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As inflation bites, it pays to have a good grasp on the dynamics in office leasing

With New Zealand’s annual inflation hovering around 7 percent – the highest it’s been in three decades and well outside the Reserve Bank’s target of 1-3 percent – how is the rising cost of everything impacting lease structures in the office sector?

Steve Rendall, Bayleys’ national director office leasing, says tenants and landlords have become acutely aware of potential risk resulting from rapidly increasing inflation, and the effect it can have on real rental return.

“Most leases have rent review capacity built-in – typically either market based, where valuers assess the rent against market benchmarks, or fixed increases to an agreed percentage figure.

“The prevailing mechanism for prime office spaces has to-date been fixed growth of around 2.5-3.0 percent per annum with market rent reviews at lease renewal or mid-term, usually with some form of ratchet.
“These fixed growth rent structures have provided certainty to tenants and landlords, and allowed them to factor increases into forecasts and operating models.”

The rising cost of debt

The rising cost of debt, generationally high inflation levels and pandemic-related supply chain and construction/fitout challenges have started to bite, creating a structural change in the way leases are shaped.

“The problem is that fixed rent reviews across a longer-term can lead to property being under-rented, which is obviously undesirable for landlords, so rent review mechanisms have become an area of heightened negotiation as a consequence,” says Rendall.

“Landlords – and their lenders – will generally want rent review mechanisms that provide a degree of hedging against high-inflation and high-interest rates, while tenants generally seek the opposite to avoid a big jump in rents.

“Over the last six months, there’s been a preference shift by landlords towards CPI-linked – plus a margin – rent reviews, or heightened levels of fixed growth which, understandably, has caused some angst for tenants.”

Rendall says the best way for Bayleys’ leasing and advisory teams to assist tenants and landlords is by showing them where the market is at.

“As a full-service agency, Bayleys has coverage and exposure across all property sectors, giving us insight and context. We can show our clients where the market is – and therefore what a reasonable lease structure is given market dynamics and competing influences at play.”

Rendall says knowledge is empowering, and Bayleys’ full service offering enables the business to share real time data, ensuring tenants and landlords are better placed when negotiating a new lease.

Chris Farhi, head of Bayleys’ insights and data team says the Auckland and Wellington CBD office markets are currently experiencing reasonably stable rents, but with variance across sub-markets.

“Demand remains strong and rentals have been rising in the premium market, but in the secondary/lower quality markets where demand has been softer, rent changes have been more subdued.

“On top of Covid, the recent high inflation situation has created uncertainty in the office sector and while the prime market will likely accept the pre-set rent reviews, the secondary market may look for opportunities to loosen up on rent review clauses.”

Farhi analysed rental data over the past six years under three scenarios from the same starting rent: fixed annual growth at 3.0 percent per annum; inflation indexed based on CPI + 0.5% per annum; and Auckland CBD prime office benchmark rent for reference (where annual market rent reviews would be unusual).

“We found the fixed growth scenario would have achieved a higher overall rent than the CPI-indexed scenario and it would likely take a further 12-24 months of heightened inflation to balance things to similar outcomes.

“Now it’s a new ball game, given the spike in inflation only kicked in from September 2021.”

Farhi says in the premium/prime office market where vacancies are lower, landlords are seeking rent review mechanisms that will hedge inflation better, but tenants are acutely aware of the historic norms.

“The prime market is currently tending to revert to fixed growth mechanisms, although the growth rates are typically landing at the upper end of the spectrum.

“In the secondary market however, higher levels of vacancy swing in the tenants’ favour and in some extreme cases where the vacancy rate of certain buildings is abnormally high, tenants are often seeking that rent reviews be waived or deferred, or looking for incentives to renew.”

Related: The office relocation game

http://www.bayleys.co.nz/workplace/articles/insights

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