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Brexit hits London office development hardest as investors await deal decision

As the U.K. and European Union struggle in Brussels to make progress on Brexit negotiations almost 18 months after the U.K. voted to leave, the impact of the referendum decision on London's office market is looking increasingly potent.

Investment in London office developments is failing to recover from the plunge seen in the wake of the vote, according to industry analysts, with the tightening of supply expected to hit the market over the next two years. Contract awards for the construction of U.K. commercial projects are on track to fall for the second year running, data from construction industry analyst Barbour ABI shows.

Investment in U.K. commercial development reached £11.32 billion in 2014 as it began to recover from the aftermath of the global financial crisis, maintaining that pace in 2015 to hit £11.15 billion. The 2016 total then fell to £8.42 billion, with the six months that followed the Brexit vote showing a particularly steep decline. Figures show that investment in the sector is set to slow again in 2017, with £7.38 billion committed as of November.

"[Investment in commercial development has] definitely been lower since after the Brexit vote," Michael Dall, lead economist for construction at Barbour ABI, said in an interview. "And the biggest change has been the high-value, City of London office developments, which haven't been as prevalent in the figures as they were before the Brexit vote."

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According to Barbour ABI's research, development investment peaking in June to August 2015 — moving averages for those three months were £1.21 billion for June, £1.36 billion for July and £1.36 billion for August — levels that were expected to continue into 2016 and beyond in normal circumstances, said Dall.

Barbour ABI's data show a slight uptick in investment in U.K. commercial developments in the three months from August to October 2017. commercial developments, rising from a three-month moving average of £533 million in July, to £785 million in August, £739 million in September and £754 million in October. Two projects were responsible for the increase over that period — a £200 million contract awarded by Canary Wharf Group for the 1 Park Place office development and a £180 million contract for the Lakeside Leisure Centre Extension in Essex.

"For this point in the [real estate] cycle, [investment in office development is] still pretty low," Dall said.

Noble Francis, economics director at the Construction Products Association, highlighted data from the Office of National Statistics showing that commercial office orders fell by 19.7% year over year in the second half of 2016 and sank again in the first half of 2017 by 24.3% compared to a year earlier.

Francis said in an interview that the collapse in new orders for commercial offices was down to a combination of market conditions before and after the Brexit vote.

"In 2016 there was already investor concern that pricing for new high-profile commercial offices projects in London was too high," he said. "[But] it also represents a sharp fall in international investor interest in additional office space where the demand is from the financial and business services sector in London due to Brexit."

The political and economic uncertainty created by Brexit has led several large financial services firms to announce relocations of part of their London operations to other European cities, with UBS, Goldman Sachs and HSBC among those planning the largest moves.

While any large-scale exodus from the city would hurt London office landlords, those who have active development pipelines should benefit from the decrease in new stock entering the market in the coming years, according to Robert Duncan, who covers the largest U.K. real estate investment trusts with office assets as director of research at Numis Securities. Derwent London Plc, Helical Plc and Workspace Group Plc are among the UK REITs with larger and more active pipelines, said Duncan, while British Land Co. Plc, Great Portland Estates Plc and Landsec have more limited development plans.

Until greater clarity on the terms of the U.K.'s exit from the EU is received by investors, investment in commercial development is unlikely to pick up, Dall said.

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Several large financial services firms with
offices in London's Canary Wharf have
announced plans to relocate part of their U.K.
operations to other cities in the EU.
Source: Thinkstock

"Why would you award a contract for a large-scale office development at the moment when you don't know what the demand environment is going to be?" he said.

And if the ongoing negotiations in Brussels do not reach a positive conclusion, Dall warned, it will not just be commercial real estate development that sees a slowdown in investment. "That's the nightmare scenario really; that it's either no deal or a bad deal."

"I think there will be a healthy level of competing demand for the right space in the right building in the right location," he said. "I cannot see anyone wanting to take secondhand and essentially compromised space. So prime will see net positive absorption, but secondary will see net negative absorption, and that has to start being factored into rental expectations for secondary [assets]."