Office Market Overview

There was a subdued start to 2023 in the office letting markets of the Big 7 German real estate strongholds, with almost no lettings above 5,000 sqm. Total market take-up was 607,000 sqm, which corresponds to a fall of around 30 percent compared to the first quarter of 2022. Where letting volumes in 2022 were something of a pleasant surprise, the dip in the first quarter of 2023 was only to be expected, but it could also be interpreted as a temporary lull. While potential demand remains robust and companies are benefiting from a slightly improved economic environment, costs and uncertainties are impacting corporate decision-making processes.

The office letting market has experienced a rough ride since New Year and momentum has declined noticeably after the exceptionally strong year in 2022. In the medium term, we continue to see strong demand and a healthy pipeline. While deals are getting smaller, building quality, ESG criteria and central locations are playing an increasingly important role, so competition and rental price development remain dynamic. The various business sectors are also behaving highly divergently.

The developments in the individual sectors must be seen in the context of the differentiation between the economy and the labour market. Increased energy and personnel costs do not affect all sectors equally, and even if gas and electricity costs have settled back to a significantly lower level, concerns about additional wage costs remain and are not only impacting companies but also the European Central Bank. The bank sees the danger of a wage price spiral due to the continually high core inflation rate. The latest wage settlements negotiated between employers and trade unions are well over 10 percent in some cases and agreements have not yet been reached for all employees. Assuming there is an average wage hike of 10 percent for all 11 million unionised workers, this would bring additional costs of over €3 billion for the companies concerned. It remains to be seen whether and to what extent this additional cost burden will be passed on to customers and suppliers.

By contrast, staff and therefore consumers benefit from wage increases, which has already been reflected in the brighter sentiment during March. The relevant GfK indicator rose to its highest level in 10 months. Sentiment is also continuing to brighten in company boardrooms. Despite the recent banking tremors, the Ifo business climate index rose to 93.3 points from 91.1 points in the previous month. This was the fifth successive increase. Expectations for the next six months have improved significantly, including in the construction sector which has been badly hit by the interest rate turnaround.

The underlying conditions supporting moderate optimism in the office market are now in place. Better business prospects appear to compensate for higher costs and an expected slowdown in bank lending. Based on all factors in our evaluation, we expect that the total letting volume will be up to 10 percent lower than in 2022. At 3.1 million sqm, this would nevertheless be a result which would only be 10 percent below both the previous year's performance and the 10-year average.

Downturn in space take-up in the first quarter due to the lack of large-scale lettings

With a take-up of 607,000 sqm, the Big 7 real estate strongholds have been anything but consistent. Although no city was able to escape a downturn, it was more moderate in Düsseldorf (-20 percent) and Berlin (-22 percent) than in Stuttgart (-53 percent) and Munich (-39 percent).

Large-scale deals in the >5,000 sqm size category were barely in evidence in January to March. This is particularly evident in Munich where just two large deals over 5,000 sqm were registered and the average area per letting was just 753 sqm. However, some large lettings are still in the pipeline and could be completed during the year, which will have an impact on total take-up. We see good marketing opportunities, especially for larger units with new space concepts. There is a chance of another very good year because the current enquiry situation is as strong as it was back in early 2020. The question is how much of this can be completed this year.

The aftermath of the COVID-19 pandemic has not entirely dissipated and many companies are repositioning themselves or reviewing their workplace concepts. The pressure to change in the office segment remains high and often requires fundamental realignments to enable companies to survive in the labour market over the next few years. Sustainable properties with clear ESG criteria are in particular demand, including a contemporary and high-specification technical fit-out concept. This will also tend to shape demand this year. Even in the first quarter, the proportion of space take-up attributable to Grade A space was almost 70 percent. The maxim is: it does not always have to be a larger area than before, but better quality and therefore more expensive space. According to a JLL survey, more than 60 percent of companies are pursuing a hybrid working strategy involving both office work and working from home. Offices, especially in central locations, remain part of this strategy.

In terms of tenant mix, it is evident that the globally weakening tech sector is behaving more cautiously on the German office market. This applies to both further expansion plans and the current space requirement. Price sensitivity has increased across the board, and JLL has observed that more space in this sector is being marketed for subletting. By contrast, management consultants, tax advisors and law firms continue to grow, and their willingness to pay for premium space in central locations is still evident.

Vacancy is above 5 million sqm in the Big 7 cities for the first time since 2016

The vacancy level in the Big 7 cities rose to over 5 million sqm for the first time since the end of 2016. This corresponds to an increase of 12 percent compared to the same quarter the previous year. The vacancy rate therefore rose to 5.2 percent. The period of almost seven years of scarce supply on the office market is now “unofficially” over with a vacancy rate of over 5 percent. Nonetheless, JLL still does not see an excess of supply, and this confirms the forecast of a further moderate increase in vacancy rate to 5.8 percent by the end of 2023. While plenty of space is available in Frankfurt and more construction is under way, elsewhere space is already in much shorter supply and developments are slowing down. Those cities will be heading for a supply bottleneck in around two years’ time, which is already becoming apparent, and this will tend to increase the pressure in the respective markets.

The differentiation between top space in high demand and poorer quality offices continues. That part of the office market which can no longer meet requirements in terms of location and quality will fall out of the market, be converted or demolished. The future will tend to lie in the refurbishment and optimisation of existing buildings. Older space will only be successfully marketed in future with appropriate investment in refurbishment. This also applies to space offered for subletting if the space no longer fits a company’s profile or the company is looking at downsizing.

We are currently registering a volume of 827,000 sqm offered for subletting on the market. This is almost 13 percent more than in the previous quarter. The proportion of total vacancy remains unchanged at 16 percent.

Even if the overall situation in the construction industry has recovered somewhat, it is still far from normal. The building price index is still rising (+2.5 percent in Q4 2022 compared to Q3 2022), and as long as interest rates also remain high, the market for project developments will remain tight. Combined with the persistent materials and personnel bottlenecks, this continues to weigh heavily on many companies. The pull on the handbrake is also reflected in the completion figures for the past quarter. Around 218,000 sqm were completed in the Big 7 cities, which is not even half the volume from the final quarter of 2022, and the supply of new-build space fell by 52 percent year-on-year. In Berlin, the completion volume fell by 85 percent to just 45,000 sqm. It is clear that projects that have pushed ahead are still being completed, but new projects are often postponed due to incalculable costs and uncertain scheduling. Banks are also taking a more critical look at financing commitments and now demand a much higher pre-letting rate before construction begins than they did in the past. We are currently registering over 100 office projects under construction in the Big 7 real estate strongholds, more than half of which are already pre-let (excluding owner-occupier properties). This correlates with the letting situation of projects completed in the first quarter, when pre-lets accounted for around 50 percent.

So where do we go from here? For the remainder of 2023, 1.4 million sqm is still under construction, and so the divergence compared to 2022 should disappear by the end of the year and a similar volume of new-build completions can be expected. In the current market situation, this consistency can be interpreted as a positive sign. Even if the expected completion date for some projects has been pushed back, simply abandoning projects which have already commenced would certainly be a very bad signal. Equally positive is the fact that pre-letting for 2023 is already at almost 60 percent, so there is no significant pressure being exerted on the vacancy level by the new-build sector.

Prime rents continue to rise but at a slower pace

After the rental momentum over the last year, growth in prime rents will flatten out during the course of 2023 due to the causal effect. However, at the moment, JLL’s prime rent index is at 264 points which is 13 percent up on the previous year’s figure. Nonetheless, the only big hike in prime rents compared to the last quarter of 2022 was in Cologne, with a moderate rise in Berlin and Munich. For the year as a whole, JLL expects an average increase of just under 6 percent across the Big 7 markets. The focus on high-quality offices will continue. At the same time, inflation will remain at a comparatively high level over the next year. As the majority of leases are index-linked to reflect inflation, pressure on rents will remain, even outside the narrow premium band. However, owners are increasingly accepting other rent adjustment clauses in new lease contracts, such as stepped rental increases.