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Flexible terms in flexible space: is London’s office market changing for good?

The London office market is not what it was 10 years ago.  A combination of “place-making”, changes to employee working patterns and the development of efficient and robust IT infrastructure has enabled London’s work force to become a much more mobile community which has prompted a change in attitudes to leasing.

Businesses, particularly small to medium enterprises, are changing the way they manage their exposure to the property they occupy.  SMEs think in much shorter timelines, which at its most extreme is on a quarterly rolling basis and at the other end, over a 2 year cycle (invariably tied to the EU negotiation timeline).  As such, the growth in the “non-traditional” leasing sector that is suited to this type of occupier has been meteoric over recent years, leading commentators to suggest that by 2030, 30% of all office space in the capital will be let under “non-traditional” or “flexible” leases.

Larger corporates that have the resources to commit to property long-term (both space requirement and financial exposure) remain suited to a traditional “investment grade” lease.  That large proportion of London’s leasing market remains relatively undisturbed.   However, change is underway and influences from the non-traditional market are beginning to break into the mainstream.

Further, as the British Property Federation’s Model Commercial Lease gets adopted over time, it will create a more even and customer focused market for tenants looking up and outside investors looking in.  The introduction of a better dilapidations protocol, a less burdensome alterations process, a relaxation around the use of space and generally a more realistic business platform, will move that end of the market into a new (and some would say “non-traditional” space altogether).

With the shortage of brand new supply in the capital, landlords (and the larger corporates mentioned above that no longer require full occupancy) are maximising the use of second hand space.  This is true of both established landlords (the likes of British Land) and new players to the market (WeWork, The Office Group).  These entities have capitalised on the growth of SMEs in the financial-tech, TMT and creative sectors by presenting opportunities for SMEs to maximise the use of space in a more flexible and customer focused way.

Principally flexible leases are shorter (both length of term and the document itself). They narrow the occupier’s financial exposure relative to the low cost of equipping the premises and allow SMEs to occupy the space immediately to avoid protracted fit outs and delays, which appeals to SME start-ups and companies in their infancy.  All-inclusive rent, service charge and insurance deals are common as are proportionate commitments to other occupational costs. More immediate termination rights are offered in lieu of the more traditional insured damage regime (a mechanism that would otherwise tangle the occupier in needless process at a time it needed to remain quick-footed in a moving business environment).   Legally, the non-traditional lease shares many similarities with the investment grade model.

Given the minimal fit out and connectivity to mechanical plant and equipment already in place, landlords maintain relatively tight grips on the occupier’s ability to alter, as they do around commonly required investor, group or “hub” sharing provisions by taking the leases (and the space sharing provisions within them) outside of the protection of the Landlord and Tenant Act 1954.  Similarly, the occupier’s ability to offload the space is suitably narrowed to avoid occupiers creating layers of interests that could impact landlords’ liquidity.   Contrast that with lighter touch tenant break options (frequency and conditionality) and you can see how these arrangements favour both parties.

Economically, the rise in non-traditional leasing has had a negative effect on both rental value and demand for space in the institutional sector where landlords have voids to fill.  In a growing flexible sector, SMEs have more choice and current estimates suggest there are around 150 flexible workspace centres in London, a number that will no doubt increase through Brexit and beyond.   There’s certainly room for new players in this rapidly growing market, but they had better act fast.  The wider feeling is that the rapid rise in the non-traditional leasing sector will have a truly transformative effect on the London market in years to come.

An earlier version of this article appeared on EGi and in the EG London Investor Guide series.