The office sector of the property market has been experiencing boom times, with its property values and demand for space ever increasing.
And the fact that the South African economy is expected to show growth of 4,5% to 5% per annum over the next 18 months is likely to drive the demand for office space even more.
“Sustained economic growth at this level will have a definite impact on demand for office space, which will drive rentals upwards,” says Neno Haasbroek, CEO of Sycom Property Fund. However, he says that the main question remains how rapidly demand will or can be satisfied by new developments.
Haasbroek believes that new building supply will be insufficient to satisfy demand, which will, in turn, drive rental levels upwards.
“One of the factors causing fewer developments is the fact that land has become much scarcer, with government less willing to allow re-zonings and a considerably longer time needed to bring new projects on stream.
“In addition, the building industry has limited capacity, with longer lead times for the supply of materials and uncompetitive pricing. This puts upward pressure on rentals as new buildings cannot come on stream at current market levels,” he says.
James Templeton, CEO of Emira Property Funds, agrees, saying that “building costs are rising sharply and therefore we expect to see an upward squeeze on rentals.
“Land costs have been accelerating upwards and there are power issues in certain areas, meaning they have limited development. Rentals are still growing sharply – we estimate between 15% and 30% in some areas over the past 12 months.”
It is estimated that new buildings will probably have to see rentals of R100sq m or more to be viable.
A further factor to consider is the conversion of office buildings to residential use, which is happening in the Johannesburg CBD and Braamfontein. This is taking a large part of secondary office stock out of the market, which will give an additional boost to the existing office market in Johannesburg.
Even if the South African economy fails to achieve the expected growth rate, office space is likely to remain at a premium. Haasbroek notes that “the oversupply in office space which existed a few years ago has now largely been eliminated and any new demand will have to be met by the supply of new buildings”.
The Fountainhead Property Trust office vacancies were at 7% in March 2006. By March 2007, they had slipped to a mere 3%. In certain nodes, vacancies are down to virtually zero, which relates to the shortages in those areas.
SAPOA office vacancies show that national office vacancies were 6,9% in March 2007 (4,5% if you exclude the Johannesburg and Durban CBDs).
Property economist Prof Francois Viruly of Viruly Consulting says the average natural office vacancy rate is around 7% to 8% and that in some nodes it is below 5%. He explains that no market reaches a zero vacancy rate because tenants are always on the move and thereby creating vacancies.
“I take the view that there is a natural vacancy rate for the office sector like natural unemployment, but that at the moment we are dipping below the natural vacancy rate of this market. There is enough evidence to show that the moment that happens rentals start moving up in real terms – increasing at a faster rate than inflation,” he says.
“We will end up with historic low figures in the office sector in terms of vacancy rates.
“If I were to make one call at the moment it would be on the office sector. Government has R400bn of capital expenditure almost crowding out the private sector, and with building costs going the way they are, A-grade office rentals are going to go through the roof. They will take the rest of the market along with them, so the office sector is strong.”
Historically, new office developments were brought on to the market with considerable ease, and therefore they did not compete as much as the other classes. “An increase in demand for space triggered a massive boom in new developments, thereby immediately oversupplying the market and depressing rentals,” remarks Haasbroek.
“Land was easily available for development. Consider all the beautiful residential suburbs such as Illovo, Sandhurst, Rosebank, Hyde Park and Parktown, which were destroyed in this way, and you will see what I mean. This trend has now been reversed by much stricter planning controls, which will cap new developments.”
The trend to higher rentals is most notable in the B and C-grade office market as they are coming off a lower base.
When it comes to new office developments in decentralised nodes, close to 60% of them are constructed on a speculative basis, showing developer faith in this sector of the property market. Viruly says office vacancy rates are at 10-year lows in decentralised nodes across the country, resulting in developers making use of this opportunity.
Viruly points out that in Sandton speculative development is as high as 80%, which means that developers are confident that in two years time the office sector will be strong enough to ensure that the new space is let. But he says that perhaps too much speculative development could be taking place in this node.
Property economist Erwin Rode of Rode & Associates concurs with Viruly on this point, i.e. that perhaps developers are being over confident in Sandton, especially when it comes to buildings constructed on a speculative basis. Overall though he is upbeat about the prospects for the office sector and anticipates a long upswing cycle for it.
Of interest is that the strengthening of the office sector commenced in the face of declining interest rates. The question that then comes to the fore is whether, with the recent interest rates hike and a possible further hike later in the year, this sector of the market will be affected, and to what extent.
Property analysts generally concur that interest rate hikes will not have much impact on the office market as developers will burden tenants with extra costs in the form of rentals. Tenants in turn are expected to swallow these higher rentals because of the scarcity of vacant space.
As Rode says, rising rentals are only possible where there is a shortage of space, which is the case in the office sector. And obviously the smaller the scale of the development, the more it will feel the impact of interest rate hikes.
Hope comes in the form of First National Bank’s property strategist John Loos who believes South Africa is near the peak of the interest rate cycle. He believes that strong net income growth is on the cards, especially in the areas of industrial and office space, and for that reason he doesn’t think the current mild interest rate hiking will have too much effect on office developments.
“The office sector will have a lot on its plate besides the prospect of great returns over the next few years. Location and design issues are set to become increasingly important due to the combination of strong rental growth driving densification of use of office space, along with strong growth in the number of vehicles coming onto the roads,” he says.
“Unlike property, motor vehicle affordability is improving, which is probably shifting a number of people who may have used public transport towards private motor vehicles. In addition, a gradual densification of inhabitants in certain office buildings could in many cases be leading to a mounting parking shortage, both in older inner city buildings as well as in many de-centralised office parks.
“Buildings with either a good supply of parking or in close proximity to a parking garage may have a ‘competitive advantage’ in the years to come, given that comprehensive high-quality public transport for most of us appears some years away. Proximity to Gautrain stations will also be a major plus for this reason. This could suggest strong returns in the longer term for parking garage investors too.
“A change in corporate behaviour may also be starting to gather momentum due to traffic congestion. As we move from ‘rush hour’ congestion to ‘all-day’ congestion, proximity to a business node where a company has strong links to other businesses is expected to become a greater priority.
“This is expected to drive strong demand for office space in and around key business nodes. The combination of a major state-of-the art transport corridor such as the Gautrain-M1 Corridor, which will also be home to some of the country’s major business nodes, is expected to be a ‘winning recipe’ for office property performance.”