International News Research

Prime time for European CBD office space while non-CBDs trail

Global real estate investment and asset manager, AEW, has published a report on the European office market to fully capture the polarisation between prime and secondary buildings which has accelerated with the increase in remote working.

European office markets continue to adapt to the new normal of remote working. Office usage rates and planned office footprint reduction point to a lasting impact on occupier demand with continued growth in office-based employment, and a recent stabilisation of office space per employee, partially offsetting these impacts.

The fundamentals of occupier demand and supply show a balanced picture going forward in Europe. Stock growth, which has been contained since the Global Financial Crisis (GFC), is expected to be further scaled back to under 1% per annum after a moderate catch-up post-Covid-19.

Simultaneously, net absorption is expected to revert to higher, pre-pandemic levels from 2025.

Combined with an increasing number of office conversions, supply and demand in European offices markets is expected to rebalance with the vacancy rate anticipated to peak at 9% in 2024 but to decrease by 200 basis points over the next five years as new developments start to slow down. A peak in European office stock is expected in the coming years.

The more than twice higher vacancy rate of non-CBD office sub-markets (10%) compared to CBD locations (4%) illustrates the current level of market splits. Occupiers are now favouring more central locations to convince workers to return to the office and can afford to do so as they reduce their office footprint. Sought-after CBDs are facing a lack of available supply which is driving prime rental growth.

By contrast, average contracted rents have remained stable, and incentives granted to tenants on signature of a lease in non-CBD locations, have increased. On a net effective basis, secondary rents have been falling more than prime rents.

Combined with an overall high level of capex in the office sector, means that net operating income for office investors often disappoint. In addition, energy efficiency is no longer a nice-to-have feature but a must-do reporting based on real energy consumption data to meet the requirements of both regulators, (potential) tenants and future buyers. This is expected to further exacerbate the current divide between prime and secondary assets and further increase associated capex.

The European office investment market remains subdued with activity focused on small lot sizes and central locations with 2023 volumes close to a record low. This was triggered by investor’s concerns about the impact of remote working and their decision to diversify their portfolio away from offices.

The record high yield spread between CBD and non-CBD submarket yields of 140 basis points, also confirms the current split.

Centrally located, prime assets, remain sought-after by many investors. Refinancing challenges – as quantified in our relative debt funding gap – remain significant for European offices and are expected to be concentrated in the non-prime part of the market.

Looking ahead, prime office values are expected to recover faster than secondary offices, from H2 2024 onwards, after a significant repricing of more than 32% for CBD offices and 38% for non-CBD offices since mid-2022.

This offers an attractive entry point for new investments in prime European offices. In fact, prime office returns are forecast at 9.6% per annum driven by a combination of an expected average yield compression of 60 bps and solid prime rental growth. This is highest among all property sectors.