"The trend in super prime real estate is putting pressure on the availability of office space because it's being swallowed up by residential developments," explains Simeon Howard, director of office space and virtual office solutions provider City Office. "That's what's causing the up-trend in office space cost and I think we're heading for a perfect storm."
Analysis by accountancy firm Deloitte found the amount of office space available to rent in central London has halved since its 2009 peak and fell by 14 per cent over the last 12 months.
At the same time, take up of central London office space achieved a four-year high in 2014, increasing by 16 per cent compared to the previous year to reach 15.9m sq ft, according to property advisor Knight Frank.
The tension around the supply and demand of grade A office space is concentrated in the key central London districts of Mayfair, Belgravia, Kensington, Chelsea and the West End.
The sheer level of demand in the West End led Deloitte's head of tenant representation to describe the vacancy rate as "critically low" after it fell by 46 per cent to 4 per cent last year.
What does shortage of prime office space mean for rental rates?
"We have the case of low supply and high demand, so clearly a rise in rates is to be expected, but what's interesting here is the potential compounding effect in rate rises due to the type of clientele pouring into market," says Howard. "Watch out for new operators specifically gearing their products to the super rich, they will set the trend with record breaking rates and the rest will follow and take advantage of this new reality."
Howard adds the trends seen in high-grade office space causes a trickledown effect pushing up the price for more common types of office space in the surrounding area increasing.
The issue's been caused by the profit available in the residential sector, which has led an increasing number of commercial developers to change their focus to residential.
"You have to look at a situation where developers or investors would buy real estate and seek to maximise value," says Dean Main, founder of luxury residence management company Rhodium. "You can run as many exercises as you like, but the bottom line is that residential makes the most sense from an investment angle. This is a pattern that started to emerge five-six years ago, with developers and investors saying ‘the only thing we can do now is residential'."
Main added developers could achieve three times the value for residential projects in the most sought after districts.
Examples of the changing priorities of central London's property developers can be seen in the years following the financial crisis.
British Land purchased Wardrobe Court, a residential development located a few minutes' walk from St Paul's Cathedral, for £57m in 2011. The move was heralded by the company's chief executive as a signal it had changed its strategy because the residential market was becoming increasingly important and its annual report pointed to the start of a major new office cycle that's manifesting itself today.
Shortly after the Wardrobe court deal went through the government set out plans to relax planning laws, which Chancellor George Osborne billed as "the biggest reduction of business red tape ever undertaken". The developer-friendly reforms made it even easier for London's developers to convert commercial units into residential properties.
"It's become quite an easy process, you have your permission to change land use in eight weeks," says Main. "It means a lot of these commercial buildings, mainly in the West End, began being converted to residential properties."
Rhodium has a £1.5bn residential property portfolio and its clients include Finchatton, Investec and Brockton Capital. Main estimates that 65-70 per cent of the new residential developments the company's working on were previously office or mixed-use schemes.
The demand for residential property is being driven by clients from overseas, particularly Russia, China and the Middle East.
"You're finding you have to service new high-end individuals that are coming into central London looking for something totally different to what the market's offering and companies are creating office space specifically geared towards this market," says Howard.
Developers' decisions to cater for the residential demand from these ultra-high-net-worth individuals and the shortage of prime office space has led them to adapt their offering; where you'd typically find a spa, gym and communal area, you're now also seeing offices. However, the move to add these facilities to residential developments has done little to alleviate the pressure on prime office space.
Howard says the shortages in key central London areas like Mayfair has caused other districts to become more attractive.
"We're looking at other areas where we can get the same quality of space and be central. Knightsbridge, Belgravia and Chelsea are going to see a spike in rentals levels because there simply isn't the supply," he says adding rents in these areas have increased by 20-30 per cent in the last few years.
Deloitte predicts 6.3 per cent rental growth in the City and 8.7 per cent in the West End on Grade A office space during 2015, which it says will lead to pockets of "super growth".
The constantly improving economy means more business are looking to expand in central London locations while availability decreases. This combination of increased demand and falling supply will keep the foot squarely on the pump that's pushing air into the property market bubble.
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