Meadow Partners' Andrew McDaniel on The State of the London Office Market

London Office Q&A

How does London office vacancy compare to the U.S, historically and today,and what does that tell you about the market, particularly in terms of supply constraints?

London vacancies arealmost always significantly lower than comparable international markets. Marketvacancy commonly stabilizes in the 5% range within our core office markets.London's extremely limited supply of land and cumbersome land use system thatmakes development slow to respond to price signals is an additional benefit.These factors in the post-Covid environment are resulting in even lower supplythan usual with a minimal forward pipeline (less than 1% of existing stock) ofdevelopment deliveries expected over the next three to four years which are furthercomplicated by elevated interest rates and construction cost inflation.

The occupationalmarket is really turning now. Major occupiers have significant pent-up demand -many are facing too little space following mistaken Covid-era expectations -with few options existing to move. We expect that what were very recently 4- to5-year forward projected prime rents will end up being achieved in the next 12-to 24-months. These factors are leading to the most compelling officeinvestment environment that I have seen in nearly 25 years of living in London.

What has happened with employment in London compared to pre-Covid?

The story starts beforeCovid with Brexit actually, which was widely projected to erase numerousfinancial and professional services jobs in London. However, those projectionsnever materialized because London doesn't have a direct competitor in Europe capableof absorbing its depth of talent, which meant the impact of Brexit was far moremuted irrespective of bad policy decisions.

The market anticipatedthat Covid would be a second major blow and leave a wide swath of redundantcentral London office space. Instead, office jobs in the City of London havegrown approximately 25% versus pre-Covid levels, an astonishing feat againstall projections otherwise.

What that shows us isthat London's employment base is genuinely diverse, dynamic and resilient. It'sproven to be a durable competitive advantage, not just a talking point. Itinsulates the office market from the kind of sector-driven demand shocks thathave hit other cities much harder.

What is happening to rents in London, and are current levels sufficient tojustify new development?

Rents are rising, butthey haven't yet reached levels that justify large-scale new development.Construction cost inflation has been severe enough that, even with meaningfulrent growth, we estimate rents still need to meaningfully increase before theytrigger a significant supply response.

That gap between whererents are today and replacement cost is, paradoxically, one of the mostimportant features of the investment case. It means that even as rents movetoward replacement cost over the medium term, the price signal doesn'ttranslate to immediate new supply because of the lack of space available andthe difficult development environment. The price signal and the supply responseare fundamentally decoupled in London in a way that simply doesn't exist inmost other markets.

Buying existing assetsis the best and one of the only ways to access forward rental growth potential,which is only truer, when viewed on a risk-adjusted basis. Acquiringwell-located, tenanted buildings at discounts to replacement cost gets you thesame upside with a fraction of the risk.

Do you see opportunities broadly in office across Greater London or, likeNYC, is the demand concentrated in certain areas and for specific products?

We are highly focusedon central London offices and established, core locations. We are targeting100,000 square feet or more, Class A buildings with top-quality internationaltenants in-place. The current environment is creating the ability to buyexisting buildings at significant discounts to replacement cost which is atypicalin London but is the most compelling opportunity available now.

We're pairing thatwith a deliberate strategy identifying high-end corporate users, leading lawfirms, and other strong-credit tenants that have leases expiring over the nextfour to six years. We've already made two office investments and are using ourlong-standing market presence to generate more targeted investmentopportunities across our opportunistic funds and SMAs.

How are Meadow's investments, such as One Wood Street, informing yourviews of the London office market?

One Wood Street is amicrocosm of what we see playing out across the London office market broadlyand reinforces our conviction that compelling opportunities exist to invest inwell-located London offices where the underlying demand remains strong. TheGrade A building sits on a prominent island site in the heart of London betweenthe Bank of England and St Paul's Cathedral, and offers excellent natural lightand floor-to-ceiling windows that allow for sprawling views of the surroundingareas. The property is a prime asset in a market where high-quality supply isincreasingly scarce, and higher rents can be commanded.

Tenants increasinglywant to work in the best buildings in the best locations, but there is simplynot enough new supply coming through the pipeline to satisfy tenant demands.Planning and regulatory delays, construction costs and the availability ofdevelopment capital are all making it increasingly difficult to add new officespace in London.

One Wood Street is anexciting and particularly interesting investment because it not onlyillustrates, but allows us to take advantage of, the disconnect between demandand rents. Existing office rents in Londonare significantly below prevailing market levels, while demand for high-qualityspace continues to strengthen. One Wood Street serves as an opportunity to owna great building at an attractive basis, while benefiting from the rentalgrowth we see.

How are UK lease structures different from what you see in the US?

The standard UK officelease is arguably the best in the world. To start, UK leases have longer datedlease terms of 15- to 20-years rather than 10-year terms found in other cities.Landlords benefit from net rents unlike gross rent, which is commonly found inmost other markets. Building operating costs and real estate taxes are paiddirectly by tenants, a great inflation buffer.

Tenants are alsorequired to pay repair costs and replace the building façade through the lifeof an asset, which further reduces future Landlord cost exposure. Put itall together and these office investments offer a cash flow stream that islonger in duration, lower in volatility, and are structurally positioned tocapture rental growth. That makes UK office assets more attractive on arisk-adjusted basis than a surface-level yield comparison to other marketswould suggest.

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