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Narrowing gap between Grade A and B office buildings

While the short-term outlook is weak, growth may return beyond end 2017 once the supply wave passes and if economic prospects are positive.

ACCORDING to the Ministry of Trade and Industry, Singapore's economy grew 2.1 per cent year on year (y-o-y) in Q2 2016, the same rate of growth as the previous quarter.

With looming concerns over the weaker global outlook and the impact of Britain's vote to leave the European Union, its economic growth forecast for 2016 also narrowed to 1 per cent to 2 per cent instead of the 1 per cent to 3 per cent projected earlier.

Concerns over the global economic climate continued to dampen Singapore's business outlook which in turn negatively impacted the performance of the office market.

Net new demand remained muted with few expansion plans and more modest space requirements from fewer new market entrants.

All these come at the same time as an upcoming wave of new development completions.

As a result, the rental premium between Grade A and Grade B buildings has narrowed, spurring occupiers to make a "flight to quality" move to premises at more competitive rentals.

As at Q2 2016, the average Grade A CBD Core rents tracked by CBRE Research have declined for the fifth consecutive quarter, contracting 4 per cent quarter on quarter (q-o-q) to S$9.50 per square foot per month (psf/month). The average Grade B CBD Core rents also corrected by 3.8 per cent to S$7.65 psf/month.

Generally, CBRE Research defines a Grade A building as a landmark building with modern flexible layout and floor plates above 18,000 square feet (sq ft). The building size is above 300,000 sq ft and offers underground parking and good lift services zoned for passengers and goods delivery.

It offers high technical specifications (such as raised floors, 24-hour cooling system) and good quality building services (for example, security, CCTV), and is professionally managed. The building should also be located close to public transport.

Out of a CBD Core office stock of about 27.6 million sq ft, approximately 43 per cent of this stock is classified Grade A CBD Core. The rest of the office stock is classified Grade B CBD Core.

Highly sought after

Grade A buildings are highly sought-after especially by multinational institutional occupiers as they offer modern office features with large contiguous, often column-free space, with modern specifications as well as prestige.

Rents for such office buildings therefore are transacted at a premium over other buildings that do not necessarily meet all the Grade A features and specifications. The latter is generally classified Grade B.

This rental premium can be seen in the chart where the rental premium of the average Grade A CBD Core over Grade B CBD Core office rents is shown.

The chart shows that the rental premium is currently 24 per cent. This is the lowest for a 10-year period from Q1 2006 to Q2 2016 in light of current weak office demand and rental conditions.

Nonetheless, while the 10-year average rental premium is 36 per cent, it should be noted that this is propped up by the high rental premium achieved during the period from 2007 to 2009 when the average Grade A CBD Core rents rose at a faster pace than the average Grade B CBD Core rents.

Being more representative of recent market conditions, the five-year average rental premium is slightly lower at 30 per cent. This is also a reflection of a less volatile Grade A market in the recent cycles.

With the current rental premium 6 per cent lower than the five-year average, occupiers are enticed by the opportunity to locate their operations in Grade A buildings. "Flight to quality" has been driving leasing commitments to Grade A office developments.

Developers of upcoming Grade A office buildings especially have found it necessary to offer very competitive pre-lease terms in order to secure leasing commitments.

Faced with increased competition, existing landlords have also sought to retain occupation through the structuring of new renewal deals. They have found it necessary to adjust to market conditions with more competitive pricing and flexibility in leasing terms.

Unsurprisingly, Grade A rents continue to correct faster than their Grade B counterparts.

With limited net new office demand, office leasing deals are mainly driven by a "musical chairs" movement from one building to another. Grade B buildings that have hitherto enjoyed relatively high occupancy levels will thus face greater challenges to retain their existing tenants or attract new tenants.

In the past six to 12 months, a marked increase in leasing activity in the Grade A market was observed, bolstered by this "flight to quality" movement and occupiers taking advantage of attractive terms on offer. It should be noted that these opportunistic leasing deals were primarily focused on new Grade A projects and a few large deal negotiations have been reported.

Vacancy rate

With no new completions this quarter, the vacancy rate for the Grade A CBD Core office market remains relatively stable, registering only a marginal increase from 5 per cent to 5.2 per cent. The vacancy rate for Grade B CBD Core remains at 4.6 per cent q-o-q.

However, it should be mentioned that the CBD Core office market will not be able to enjoy such low vacancy levels for long.

Vacancy levels are expected to rise sharply over the next six to nine months with the physical completions of a number of new developments which collectively offer a significant amount of space available for lease.

Despite the Grade A market benefitting more from the "flight to quality" moves, it should be noted that all is not lost for the Grade B office market.

Not all potential office occupiers require Grade A specifications for their occupation needs. Some occupiers, especially smaller-scale businesses, do not require large floor plates or high specifications. They prefer low occupancy cost and low price volatility.

Hence, landlords of Grade B buildings should find ways to cater to SMEs and include them as another source of demand alongside traditional large occupiers.

While it is clear that the smaller space requirement of SMEs limits their potential leasing demand and they are unlikely to ever match the role large companies play in office space take-up, CBRE Research believes there is still a role for them alongside large corporations as a supplementary office demand driver.

What they lack in scale, they make up for in numbers. This is predicated on a strong SME and startup growth trend, that SMEs will be a distinct focus for the government as well as the rise of the sharing economy. Thus stability in the Grade B market is expected in the mid to long term.

This is an opportune time for landlords to relook the way the office leasing format has traditionally been run. This is not to say a revamp should be on the cards but there is definitely room on the part of landlords to incorporate greater flexibility in office space use to target SMEs.

The potential benefits far outweigh the costs involved. With a little effort, landlords will be able to capitalise on a relatively untapped pool of demand that is expected to grow from strength to strength.

Looking ahead, while the market is affected by the weak global economic outlook and caution has surfaced around the large future stock due for completion over the next six to nine months, the narrowed premium for Grade A rents has seen some encouraging leasing activity among the new developments over the past couple of quarters and may in due course help to build some momentum for the office sector.

Return to growth

While the short-term outlook remains weak, CBRE Research believes that the market may return to growth beyond end 2017 once the supply wave passes and assuming prospects for the underlying economy improve.

The rental premium between the Grade A and Grade B office market may widen slightly back to five-year historical levels of about 30 per cent.

However, because of decentralisation options, a constantly improving quality of office stock as well as a pro-actively managed future supply, this rental premium is not expected to surpass levels last seen from 2007 to 2009.

  • The writer is head, CBRE Research, Singapore and South-east Asia.