Supply shortage is main challenge

LSH

4th January 2017

Property Portfolio

Lambert Smith Hampton

AN acute shortage of quality supply is arguably the main challenge to the long-term vitality of the Midlands Engine region's main office occupier markets. While the dynamics support speculative development, investors and developers remain cautious, particularly in light of the recent Referendum result. In tackling this challenge, the public sector can play a vital enabling role to kick-start development.

REFERENDUM RESULT COMES AT AN AWKWARD TIME

Despite UK property's global appeal, the impact on developer confidence stemming from the shock EU Referendum result cannot be downplayed. As the complex process of Brexit negotiations runs its course, the period of uncertainty may be protracted and we can only hope that the outcome works for

the long-term interests of the UK economy. The timing of the Referendum result has come at an awkward moment in the cycle. Developer confidence was improving in the Midlands, with cranes justifiably returning to the Birmingham skyline over the past 12 months. Before the Referendum, the question was not will development spread to other Midlands locations, but when. It's unfortunate, but understandable, that the result has put investors onto the back foot.

Crucially, however, the Referendum has had no bearing on the attractive supply fundamentals in the Midlands occupier markets. While the appetite for development may have weakened, the case for new office development in the region is now, frankly, compelling.

SPECULATIVE DEVELOPMENT IS IMPORTANT

If occupier-led development can deliver new space, what's wrong with waiting for the pre-lets to arrive? Office-based employment is crucial to the UK economy and in any large urban area, speculative development is vital to support jobs and business growth. This view was echoed by urban policy think tank, Centre for Cities, in its 2012 paper Making the Grade.

While a pre-let commitment may be appropriate for a minority of occupiers, the majority are frankly not in a position to wait at least two years for a bespoke solution. Ultimately, most occupiers want to visualise and experience the physical space prior to taking it. Provision of new space is therefore fundamental to providing the environment for modern businesses to grow and flourish.

BEYOND BIRMINGHAM

So what does Birmingham have that the other markets do not? The general aversion to speculative development in the region's other key markets is ultimately rooted in the perception of risk. Put simply, the smaller the market, the lower its critical mass, the higher the perceived risk of void. However, the dynamics to support development beyond Birmingham are largely in place. Occupier demand has recovered strongly in recent years, eroding grade A supply to such an extent that the majority of markets are unable to satisfy requirements above 10,000 sq ft. Poorer quality stock has also been lost through the relaxation of planning law, allowing space to convert to residential. This has put rental levels under pressure in the region, albeit focused on quality second-hand space due to the virtual absence of brand-new supply. Ironically, the lack of prime headline growth in some of the Midlands Engine markets reflects the lack of product, as opposed to an unwillingness to pay. Rental growth is crucial, as it boosts the viability of proposed schemes.

If the private sector cannot grasp the opportunity, the public sector can, of course, use its regeneration powers or strength of covenant to drive development forward.

Firstly, the public bodies should be as accommodating as possible. In some cases, the local authority has the land but is governed by archaic rules whereby a developer must secure a 50% pre-let before it can secure what is publicly controlled land. This is far too restrictive. We have also seen examples where developers have not quite achieved the required level of occupier commitment, thereby failing to unlock or deliver a scheme, despite being well funded and willing to commit to the speculative element of a scheme. This, frankly, must be addressed if the public sector inward investment teams are to be true to their sales talk.

Northampton Borough Council is currently looking to commit to a 60,000 sq ft office development at FOUR Waterside on this very basis, as part of the Northampton Waterside EZ. Rather than seeing this as a high risk strategy, local authorities need to look at the wider regeneration benefits for their respective towns and cities. Their financial powers and the value of their covenant may prove key to driving forward the delivery of a new generation of office development.

LSH