The soft property market is about to firm up, but tenants are looking beyond cheap deals in their search for value.
CFO 01 April 2004.
Three years of good news for tenants, in which rents have fallen and incentives have risen to up to 25 per cent of the gross value of a lease, are coming to an end. This is despite the fact that building owners have more than 1.7 million square metres of space waiting to be filled – enough to house between 100,000 and 140,000 staff, depending on how tightly they are packed in.
According to the latest figures from the Property Council of Australia, out of the 13.3 million square metres of CBD office space in Australia, 9 per cent, or more than 1.2 million square metres, is vacant. Of the five million square metres of non-CBD space – North Sydney, Chatswood, St Kilda Road, the Gold Coast and so on – 8.9 per cent, or more than 517,000 square metres, is vacant.
Why, when there has been a residential property boom, is so much office space empty? The answer is that the link between rising interest rates and falling property values and rents does not hold true for the commercial sector. For offices, the supply and demand equation is directly linked to the global, rather than local, economy and the cost of capital.
While the residential market boomed on the back of low interest rates, and the retail sector boomed because investors were looking for a smart place to park their money, the commercial property sector has been in recession since 2000 – bad news for company shareholders, but good news for anyone re-negotiating a lease in a soft property market.
According to the head of property investment research at Macquarie Bank, Rod Cornish, the fortunes of overseas companies have a big influence on local property markets. He says office property tends to have a positive correlation with rising bond yields. With bond yields rising as the economy improves, so will commercial property rents.
BIS Shrapnel property analyst Angie Zigomanis says that the next upswing in Australia will be driven by investment. He says unemployment is at its lowest since the late 1980s, and many businesses are operating near capacity and cannot expand without investment.
The property and business services sector – accountants, lawyers and consultants – is one of the key drivers of office demand, with business services accounting for about 85 per cent of the action. Despite the buoyancy of the property sector, business services have been shedding staff and looking to cut property space. Local offices of global companies have been cautious in their plans for expanding office space, reflecting head-office concerns over what has been a weak world global economy.
“Even though the Australian economy was performing well, there was a lot of concern over what was happening overseas, so tenants wouldn’t take up space,” Cornish says. Effectively, he adds, Australia has been in a white-collar recession, with the demand for space from business services companies weaker than during the recession of the early 1990s.
The improving global economy, says Cornish, is having a positive influence on leasing demand and will lead to increased rents. In 2004 he expects the white-collar economy to overtake the blue-collar economy, leading to an upturn in demand for office space.
Despite the economic good news, current demand for office space is still very weak. There is a nine-month lag between business conditions improving and companies leasing out space, according to Cornish.
Market analysts agree that office rents will rise; the only question is whether they will do so towards the end of 2004 or early in 2005 in Sydney. Usually, Melbourne lags behind Sydney.
According to the latest Property Council of Australia office market report, vacancies in the Sydney CBD increased to 9.5 per cent of 4,468,334 square metres for the six months to January 2004, up from 8.6 per cent in July 2003. The total vacancy rate for A-grade property in Sydney rose from 7 per cent in July 2003 to 11.2 per cent in January, and B-grade property was up from 8.6 per cent to 9.2 per cent. Outside the CBD, tenants have even more leeway with higher vacancy rates – 9.9 per cent in North Sydney, 12.3 per cent in Chatswood and 14.6 per cent in Crows Nest.
In the Melbourne CBD, vacancy rates rose from 7.8 per cent to 9.6 per cent of 3,195,443 square metres, with 128,056 square metres added to the market in the year to January and further new space becoming available in 2004. On St Kilda Road, of the 770,700 square metres of space, 10.2 per cent was vacant.
Brisbane, in contrast, is benefiting from a migration-driven boom. Each week, more than 1000 people are moving to the state. In the CBD, 6.4 per cent of 1,649,620 square metres of space is available, or 104,935 square metres. Outside the CBD, there is a vacancy rate of 12 per cent.
In Adelaide and Perth, vacancy rates are into double figures – 11.7 per cent and 12.2 per cent respectively.
Despite the oversupply in offices, these figures do not reflect the vacancy rates among quality building owners that manage their property portfolios to minimise peaks and troughs in demand. The Investa Property Group’s managing director, Chris O’Donnell, says the group’s vacancy rate across the whole of Australia is 4 per cent, despite last year’s takeover of the Principal Office Fund (renamed Delta), which has a vacancy rate of 7 per cent. The Investa portfolio has a 2 per cent vacancy rate. O’Donnell says the group tries to manage its lease expiry about 10 per cent each year. During 2004-05, about 7 per cent of the group’s leases will expire.
In a market overflowing with opportunities, agents are inevitably trying to seduce tenants with incentives such as fit-outs and rent-free periods.
Incentives have been widely available in the Sydney market for the past three years and in Melbourne for the past two.
In Sydney and Brisbane, incentives can amount to between 20 and 25 per cent of the total value over the life of a lease. For prime space in Melbourne, says FPD Savill’s national research manager, Marc Pallisco, tenants can get an incentive worth between 15 and 25 per cent of gross lease value.
Pallisco expects incentives to be offered for the next few years but to peter out in Sydney over 2004. “The difference in Melbourne is that we didn’t really have any incentives up until two years ago,” he explains. “It has hit the market very hard.” The buildings with the highest incentives in Melbourne – Arthur Andersen’s old offices at 360 Elizabeth Street and 1 Spring Street, occupied by Shell before it relocated out of the CBD to Hawthorn – are mostly fully leased now.
“Tenants definitely hold more bargaining power. It is an opportune moment for them.”
In a recent survey of corporate real estate by property agent Jones Lang LaSalle, more than half the respondents wanted to cut property costs by 10 per cent in 2004. Enlightened tenants such as accounting firm KPMG (see page 52), National Australia Bank, Bendigo Bank, Lend Lease or BHP Billiton are looking further than the raw numbers in making their property decisions, and are not opting for the cheapest in the market.
In competitive recruitment markets such as professional and financial services, tenants are realising the benefits of a building’s environment to the productivity of employees. They are also highly aware of where green issues fit into their policies for corporate and social responsibility, and the savings in running costs that environmental responsibility can bring.
Landlords such as Australand, Deutsche, General Property Trust and ING are switched on to creating a green marketing edge in new developments. Although the rentals may be equivalent to CBD premiums, tenants are benefiting from lower running costs. O’Donnell says he is seeing a growing client demand for green buildings. “It’s attracting an increasing level of importance with tenants. It is now becoming more of a feature, whereas three years ago it didn’t really rate at all.”
There are varying levels of awareness among tenants. Mining and resources companies such as BHP Billiton are typically showing more interest, but other industries have yet to focus on the environmental issue. O’Donnell says that when he takes time to talk to others about some of the options available in becoming a green tenant and cutting running costs, many become interested.
But cost is still a major factor for some. “It is fair to say that most tenants reflect on the financial bottom line as a key factor,” O’Donnell says. “I don’t think there are many tenants who are prepared to pay extra for green buildings, but from our perspective, the initiatives that we have put in place don’t [necessitate us] having to pay extra.
“I think that when you have got a tight tenant market and a tight leasing market, there’s no doubt you have to compete on price. However, if you have a competitive edge in something like sustainability, I think that point of difference will persuade people to choose your building over someone else’s offering.
“Most people, when you point out that they can really make a difference in their tenancy, want to start working at it. There is still a long way to go, but I’m seeing a lot more enlightenment in tenants.”
Pallisco says that buildings’ green performance is slowly coming onto the agenda. “Environmental performance of buildings is becoming a priority – but not the priority,” he say