Office Property – A laggard in the South African Property Cycle?

Of the major 3 commercial property categories, office space is at the back in the cycle, behind retail and industrial property, implying the expectation of further acceleration in returns. On a nationwide basis, the vacancy rate has been declining steadily since 2003, and according to SAPOA (South African Property Owner’s Association) data, the national A- and B-Grade (based on major data of metropolitan areas) vacancy rate has declined from 15% at the beginning of 2003 to 6% as at the third quarter of last year. The A-grade vacancy rate is even lower at 3.9%. Given that there will always be location and design issues around office property, it is impossible to match all property to the organisations searching for space. As such it is believed that somewhere in single-digit territory the “natural” vacancy rate will be reached at which stage there is effectively no suitable space available given the composition of demand. At this point rental inflation will start to accelerate, which is precisely the case in the office property sector at present. However, although on an accelerating path, office rental inflation rates have yet to set the world alight in the same way that industrial rentals have been doing for some time, and this is reflective of the property class’ laggard status. Erwin Rode, who authors the authoritative property journal called the Rode Report, estimates rental inflation for decentralised areas, on a national basis, at around 7% year-on-year, while Central Business District (CBD) rental inflation is a more impressive 13%.

In recent years, the country’s CBDs have been playing some catch-up with the more illustrious decentralised areas in terms of rental levels, although they still remain considerably cheaper. Whereas A-grade space in Sandton had an average rental of R80/square metre in quarter 3 of 2006 according to Rode, the Johannesburg CBD was running at an average R44/ square metre. The high rental rates and low vacancy rates in many decentralised nodes have forced some to re-consider the cheaper CBDs. In addition, the combination of mounting traffic congestion in decentralised areas and efforts by the authorities and some corporates to rejuvenate CBDs has improved the relative popularity of the CBDs. The result has been some narrowing in the rental differential in recent years and significant capital growth in CBDs.

Cape Town CBD leads the pack in terms of CBD property performance, with A-grade rentals at R63.66/square metre as at the third quarter of last year, while Joburg is still arguably the laggard of the major 4 CBDs (the other 2 being Pretoria and Durban).

Nevertheless, even for Joburg CBD, the future looks far brighter, and it too has seen a sharp downward trend in cap rates in recent years. Besides low vacancy rates in decentralised areas driving increased demand for CBD office space, conversions of older office space to residential units in CBDs also constrains office supply growth.

Office space, while having links with every sector of the economy, is arguably more linked to the services sector of the economy compared with industrial and warehouse space. The services sector accounts for almost 60% of the economy and is the major long term growth area. It is also the more stable part of the economy. As such, we should expect a steady long term growth in demand for office space. While there has been a substantial increase in office space plans passed in recent years in response to declining vacancy rates, this has yet to translate into a meaningful increase in completions. The IPD reported returns of 24.5% for the office sector in 2005, the third year of acceleration, and it is believed that this could have risen to above 30% last year. With little evidence to suggest that building space completions are accelerating just yet, it is realistic to expect that such rates of return may continue for some time to come.

It is harder for the amateur investor to be intuitive when investing in offices. Professional advice is essential to make the right choice of property, offering safe returns on the open market. The IPD index shows that after shying away from offices and industrial in 2003, investors in 2004 chose to increase exposure to property across the board, rather than betting on one particular sector. It is anticipated that sustained growth in the office market should add further impetus to the recovery of the office market, pushing rental growth into positive figures.

WHAT TO LOOK FOR

• Location is crucial to the success of your investment in offices, as are transport links, car-parking facilities and close proximity to retail centres.
• Take note of fashions in office design – open-plan offices in modern buildings with lots of glass and steel are now highly desirable. So look carefully at the age and design of the building. If contemplating buying office blocks built in the 1960s and 1970s, consider if they may require refurbishment in order to keep rental levels up.
• Evaluate the adaptability of the internal structure, such as the location of toilets, lifts, and communal areas in multi-let buildings. The potential to refurbish affects the ability to let and is a particular nuance of this market.
• Consider the quality of a building’s mechanical and engineering components: assess its air-conditioning and lifts, and establish whether it has raised floors or lowered ceilings to discreetly house cables for technology.

“Information courtesy of the Alliance Group Property Investor Guide, available at all Alliance Group offices nationwide. To find out more, call 0861 ALLIANCE, or visit www.alliancegroup.co.za to download an electronic version“