Office rents will need to rise before supply catches up with demand

Frank Gelber - The Australian April 07, 2011

The collapse in new office developments during the global financial crisis is hitting supply - even moderate demand will result in falling vacancy rates.

The tightening leasing markets will shift the balance of power from tenants to owners, causing a rise in rents.

The problem is on the supply side. We're not building nearly enough office space. In fact, the softening in office yields has left prices below replacement cost levels, inhibiting new development. This is made worse by extreme caution in both equity and debt markets, requiring substantial pre-commitments that lock in current low rents.

If I had a site and choice over timing, I wouldn't develop now. Pre-commitments at current rents mean locking in a reduced cash flow and a lower value for the building. It doesn't make sense. I would wait three years.

The problem is that the GFC-induced correction is only half-finished. The first part was in investment markets - the correction in prices/yields. The second part has yet to come - that is the rise in rents required to underwrite financial feasibility for the next round of development projects.

The office property markets have started to recover. But this is just the beginning. Rents, and hence prices, will rise a lot more before this is over.

Tenants won't pay more rent just because owners say they're below replacement cost levels. They'll do the best deal they can in the current market and that will continue to inhibit development. It's the consequent tightening in leasing markets that will raise rents. That rise will underwrite the next round of construction.

That's the mechanism by which we'll generate increases in supply. But it's slow. Even if we start now it would take years to get substantial additional supply on the ground.

Meanwhile, the demand for office space has picked up. Let me be more specific.

The recovery in the net absorption didn't come out of the blue. It was preceded by strong office employment growth, underwriting an increase in the "underlying demand" for space. Net absorption has only just caught up to underlying demand. Employers have been reluctant to take on new space, squeezing more employees into existing space and tightening workspace ratios (office space per employee). That creates a latent demand for future take-up. The same thing happened in the early part of last decade. 

Where is all the demand coming from? Property and business services constitutes a quarter of the office workforce. Add in public administration, finance and insurance, and we're up to almost half. Then manufacturing, health and construction add more than 7 per cent each, making more than two-thirds of the office workforce.

Employment has rebounded strongly since the GFC, up 3 per cent in the year to December. It stalled in the first two months of this year, but should resume solid growth as the year proceeds. By sector, it's a mixed bag on performance. Business services, the greatest contributor to the office workforce, has been particularly strong, up more than 20 per cent in the year to February. So too was government administration. Finance and insurance is languishing, along with manufacturing, but construction, education and health are strong.

About half of office employees work in dedicated office buildings. We call them the stand-alone office workforce. For us, the "underlying demand" is the additional space required to house growth in the stand-alone office workforce at existing workspace ratios.

It has always been a great leading indicator of net absorption. And it's strong. This time was no exception. Underlying demand picked up before net absorption, creating a latent future demand. The last quarter's pause in employment has brought it back to the level of net absorption, about 750,000sq m in the metropolitan areas of the major capital cities. This year it will be back at 900,000 to 1 million sq m a year. Net absorption will strengthen further.

The composition and strength of stand-alone office employment can vary by state. Interestingly, Melbourne and Sydney are showing the strongest growth.

Having missed the pre-GFC construction boom, their vacancy rates are lower than the minerals boom cities. But employment is growing in all states, driving strong underlying demand. And all states were affected by the collapse in development.

Put simply, we're not building enough. Vacancy rates will fall over the next four years at least before the next round of development alleviates the shortage.

Before that can happen, we'll need strong rises in rents. Given the lead times in development, rents will overshoot current replacement cost levels, underpinning price rises, attracting investors and underwriting the next boom.

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