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CAPITAL CONCERNS
Part III

Published Thursday 13th September, 2007

The Office Crunch

MODEL FIRST-CLASS OFFICE BUILDING

Land                      30,000 sq ft @$1,000 per sq ft                 $30 million

Building                 100,000 sq ft @ $1,000 per sq ft              $120 million

On-costs*                                                                        $12 million

Total Scheme costs                                                          $162 million

*On-costs refer to the associated, intangible development costs such as stamp duty on the purchase of the site, professional fees (these include attorneys’, architects’, project manager, quantity surveyors’ and engineers’) and insurances. Finance is not included here.

If the scheme is wholly financed by an eight per cent facility to be repaid over a 15-year term, this would require monthly payments of the order of $1,080,000. If we assume that the building has 85,000 sq ft of rentable space, that implies a monthly rent per sq ft of $12.70.

This is an optimistic estimate since it does not take account of:

·         Carparking: The cost of providing the carparking such an office would require (about 150 spaces).

·         Costs: These are significantly understated since we have reliable information as to higher costs for both land and construction of these buildings. If costs keep escalating, the break-even rents also keep rising, all other things being equal.

·         Higher interest rates: The interest rate used in the example is low and would likely exceed ten per cent in open market terms. Such an increase would raise the break-even rent to about $16 per sq ft.

Last week we ended on the juxtaposition of rising construction costs with a likely oversupply of first-class offices. What are the probable consequences of that on our capital’s office market?

If we examine the basic example set out in the sidebar, we can see the break-even rents which a developer would have to charge to make the lender’s repayments. Please note that this does not allow for any profit which is only possible if rents above those figures are achieved.

Some points to note here are:

1. Voids

The developers of these buildings have to make allowances for the periods when parts of the building are unoccupied. One way of managing that risk is to enter agreements for lease with a single company for the entire building, but those cannot completely eliminate the risk, as we see below.

2. Renegotiation of contracts/oversupply of offices

All the signs point to an oversupply of offices in our capital. If that happened, it is reasonable to expect that occupiers would then hold the upper hand in rental negotiations.

In that case, there could be attempts to reduce rents by even those occupiers who have already signed leases. If there is a situation in the market of more supply than demand, developers could be forced to consider accepting lower rents than they had bargained for.

A thought arising from last week’s column is that Nicholas Tower was completed more than three years ago but there is still space available at about $10 per sq ft. As set out here, the new office buildings will all have break-even rents in excess of $13 per sq ft.

Given that background, how realistic is it to expect that office rental levels can be maintained when the new buildings, comprising 50 per cent of the present supply, are completed?

3. Opportunities to redevelop

If the scenario we are sketching is true, there will be serious challenges for those who have invested in these new office buildings. That would have to include the taxpayer but that is for the final one in this series. The point being advanced here is that a market in such a state of flux as is being suggested is also a place of opportunity. By that we mean the potential for alternate uses for those office buildings which are no longer in demand as offices. The decisive question here is whether there can be a fruitful collaboration between property owners, planning authorities and lenders to seed the necessary changes.

4. Lenders

An assumption stated in the sidebar is that all other things would remain equal but—although it is a common and understandable academic benchmark—reality can be much different. To give just one example, in light of the emerging risks, prudent lenders may start taking steps to reduce their exposure to this market. These might include a moratorium on further lending for new projects, swifter implementation of penalty clauses in loan agreements or increased interest rates to existing borrowers.

5. Owner-occupiers

Another aspect of this situation is that most of the space is being built by owner-occupiers such as the State, RBTT and CMMB. They are not therefore directly exposed to the perils of falling rents since they are not looking for tenants but, in economic terms, they have a distinct exposure. That exposure stems from the possibility that the break-even rents on their new buildings could be greater than the cost of continuing to rent for a significant period.

If that did happen, it would mean that it would have been cheaper to keep their money in the bank and just rent from someone else.

This is all unplanned activity. Yes, we are charging that this wave of development was, in fact, unleashed without proper planning and consultation. Once again, it seems that money is no problem for us. The potent question, in a time when we feel that we can do more than ever, has to be: how can we do better?

I am sure that every project listed has all the required approvals, but that is the very point. Should our development control authorities be allowed to approve such colossal changes without the framework of a strategic plan or any public consultation?

Next week, we conclude this analysis by asking what lessons can be learned from all this.

Afra Raymond is a director of Raymond & Pierre Ltd. Feedback can be sent to afra@raymondandpierre.com.

Afra Raymond - Property Matters

This is all unplanned activity. Yes, we are charging that this wave of development was, in fact, unleashed without proper planning and consultation. Once again, it seems that money is no problem for us. The potent question, in a time when we feel that we can do more than ever, has to be: how can we do better?