Monday, August 9, 2010

Office market glasses at least half full?

The recent release of the Property Council’s Australian Office Market report was greeted by several media outlets as an opportunity to focus on ‘soaring’ vacancy rates. But what if, for a moment, we focussed instead on the occupancies, not the vacancies? Would that tell a different story?

The office vacancy rate statistic is a pretty straightforward measure of the gap between supply and demand. The Property Council, and most market commentators, have traditionally focussed on the vacancy rate as a barometer of market health. But the vacancy rate can fall in a shrinking market if older, redundant stock is removed from the stock survey for a variety of logical reasons. Equally, the vacancy rate can rise in a healthy market, if additions to supply exceed total new demand.

Another way to look at the health of the office market is to disregard the total vacant space (both direct and sublease) and simply focus on what’s left. That is, what’s really happening to overall demand – the space that’s actually occupied? After all, an excess of new supply can simply reflect bad timing or an over exuberant development market – it doesn’t necessarily mean that demand has weakened dramatically.

An analysis of the Property Council figures on this basis produces a different picture to that painted by the media headlines. What it shows is that total occupied space – or if you like, total demand – has done little more than plateau since it’s peak in January last year. There has been a minor fall in overall demand, of just 150,000 square metres of space, but that’s across the entire country and all the various submarkets covered by the Property Council Survey.

What is just as obvious is that office markets around the country have remained remarkably resilient to the effects of the global financial downtown. If you had believed the Nostradamus-like warnings of impending doom, or followed the share price of any number of listed A-REITS heavy in the office market, you’d be forgiven for thinking there’s been something of a calamity at play. Not so.

If demand had dramatically softened, as some have suggested, you would expect to see a significant fall in total occupied space. A plateau is not a significant fall (unlike global share indices may be used to).

Of course if you’re in the business of leasing new office space in a market which isn’t expanding, that’s another story. But traditionally, vacant space has migrated itself from lower standard buildings to higher standard (ie new) ones. And an interesting thing also then happens (or at least, it has in the past).

As new buildings are added to the stocks of office space, they have rarely over the past 20 years opened fully let. But as they lease up, they do so at new levels of benchmark rents. It stands to reason – new buildings cost more to develop than older ones did, and usually feature higher standards of technological features or sustainability virtues. ‘New’ always comes at a premium to ‘old’ so waves of new building construction have tended to correspond (albeit with a lag) with cyclical spikes in market rentals. And the cost of new construction is not about to fall.

The new buildings command more rent, and those rents are then used as benchmarks for the Grade of building below that, and through the market the ripple flows.

So when new buildings arrive on the market, they obviously add to supply which can tend to bump up vacancies (especially given the ‘lumpy’ nature of new supply in large commercial buildings). But they can also tend to lead rental growth. It is a mistake, or can be, to interpret rising vacancies and stable or falling rents as a sign of weak demand – these things can reflect temporary surplus of supply.

So the short version of all this is that maybe the glass is more than just half full? Total demand for office space hasn’t collapsed or even significantly shrunk, despite the tsunami of economic events endured by global and domestic markets in recent years. Plus, the new additions to supply now coming on stream may just portend the next wave of rental growth in office markets generally, as the economy inevitably improves?

You can read what you like in the daily papers. But believing them is another thing altogether. It’s worth contacting the PCA and buying their Office Market Report, and doing the same analysis yourself for whatever local market interests you. You might just be surprised.

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