“Effective office rents will triple in 3 Years” – sorry, but it’s time for a reality check

If you've had time to take in some of the press over the last few weeks, you could be forgiven for thinking that your property rental costs are about to threaten the very existence of your business.  If premises costs equate broadly to 10% of your operating expenditure, and these triple, there goes your profit and your financial viability.

As ever, who do you believe in a property landscape made deliberately opaque for tenants?  There is no doubt that the claims being made rely on solid ongoing growth in the jobs and the general economy, both local and global.  To challenge the claims being made, I simply make a series of statements below and pose several questions:

1. Commercial office rentals operate to a typical supply and demand curve:

In some markets, notably Brisbane & Perth, the ‘roller coaster’ curve is steeper as sharp tenant demand changes, both positive and negative, are less easy to respond to.  The curve for Melbourne conversely has, for more than 20 years, been a relative ‘ripple on the water’ as cheaper and rapidly constructed Docklands buildings can quickly temper demand.  At a given point in any cycle, the curve is representative of the ‘here and now’ market, i.e. the effective rental deals available to a tenant acquiring space for occupation generally in the next 12 to 18 months.  The horizontal line, as ever, represents the economic effective rental or, in other words, the minimum rental that a developer would need to achieve in order to satisfy financiers/backers that a return can be made on a new project.

If we say, then, that the Barangaroo development of some 300,000m2 of commercial office space had, from inception until a little over 2 years ago, a fixed rental profile and incentives of around 22% of the total gross income for any given leasing deal, how is it that whilst that same rental profile remains, the incentives now on offer have increased by 50 to 100% over the previous offerings?    Other space in the Premium market is offering equally aggressive deals to get space away.  So how can it be doom and gloom for office tenants!

2. Historically, the value of commercial office buildings has followed (logically) the strength or weakness of the leasing market, with a lag of perhaps 1 to 3 years. That is, until now. With the weight of global capital driving down yields, the values are in fact remaining high, so much so that developers are now seeking to building new stock on the basis of current property valuations, not demonstrated demand. Little wonder that landlords are happy to announce rental rates achieved, but not incentives. Such face rental information in isolation consequently means, well ……… very little at all.

If there is good news for landlords, it is in the B-grade market where withdrawals for the Metro project have exacerbated an already tightening market.  Ironically, B-grade tenants are currently able to secure A and even Premium-grade alternatives with minimal, if any, effective rental increases vs. the few offerings in B-grade, particularly if the tenant is able to achieve a reduction of premises area with a more efficient office layout.

Kernel is an independent firm which advises commercial office tenants on all aspects of their lease undertakings and exit strategies.  The firm challenges the norm in all of its thinking.