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Counting Cranes

Clockwise Belfast Seating

Counting Cranes

At our annual meeting Mike discussed at length one of the very simple but powerful metrics we use to understand the rental cycles in London: the amount of space under construction. It causes us some amused frustration that many brokers in our industry don’t spend much time on a day-to-day basis thinking about which factors move rents up and down. Some do not appear to understand the concepts of cycles or mean reversion, full stop. The more thoughtful ones typically focus primarily on demand: for example, trying to figure out whether the rise in tech demand is replacing the fall in financial sector demand, or whatever other demand-related issue seems fashionable to speculate on at the time. This becomes even more complicated in a world where over 20% of current demand in London is coming from serviced office providers, who aren’t space users at all but are more akin to levered owners. We didn’t see that same dynamic in previous cycles.

Internally we tend to shy away from relying on macro predictions related to tenant demand because a good portion of demand can change suddenly based on wholly unpredictable events. Rather, we look at a variety of factors combined, starting with one of the simplest: more space implies lower rents.

To illustrate the power of this point, we created a simple comparison of rental growth with space under construction to see if the two had a significant relationship. Every six months, Deloitte produces a great report called the London Crane Survey which effectively counts the cranes (and the associated space under construction) dotting the horizon across central London. We compare this space under construction in central London to the one year forward growth in prime net effective rents in the City of London. What the resulting scatterplot shows is simple, but powerful: as space under construction in central London increases, prime net effective rental growth in the City of London declines and then turns negative. The R-squared value indicates that nearly half of the variation seen in the one-year forward growth rates in net effective rents can be explained purely by the amount of space under construction right now. Statistically this is a reasonably high degree of correlation.

Even more interesting, we think, is another clear pattern in the scatterplot. When space under construction exceeds roughly 11 million square feet, it is fairly likely that rents will fall by some degree. In fact, over the past 15 years, when space under construction exceeded 11 million square feet, rents have fallen over the following year in every case.

Of course, you may ask yourself: “Isn’t that somewhat obvious?” But the beauty of this relationship is in its simplicity. We can easily look at space under construction and have a fair idea about whether rents are more likely to rise or fall next year, which when combined with our own experience (and other data) helps us to make better predictions about where we are in the rental cycle. And as we’ve said many times before, future rental assumptions have a massive impact on what prices an investor should pay for a value-add refurbishment opportunity. How much space is under construction right now? 13.5 million square feet, up from 12.6 million square feet as of the last survey. We’ll leave you to make your own guess about whether rents are more likely to increase or fall over the next year in the City!

21st July 2018

Market Commentary