Fitting in the Fit Out

Economic Trends and Real Estate Impact

Inflationary pressures that dominated the economic environment in 2022 and 2023 are showing signs of easing across the UK economy. The consequential increases in the Bank of England’s base rate up to 5.25% – the highest level since 2008 – are now expected to gradually ease over the medium-term.

While price rises are slowing, they remain at elevated levels bringing impacts across real estate. Tender prices, for example, have risen by 17% since 2020 with developers having to pay higher prices for materials and labour. Raised interest rates have also pushed up borrowing costs, causing prime yields to move out by over 200 bps in some markets.

Rental Market Dynamics and Office Trends

Pricing pressures combined with the limited supply of in-demand Grade A space across the Big Five and South East office markets are causing prime rents to increase, particularly in under construction schemes.

Across the Big Five and South East office markets, anticipated rental values in under construction schemes are an average of 20% above local prime rents recorded in Q1 2022 at the start of the inflationary period. This is driving the growth of the ‘super prime’ office market across the UK, and is a significant increase from even six months ago when we released our original analysis of this rental growth trend.

Given these conditions, it is then unsurprising that our 2023 global research report, What Occupiers Want, identified cost pressures as the most important strategic driver amongst occupiers for informing key office real estate decisions in both EMEA and globally.

Fit Out Costs and Negotiations

As a result of this fiscal focus, as well as the changing nature of the office toward a place of collaboration, experience, and interaction rather than ‘just a workplace’, occupiers are becoming increasingly discerning in their search for space.

While the rental growth seen across the UK is evidence that tenants recognise the return on investment over the long term provided by finding the right property despite potential rental premiums, cash-intensive elements of major office moves remain under heavy scrutiny. Arguably, the most substantial of these is the fit out cost.

Costs are also rising, with materials, labour and supply chain stress all contributing factors. Required specifications are increasing too as the role of the office changes. The focus on collaboration as well as attracting people back into the office has increased typical provisions for meeting facilities, communal spaces and feature fittings, all delivered to a high-quality finish and using sustainable materials. These factors all come at a cost and budget restrictions – particularly on the capital expenditure side – may mean that not everything can be included.

In our 2024 EMEA Office Fit Out Cost Guide, we highlighted that a medium-spec office fit out costs an average of £213 per sq ft in London, rising to £316 for a higher level of finish. This is an increase of 4% and 2% respectively versus London fit out costs in 2023. While national markets offer discounted fit out costs relative to the capital, average local rent levels mean that these costs are often more expensive than London when considered as a proportion of the overall price of the lease.

These costs can be met with resistance due to the capital expenditure intensive nature alongside increases in rent liabilities that are likely to come with an office move, despite the long-term gains to employee satisfaction and productivity strong fit outs provide. However, fruitful negotiations between prospective tenants and landlords can achieve a mutually beneficial solution.

Landlord-Tenant Collaboration and Future Trends

There are increasing examples of landlords working with tenants to take on the upfront capital expenditure required for fitting out their space, providing this as an incentive with the cost then spread out across the term of the lease. The upfront expense is often more palatable for landlords as they typically take a longer view – particularly if it helps to minimise vacancy and reduce voids – whilst the structure of the deal also invariably requires a longer lease term than they might otherwise be able to achieve. Landlords who own or operate multiple spaces are also likely to have greater experience in delivering fit outs and may also be able to achieve discounted rates through deals with contractors to work across their portfolio. This is particularly relevant given the shortage of contractors available.

Meanwhile, occupiers to are able to minimise exposure to double property overheads that they would otherwise have to cover to during a fit-out of new offices, and move into their new space without a substantial cost beforehand while still having a bespoke workplace suited to their specific needs. Additionally, any potential consequential increase in rent tends to be more amenable to occupiers as this falls under operating rather than capital expenditure, and hence tends to sit better on the balance sheet.

Providing this fit out incentive rather than a typical rent-free package is likely to increase in popularity as it can provide a greater benefit to both parties and enables essential real estate decisions to be enacted in a cost-sensitive economic environment.