Supply and demand – upward pressure on rent in the office market

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Rising land values, population growth and constrained supply of new office accommodation is likely to put upwards pressure on Melbourne office rents in the near future according to Forza Capital, a property investment provider to high net worth advisers and family office clients.

“Rental growth is driven by simple economics and we are seeing demand outstrip supply,” says founding Director Adam Murchie.

Forza Capital says the market rent for new office accommodation is generally determined by the terminal value of building a new project. Over the past five to six years the tightening of investment yields, which have generally tracked bond rates, have helped keep downward pressure on rents as office developers were obtaining their margin from yield compression, and not growing rents.

“With bond yields now trending upwards, the market can no longer look to yield compression to keep rents constrained,” commented Mr Murchie.

“Instead, softening investment yields are anticipated to put upward pressure on rents as new supply will not be economically feasible until the softening in cap rates is offset by substantial rental growth.”

One of the key drivers of the increased cost of delivering new office stock in CBD and surrounding inner city locations has been the stratospheric growth in land values.

“In the past decade we have seen CBD development land values increasing five to seven-fold; at the same time, the cost of construction has increased at nowhere near this rate,” Mr Murchie said.

“As a result, the overall cost of delivering new office stock has increased dramatically, which means higher rents are necessary to justify new supply.

“Typically, you see upward rental movement on existing stock until such time as economic rents support the supply of new space”.

Interestingly, the primary driver for increasing land values has been the repurposing of office development sites to residential developments. Supply side constraints are being further exacerbated by demand side drivers.

The current vacancy rate is 3.8%, the lowest level in nine years and net population growth is as strong as it has ever been. The Melbourne CBD office market is now approximately 4,500,000m2 and with a new supply pipeline of 540,000m2, is expected to exceed 5,000,000m2 by late 2019.

There are three dynamics Forza believes will drive an increase in office rents:

1.     Melbourne’s population is currently growing at a rate of 2.7% per annum or 125,000 new residents each year, which has resulted in a fundamental alteration in long term annual office absorption forecasts. Essentially, the commercial office market can absorb annually almost double the amount of space it could a decade ago. We expect this will result in a supply shortfall and an increase in rents.

2.     The move to open plan accommodation, followed by the concept of hot desking, has seen average office densities reduce significantly from 1 person per 20m2 to approximately 1:12m2. Forza Capital’s view is that the ability to further compress workspace densities is limited and thus will increase pressure on future rental uplift.

3.     The war for talent is leading businesses to continually upgrade their office accommodation to make it relevant to the new and evolving workforce. To attract the best human capital, a key element is the quality of the office accommodation, in addition to location relative to social amenity such as cafés, restaurants, bars, gyms and public transport.

“We are witnessing a combination of low vacancy, modest supply delivery, significant increases in land value, increasing construction costs, record population growth, investment yields that have reached the bottom of the cycle and a growing number of Gen Y employees that demand higher quality accommodation,” said Mr Murchie.

“All of these factors combined suggest rents for new office stock will be trending upwards in the near future.”

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