London Rents Are Falling Down

The global slump is hitting commercial real estate

It's 40 stories high, tubular in shape, and at night is bathed in bright green lights. So it's no surprise that the new building on St. Mary Axe in the financial district, known to wags as the Erotic Gherkin, is the talk of London. Unfortunately for its owner, Zurich insurer Swiss Re, it's also the subject of much gossip among real estate agents. For the Gherkin, despite its celebrity, is having trouble finding tenants.

What goes for Swiss Re's London headquarters goes for the city's other commercial properties, too. As Europe's economy stagnates, the market for London office space has suddenly gone soft. Rents for high-end buildings in the City of London, as the financial center is called, are down 20% from their peak in June, 2001, to $80 per square foot. Meanwhile, vacancy rates are rising, and leasing activity is at its lowest level since 1984. Most analysts say conditions won't improve until at least 2004. "The falloff in rents is a byproduct of the weak economy," says Peter Damesick, research director at London property consultant Insignia Richard Ellis. The sinking property market, he notes, will likely have ripple effects on London's larger economy, as leases on unneeded space drain companies' profits and force a slowdown in construction.

Blame the reversal of fortune on the financial-services industry, London's main growth engine. A slowing global economy and the bear market in stocks have eroded financial firms' profits. In the past 19 months, an estimated 35,000 City jobs have disappeared, says financial-recruiting group Heidrick & Struggles International. With head counts in the City at 1996 levels, demand for office space has dried up. During the 12 months ended in March, 2001, 20 million square feet was let or pre-let in central London. For the year ended Dec. 31, new leases dropped to 8.7 million square feet.

Commercial-property developers can only look on with envy at their counterparts in the residential sector, where only rents at the very top end are falling. That's because there's a shortage of quality housing in London but a glut of office space, with 14 million additional square feet to be added to the pile in the next two years. Financial firms in the City and at the Canary Wharf office complex in London's Docklands have lots of space to sublet as they cut back on staff. Vacancy rates, 10% at the end of 2002, could hit 15% by the end of this year, says Derek Epstein, an associate director at international real estate consultant Jones Lang LaSalle.

Little wonder many of the biggest names in the property market are suffering. Britain's largest listed commercial-property company, Land Securities, reported an 8% drop in half-year profits at the end of November, to $247 million. A spokeswoman for Canary Wharf Group PLC, which rents 13.5 million square feet, says the firm isn't offering any discounts on rents, currently $71 per square foot. Yet publicly traded shares in Canary Wharf have been hammered, falling more than 34% last year as investors became skeptical that it can keep profits up.

Swiss Re, meanwhile, is not worried about empty space in its new building, half of which it will rent to outside tenants. "We're confident we will achieve the highest rents in the market," says Sara Fox of Swiss Re's real estate department. "What is yet to be tested is what those rents will be." Those rents will be decisively lower, experts say. "The Gherkin will face greater competition at the same time demand is weakening," according to Damesick.

Analysts reckon the commercial-property swoon won't be as dramatic as that of the late 1980s and early '90s, when rents fell more than 50%. For starters, there's a lot less speculative development. Sixty percent of the 14 million square feet under construction in London is already leased. Also, Canary Wharf and other big property companies now get financing not just from banks but through the capital markets, issuing bonds backed by future rental income from blue-chip tenants. "The process imposes greater discipline on the market" because the financing has to be vetted by rating agencies and bondbuyers, says Robert Gray, executive director of Morgan Stanley's London real estate group. "So speculative development is less likely to soar out of control."

Nevertheless, the current market favors tenants over owners, and profits are bound to fall. Leases are getting shorter, and tenants are demanding perks, such as longer rent-free periods, before they sign on. It's a renter's market. The boom years are really over.

By Kerry Capell in London

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