing level of rent free period incentives well before any movements in headline rents, particularly when demand and take-up are declining.
Our Net Effective Rent Index illustrates the combined impact of changes to both headline rents and the typical length of rent free periods across 22 key central London districts. The index also reflects different lease lengths by providing analysis of five and ten year leases, which has a significant impact on the net effective rent for each district.
Note: the impact of the timeframe for the ingoing tenant to carry out its fitting out works has not been factored into the Carter Jonas net effective rent analysis simply because the timeframe will be influenced by the quantum of space to be leased.
Net effective rents – the headline results
Many employers are seeking to encourage their workforce back to the office through a high-quality work environment that reinforces staff health & wellbeing, recruitment, retention and productivity strategies and underpins ESG policies. As a result, occupier demand is firmly focussed on grade A space.
The ongoing shift in demand towards quality space, coupled with constrained supply, has meant that the impact of the pandemic on grade A office rents has been modest. Headline rents for grade A stock in central London have fallen, as a whole, by an average of only 1% since the start of the pandemic, driven by modest declines in selected submarkets where grade A supply is less restricted.
During Q3 2021, headline rents for central London grade A stock were broadly unchanged, although some landlords are now beginning to increase advertised rents on best in class, prime located, buildings.
As is usual during the economic cycle, changing market conditions have been reflected to a greater degree in the rent free incentives that can be negotiated. Rent free periods have increased by, typically, 3-5 months for a 5-10 year lease since the beginning of 2020 across all London submarkets.
With rising business confidence and greater certainty over how their business is likely to operate in a post lockdown world, employers have begun to implement their real estate strategies for the future. As a result, the central London office market has witnessed a gradual rise in leasing activity since the beginning of the year, in terms of both the number, and average size of lettings.
The pandemic has resulted in a steady increase in office vacancy across much of the central London office market, driven by development completions and businesses downsizing. However, these trends have not increased the stock of vacant grade A space appreciably in some submarkets – including the West End, Midtown, and South Bank submarkets where grade A vacancy is low and choice relatively limited.
Against this backdrop, Q3 has seen a modest but noticeable fall in the rent free incentives typically negotiable for grade A space in these submarkets. For most submarkets, this reduction has amounted to no more than one or two months. By contrast rent free periods in the City and Docklands have remained broadly static during the third quarter of the year, reflecting the differing supply and demand dynamics of these submarkets.
The overall impact on central London grade A net effective rents in comparison with headline rents is illustrated in Figure 1. The fall in grade A headline rents of 1% from the start of the pandemic to Q2 this year contrasts with a much greater fall of 6% for net effective rents, assuming a 10-year lease, and 8%, assuming a 5-year lease.
However, whilst grade A headline rents held steady during Q3, net effective rents have increased by 2.4%, assuming a 10-year lease, and 3.0%, assuming a 5-year lease, reflecting the mild contraction in rent free periods in some submarkets. As a result, net effective rents are now only 3.7% below their pre-pandemic level, assuming a 10-year lease, and 5.3% below that level, assuming a 5-year lease.
Figure 2 illustrates the percentage change in grade A headline and net effective rents between Q1 2020 and Q3 2021, across the four main central London markets. This shows that grade A net effective rents in the West End and Midtown are not as far below their pre-pandemic level as those in the City of London, whilst rental levels in Docklands / East London are the furthest below. This largely reflects the differing levels of immediately available grade A supply.
Figure 3 illustrates the recovery in net effective rents during Q3 by submarket (assuming a 5-year lease). This shows that faster recovery is occuring in the West End and Midtown, with net effective rents rising by 4.3%, compared with 2.5% in the City of London and 2.2% in Docklands / East London.
The occupier focus on high quality space, and mismatch with the significantly greater amount of lower quality space available, means that the upturn in grade A net effective rents has not been mirrored in grade B stock. Figure 4 compares the recent trend in net effective rents (based on a 5-year lease) for grade A and grade B stock.
In the year prior to the onset of the pandemic (Q1 2019-Q1 2020), grade A net effective rents increased by 5.2% (assuming a 5-year lease), whilst grade B net effective rents were virtually flat, reflecting the divergence in the stength of demand for good quality and lower grade space – a trend that had become established before the onset of the pandemic. Both grade A and grade B rents then fell significantly between the start of the pandemic and Q2 this year (-8.0% for grade A and a slightly steeper -8.7% for grade B).
Q3 2021 has again shown a significant divergence. Whilst grade A net effective rents have risen by 3% (assuming a 5-year lease), improving conditions have had no impact on grade B stock. Indeed, we expect this divergence to accelerate in the coming quarters, with rent free periods for grade B stock likely to rise, causing a fall in net effective rents. The opposite should be the case for grade A stock, as shortages of high quality space mean shorter rent free periods are likely to be achievable.
Detailed results by submarket
The diagram below details our view of current grade A headline and net effective rents across the key central London submarkets. Figure 5 shows the annual change in net effective rents, assuming a 5-year lease.
Although central London grade A headline office rents were broadly unchanged in Q3, our index reveals that net effective rents for grade A space are now trending upwards, due to a reduction in typical rent free periods achievable. This is starting to reverse the falls seen following the uncertainty of the pandemic, although the average grade A net effective rent for central London is still more than 5% below its pre-pandemic level (assuming a 5-year lease).
This rise in grade A net effective rents is being driven by an increased occupier focus on high quality space to drive recruitment and retention, improve staff health & wellbeing, reduce operating costs, and meet broader ESG objectives. It also reflects an increasing shortage of grade A space across central London, particularly in the West End, Midtown, and South Bank, where recovery in net effective rents is occurring faster than in the City of London and Docklands / East London.
With a continued increase in the number of tenants proceeding with their plans to relocate, falling grade A availability and restrained construction activity, we anticipate further upward pressure on prime net effective rents, with rent free periods reducing further over the coming quarters. This will be most noticeable in the West End and Midtown where the supply / demand mismatch is the greatest.
The picture for grade A stock is in sharp contrast to poorer quality stock, which is likely to see a continued rise in availability as occupier demand focuses on grade A space and more poorer quality second-hand stock is vacated. We therefore expect advertised rents for grade B stock to witness declines over the next 12 months, in tandem with a widening in rent discounts and rent free period incentives.
For further information, or to speak to one of our central London office professionals, please contact us.