Opportunities abound in office markets around the world but are some already becoming overpriced? The preference is still for quality as economic uncertainty persists, says Lynn Strongin Dodds
The office markets in major cities might have regained their equilibrium but some nervousness persists due to the uncertain economic outlook. Not surprisingly, investors remain cautious and while the nuances and characteristics of New York, London or Hong Kong are still important, the overriding concern seems to be safety and security.
David Skinner, investment strategy and research director, real estate, for Aviva Investors, says: "We are seeing signs of recovery across the board but the general theme is that investors have returned first to the deepest, most liquid and transparent markets. They are generally preferring prime property with long leases where the cash flow is secure. Institutions are also conducting greater risk assessment and scenario testing because they want to ensure that their assets will behave defensively in the event of prolonged economic weakness. This is one of the main reasons why we are seeing widening price differentials between prime and secondary properties."
Breaking it down into regions, Richard Holberton a director in CB Richard Ellis' EMEA research team, adds: "Overall, European markets are stabilising, with most rental markets reaching a floor, especially Paris and London which are both experiencing rental growth. Investors are concerned about the strength of the economic recovery and there need to be clearer signs of growth for rental increases to become more widespread. As a result there is a flight to quality, which has been reflected in downward movements in prime yields for the best assets across a broad spread of locations."
Matthew Colbourne, senior research analyst, Knight Frank, shares the view that European markets are steadier but believes "there are not that many stand-out hot spots, except London, which has been the first market where there has been a substantial recovery in prime rental values. This is mainly due to a return of confidence and lack of supply."
According to Colbourne, prime rates in the West End jumped 25% to £82.50 (€99) per ft2 from £65 per ft2 per annum at the end of 2009, while West End prime office yields compressed to their current level of 4.25%, from 6% in the first quarter of 2009. Milder yield compression has been observed elsewhere in Europe with, for example, prime office yields moving inwards by 50 basis points in Paris since the middle of last year, while strong levels of investment activity have begun to push yields down in Germany.
Prospects for Paris and London are bright, say Mat Oakley, head of research, and Lydia Brissy, European research, at Savills. They note that inner London is forecast to be the third-fastest growing city in Europe in GDP terms. "This, combined with the City of London's traditional linkage more to the global than the domestic economy should ensure a steady recovery in demand for office space. Already this year 2m ft2 of office space have been leased in the City, and average prime rents have risen by 5%. We believe the City is facing a sustained period of record low levels of development completions. Improving tenant demand will combine with shortages of Grade A supply to deliver average annual rental growth of 8-9% per annum over 2010-14. Global and domestic investors are already targeting the City as one of the strongest rental growth prospects in Europe, and prime yields have fallen by around 170bps from their peak."
As for Paris, Oakly and Brissy note that the city is generating 9.8% of the national growth, while GDP is expected to grow by 2.1% per year on average in the next five years. Letting performances are growing stronger, with a rising proportion of large deals. "The available supply has started to fall and the vacancy rate has returned to under the 6% threshold, at 5.9%. Due to a shortage of new supply, prime values are picking up and leases signed at values exceeding €700/m2/year are back on the scene," they note.
Views are mixed on other European cities. CEE as well as German cities benefit from an improving economic picture and limited supply. Tim Francis, director of continental European strategy and research at Invista, says: "The office markets in German cities such as Munich and Hamburg are attractive as defensive investments. The yields are stable, leases long and the buildings are of high quality. They fit nicely into an investors' core portfolio."
Oakly and Brissy, however, like Berlin because it is the major employment hub of the five largest German cities, accounting for around 4.2% of national employment: "Office occupier demand is historically steady and the vacancy rate is the lowest - 7.6% - compared with the four other major cities. Rents are generally stable and decreased only marginally over the past year compared with other European cities."
Anne Koeman, a senior research analyst at PRUPIM, takes a different view, however. She believes London and Paris are already close to being overpriced. She sees better opportunities in the South East market where yields have not corrected nearly as much. "I think the most rental increases have already been priced into markets like London or Paris and there is better value available in selected areas outside Central London, such as Guildford or Reading. Some towns have very limited supply pipelines but are seeing increasing demand from financial service companies that want to relocate their back offices, as well as pharmaceutical and large technology companies such as IBM and Microsoft."
In the US, a similar picture emerges, with New York being the star performer. According to a recent report from property consultant Cushman & Wakefield, Manhattan has rebounded sharply, with the vacancy rate sliding to 10.8% in June from 11.6% in March, marking the first quarter decline in vacancies since the second quarter of 2007. Transactions more than doubled, with deals closed and under contract for transactions of $10m and higher rising to $5.8bn from $2.5bn during the middle of 2009.
Mark Roberts, global head of research at Invesco, says: "I expect that vacancy rates will peak for prime property this year and that gateway cities such as New York, Washington DC, Los Angeles and Boston will continue to outperform. Vacancy rates have peaked for these cities and tenant demand is stabilising. Washington is benefiting from an improved job picture, while San Francisco is profiting from growth in trade and technology from the Asia Pacific region. The city has the highest potential for rental growth because the development market slowed down considerably after the tech bubble burst in 2003. As such, the increase in vacancy was less severe when compared with other markets that were in a development cycle when the credit crisis hit."
Guy Benn, vice-president of Savills, also puts New York, Washington DC and San Francisco on his top three list. "New York is the financial capital of the US and the sector has experienced a rapid recovery since the onset of the credit crunch and collapse of Lehman in the third quarter of 2008. An extremely restricted supply of new accommodation supports acquisitions of B-grade buildings in A-grade locations. As for Washington, it has a strong tenant base. They are either government or government-related organisations or companies benefiting from fiscal stimulus packages. There is also restricted supply of new accommodation in prime locations, particularly in the central business district (CBD) near Capitol Hill."
Benn also believes that there are attractive opportunities in Houston because of the strong energy-based economy, although there is no defined prime location, as best office buildings are now spread along several corridors. Boston, with its medical and finance bias, has also had reasonably good performance, while Seattle, which is home to companies such as Microsoft, Cisco and Amazon, is benefiting from a reasonably healthy technology sector.
Looking at Asia, Andy Schofield, property research manager (Europe) at Henderson, says: "The Asian economies are expanding faster than their European counterparts, which are likely to underperform long-run trends for many years. Although a slowing is expected in China and the wider region, we are confident that employment growth will continue at healthy rates. As for office markets, Hong Kong and Singapore prime rents have resumed growth and, although there may be volatility in capital market pricing, these markets are attractive in terms of their growth potential. If I had to pick one city I would go for Singapore because the economy is expanding so rapidly. Looming supply might put investors off but it does follow a five-year drought in new completions and demand will well outstrip supply over the long term."
Hong Kong is also performing well. Grade A office rents rose by 3.4% on strong leasing demand, and vacancy rates in the core area of Wanchai/Causeway Bay dropped to 4.8%, with rents up by 4.3 % over the second quarter. Vacancy rates in the Kowloon East and the Western Corridor districts were down to 10.2 % and 11.7%, respectively, in June from 13% and 13.4% due to strong cost savings and relocations.
The general consensus is that the city will benefit from local demand from mainland China as well as foreign companies looking to tap into the strong economic growth stories of the Asia Pacific region. Both factors are seen as underpinning the office market over the long term.
Meanwhile, sentiment about Tokyo is mixed. According to a recent DTZ report, Tokyo CBD grade A office vacancy marginally rose to 6.98%, while rents fell 0.4% to ¥29,235 per month per tsubo from the previous quarter. The market is in an adjustment period in the cycle and estimates are that vacancy rates will soon begin to decline although rents will continue to fall until the end of 2010. However, concerns remain over the possibility of a double-dip recession and the view is that the real upturn in the office market will not be realised without a sustainable economic recovery and improvement in corporate performance.
Skinner of Aviva is more bullish. He believes "the office market in Tokyo is at the bottom of the cycle and while we expect some stress over the next 12 months, attractive buying opportunities are emerging. Supply is constrained and we expect to see an inward migration to Tokyo, despite Japan's demographic issues. It is the largest office market in the world and can offer investors core type of risk and returns which is more difficult to access in Asia."
The PRUPIM research team, however, believes that there is most value to be found in the Australian markets. "The Australian economy has performed well throughout the downturn and vacancy rates are falling in Sydney and Melbourne," Koeman notes. "As pressure is already building on occupiers, these markets are well positioned to perform well as the economy picks up. We expect yields to continue to fall as they are still relatively high given the low risks in these markets."
DTZ has a more tempered view that although Australia has performed well compared with other developed economies - with GDP growth of 0.5% in the first three months of 2010 - economic concerns are weighing heavily on the Sydney market. As a result, the report does not expect to see rental growth for premium/A-grade office space before the end of 2010.
Melbourne is expected to fare better due to constrained supply, and activity in the city's CBD area is likely to pick up over the second half of the year.