Tide Turns in Tenants’ Favour : Rents Under Pressure

The delicate balance of power between landlords and tenants has shifted sharply in favour of tenants across all sectors of the commercial and industrial property market.
Zotlan Moricz, director of CBRE Research and Consultancy, says 2009 is shaping up as “the year of falling rents” as the full impact of the recession bites into the business accommodation market.
Moricz says lacklustre tenant demand, increasing vacancies and adverse market sentiment is resulting in what the industry refers to as fall in “effective rentals” as tenants flex their muscles.
Landlords as far as possible try and maintain building’s “face rent” – the dollar amount of rent charged per square metre of space – because this helps retain their property’s value in the longer term. Therefore rather than drop the rent directly, they do it indirectly by offering tenants “incentives” or concessions. These take various forms, most commonly encompassing “rental holiday”, contributions to tenant’s fit-out costs or premises upgrades or refurbishments. They are taken into account when calculating the effective rent that properties produce.
After decade of steady increases, effective rentals for Auckland office space took dip in the last quarter of last year and have continued that decline into 2009, according to CBRE. Its market rental assessments show fall in prime CBD office rentals by 8.7 percent to an indicative net effective rent of $305 per square metre per annum in the year to March 2009, with secondary rents declining 14 percent to $183 square metre.
Out in the industrial hinterland, it’s similar story. There CBRE estimates prime Auckland industrial rentals dropped 5.8 percent in the March 2009 year to $110 per square metre, with secondary rentals showing larger 14.2 percent decline to $79. Industrial and commercial land values have taken big hit, with recent sales showing value declines up to 50 percent from the market peak in 2007, says Moricz.
Ironically, despite the contraction in demand for business accommodation, vacancy rates are still at historically low levels at less than 10 percent for most office space and under five percent for industrial space.
However both Moricz and Gerald Rundle, manager Bayleys Research, says this is masking an increasing amount of unoccupied space already being made available through growing sub-lease market. This doesn’t show up in the official vacancy figures because there is still lease in place over the space on which rent is generally being paid even though it isn’t being used.
“Businesses with long lead-in time to their lease expiry are considering other alternatives, including subleasing, for space they no longer need,” says Rundle. “To date, much of the marketing of this space is being conducted ‘off market’ as organisations prefer to keep their level of retrenchment private for as long as possible.”
Colliers International’s head of research Alan McMahon says vacancy rates will blow out later this year and into next year, particularly in the office market as tenants relocate to new buildings currently nearing completion that they have pre-committed to – leaving behind older buildings that will struggle to attract replacement tenants.
He is predicting doubling of CBD office vacancy over the next two years, increasing from around 7.5 percent in Auckland at present to 14 to 15 percent, and jump in Wellington from five to 11 percent.
“This will mean more bargaining power and choices for tenants and landlords will have to work harder to keep existing tenants and attract new ones,” says McMahon.
Rundle says market evidence suggests growing number of tenants are approaching landlords requesting assistance to ride out the business downturn.
“Property owners faced with the alternative of potentially lengthy letting voids are being forced to take flexible approach to negotiations while also ensuring as far as possible that in offering short-term assistance they secure longer-term benefits.”
The most common tenant requests are for rental holidays or temporary rent reductions. Rundle says reports from professional property managers indicate that landlords are in many cases willing to accommodate tenants but are looking in return to tie those businesses into longer-term leases. For example, landlord giving the equivalent of three months rent free would be looking for the tenant to commit to lease extension.
“This can benefit both parties as tenants are assisted during period when funds are tight while landlords avoid their property becoming vacant and can lock in longer lease which improves the long-term value of their building,” says Rundle.
The treatment of rent reviews is also changing, says Rundle. Reviews to market level are unlikely to show any growth unless it has been some time since they were last negotiated, in which case there may be some pent-up increase which can be justified.
Although inflation is subsiding, tenants with CPI-based reviews, however, could still be facing an increase of up to 6.5 percent, if the reviews are implemented two yearly. In such cases, there is evidence that tenants again are increasingly requesting that landlords forego the increase.
Another consequence of increasing tenant’s bargaining power is that leases, particularly in the industrial market, are being signed for shorter terms, say three to four years, says McMahon.
Business occupiers should be cognisant of the fact that the property market moves in cycles and the balance of power will inevitably shift back in favour of landlords at some stage. Therefore it is in tenants’ best interests to ensure that they maintain good relationship with their landlord, particularly if they are happy with their premises and want to avoid the business disruption and expense associated with relocation.
“The key to mutually successful agreement being reached in the current economic climate is to open discussions at an early stage,” says Rundle. “Both parties need to be flexible and also understand that any variation to the existing lease arrangements should provide benefits to both sides.”
Looking to the future, Colliers International is predicting that industrial rentals will continue to decline for the remainder of 2009, but will stabilise during 2010 before rising again in 2011.
“Industrial property is the most exposed property sector to the real economy,” says McMahon. “Given that property as whole is lag economic indicator, this means that the industrial market is usually the first property sector into downturn and the first to come out.”
CBRE is forecasting that net effective rentals will continue to decline across all sectors of the market this year and in some sectors in 2010. Face rentals are also expected to come under pressure in the second half of this year.
“Most economic forecasters are picking the bottom of the economic cycle will be reached at some stage between the third quarter of 2009 and the first quarter of 2010,” says Moricz.
“However, few are expecting this to be followed by strong bounce back to economic growth; rather we can expect period of sluggish growth. This indicates that occupier demand could stop contracting around the end of the year. However, return to stronger absorption will take longer, reflecting the current build up of excess capacity. This will take while to soak up before occupiers will look to expand.”
Moricz says the Auckland CBD office market has the largest “supply pipeline” with number of significant projects that started before the downturn due for completion over the next two years. It will take longer to recover than the non CBD, industrial and retail markets which don’t have the same supply pressures.
Sir Robert Jones, who has experienced number of property cycles in nearly half century of investing in commercial and industrial property, says the current fall in rentals will be followed by sharp increases when the market does eventually fully recover. Writing in recent issue of