The residential development cycle impact on office supply and rent

Rising land values, population growth and constrained supply of new office accommodation is expected to put upwards pressure on Melbourne office rents in the near future. Rental growth is driven by simple economics – it occurs when demand outstrips supply.  More fundamentally, rents on existing properties increase up to the point where it becomes economically feasible to deliver new supply. All other things being equal, when new supply occurs rental growth flattens as the supply/demand equilibrium is rebalanced and the cycle recommences.

Ultimately, the market rent for new office accommodation is determined by the cost of building a new project which is derived from the land and building costs, together with the developer’s margin, multiplied by the terminal market yield of the of the new asset.

Over the past 5-6 years the tightening of investment yields, which have generally tracked bond rates, have helped keep downward pressure on rents. However, with bond yields now trending upwards we can no longer look to yield compression to keep rents constrained. In fact, the inverse is likely to occur. Softening investment yields will put upward pressure on rents as new supply will not be economically feasible until such time as this yield softening is offset by substantial rental growth.

One of the key drivers of the increased cost in delivering new office stock in CBD and surrounding inner city locations has been the growth in land values.  For the past 15 years, Melbourne’s new office construction has been driven by major developments in areas such as Docklands and the western end of the CBD where cheap land values allowed developers to attract major tenants to new buildings at competitive rents.

This dynamic has seen over 1,000,000m2 of new office supply introduced to the market in the past 12 years alone.  A 2009 Savills report identified 50 potential major development sites in the Melbourne CBD and at this time such sites were trading at $5,000 – $10,000m2.

What we have seen in the past decade is CBD development land values increasing five to seven fold at the same as time construction prices have increased in line with inflation. 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 what this means is that you see upward rental movement on existing stock until such time as economic rents support the supply of new space.

Below are three examples of land transactions for major office developments (on a per developable metre basis) which has seen prices increase from $454m2 in 2006 to almost $3,000m2 in 2018.

2006 – 567 Collins Street

Developer: Leightons/APN

Price: $25,000,000

Development Potential: 55,000m2

Price per developable m2: $454m2

2015 – 477 Collins Street

Developer: Mirvac

Price: $72,000,000

Development Potential: 58,000m2

Price per developable m2:$1,200m2

2018 – Bourke & Queen Street

Developer: CBus Property

Price: $175,000,000

Development Potential: 60,000m2

Price per developable m2: $2,916m2

Interestingly, the primary driver for increasing land values has been the repurposing of office development sites to residential developments. Given the broad range of permitted outcomes under CBD zonings, huge population growth (currently running at circa 125,000 new residents per annum) and strong investment demand by local SMSFs and   overseas investors, residential overtook commercial as a preferred development outcome and on this basis the use of many sites quickly transitioned.

During the tenure of Matthew Guy as the Planning Minister the height, density and overall development potential of many development sites increased significantly. Whilst such planning outcomes have been dialled back somewhat by the current Labor Government, there are still a number of historically approved development sites with significant approvals that continue to underpin high land values. Now that the apartment market is slowing, student accommodation and hotel uses have stepped in to replace the apartment demand which will see a further transition in site use.

These supply side constraints are being further exacerbated by demand side drivers. Back in 2007, when the vacancy rate was at its last historical low of 3.5%, surplus credit (debt) saw 400,000m2 of new supply quickly added to a market of 3,500,000m2. Unfortunately, this supply was delivered at the same time the GFC hit which saw credit reigned back in and unemployment rise, reducing office demand in both the corporate and government sector.  At this time population growth was 1.8% or 79,000 people which is approximately half the current population growth rate. These various factors combined resulted in an increase in the office vacancy rate to 9.8% and an effective ceiling was subsequently placed on rental increases.

Fast forward to 2018 and the current vacancy rate is 4.6%, the lowest level in 9 years. 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.

Unlike the years post GFC, Melbourne’s population is currently growing at a rate of 2.7% per annum or 125,000 new residents each year. This seismic shift in population growth 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.

There is also another dynamic that has not had much discussion, but which has helped keep rents in check over the last 10-15 years. The move to open plan accommodation, followed by the concept of hot desking (sharing desks with multiple employees to reduce the overall amount of space required per employee), has seen average office densities reduce significantly from 1 person per 20m2 to something closer to 1:12m2. Forza Capital’s view is that the ability to further compress workspace densities is limited and thus it will increase pressure on future rental uplift.

The final trend influencing office demand is the war for talent. Generation Y employees in particular have high expectations of what their working experience delivers them. To attract the best human capital, a key element is the quality of the office accommodation (in addition to where the office is located relative to social amenity such as cafés, restaurants, bars, gyms and public transport). Businesses trying to attract highly skilled workers need to continually upgrade their office accommodation to make it relevant to the new and evolving workforce. An example of this is computer software company MYOB who are relocating from suburban Glen Waverley to significantly more expensive office accommodation in Cremorne (Richmond) in order to attract and retain a tech savvy workforce.

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