Still a case for transitional offices

Property 2011

Published September 15, 2011

Still a case for transitional offices ALAN CHEONG gives an overview of how far the market has come and the role it can play today TRANSITION offices are commercial developments built on Government Land Sales (GLS) sites on 15-year leases. The Urban Redevelopment Authority (URA) launched this category of GLS in 2007 as a creative solution to tackle immediate shortages in office space that could soak up pressing and sudden demand. Pressure on values and rentals arose in the office market in 2006 and 2007 due to a lack of new supply and surging demand from global financial institutions and their supporting industries taking root in Singapore. However, in today's situation, with ample supply in the pipeline in the Central Business District (CBD) and regional hubs, does it make financial sense to carry on bidding for transitional office sites? Figure 1 shows that initial successful bidders were showing conservatism, but by the fourth transitional site tender, prices were beginning to follow general office rents and prices. Thus far, total development costs for successful bidders for the six sites are manageable under current market conditions. The Table shows that the land price per square foot per gross plot ratio (ppr) ranged from a low of $69 to a high of $242 psf ppr. Assuming a successful bid of $250 psf ppr, the amortisation factor to recoup the land and construction cost amounts to about $4 psf per month (pm). (Given a low interest rate environment, simple amortisation may suffice.) That would constitute the return of capital. A question now arises: Is this $4 psf a reasonable rate? To answer that, the rental rates of short term office space provide a guide. Figure 2 shows the average rental rate on an estimated net lettable area (NLA) for the successful bidders of short term commercial buildings leased from the Singapore Land Authority (SLA). These are leased from the SLA on a 3+3+3 year basis. Presently, the rate is $4.12 psf pm. This is almost comparable to the amortisation rate of a purpose built transitional office with a land price of $250 psf ppr. If one were to factor in the premium payable for a purpose built new transitional office, the rate should be higher than $4.12 psf pm. Add on $0.80 psf pm for maintenance expenses, rents will close in on the $5 mark. Considering a 70 per cent debt level, the interest would add up to about $1.22 psf pm, making the total cost at about $6.10 psf pm. Although the supply of new and secondary stock is building up due to new developments in the fringe and non-CBD area, they are not cheap to develop. The average cost of developing the upcoming buildings range from $1,200-1,500 psf of NLA. Assuming an economic life of 50 years and taking $1,350 psf as the mid-point, the monthly amortisation works out to $2.25 psf NLA. While the amortisation is significantly lower than that for transitional offices, 99-year or leasehold offices have a high absolute level of debt, by virtue of the much higher land cost. If the loan to value ratio is 70 per cent and assuming an interest rate of 3.5 per cent per annum, the interest expense is about $2.75 psf pm. In total, if maintenance is estimated at $1 psf pm, the base rental to cover amortisation, interest and maintenance is therefore also around $6 psf pm. In other words, bidders for a transitional office site at $250 psf ppr and for a 99-year leasehold site at $900 psf ppr are indifferent because the break-even rental to cover return of capital, interest expenses and maintenance is about the same at $6 psf pm. The highest transitional office bid was $242 psf ppr by UOB Kay Hian. For them, it would make economic sense because rentals for UOB Plaza, where they were previously located, are going for much more than their cost of being located at Anthony Road. Rising rentals in 2007, image, the need for a large space to accommodate their front and back offices and easy access by public transport made their choice to bid for a transitional office space near Newton MRT Station a good compromise. For the six URA sites that were sold for transitional offices, three had anchor tenants. The other three were leased to multiple tenants. From observation, those that had anchor tenants bid above $219 psf ppr while those which won the site with bids less than $173 psf ppr leased out to multiple tenants. In the final analysis, some points can be made about transitional offices here. If one were to bid for a site that had break-even rentals similar to suburban leasehold office space, securing an anchor tenant upfront or early in the development stage is preferred as that will reduce the risk given that the effective time for transitional offices is only about 12½ years (1½ years for construction and about one year to return the land to the authority free and clear of encumbrances). If one were to bid at conservative levels, there is less pressure to lease out the space given that the break-even rentals are lower. But even then, there is a limit to how much time one can buy because though land costs are low, the other factor, namely construction cost, plays quite a big role in the overall scheme of cash flow (about $2.50 psf pm). Besides the bid price, timing the market is important for transitional offices because if one gets it correct and locks in the tenant for a long-term lease at or near cyclical peaks, the rewards are high. With 99-year leasehold suburban sites successfully bid for at break-even costs of $1,200-1,500 psf of NLA recently, transitional office bids should theoretically be at a discount to these benchmarks. If one were to assume a long term opportunity cost of 3.5 per cent per annum, the discounting factor from a 99-year leasehold office with a 50-year economic life to a 12½ -year economic life transitional office is 27.5 per cent. A potential and big source of demand for transitional office space could be from businesses currently operating out of industrial premises and paying $4.50-5 psf pm. Perhaps unbeknown to these users, the issue of legality of using industrial space for such activities may arise. Renting space in a transitional office will therefore clear up the air and leave no uncertainty for such tenants. The case for transitional offices is there. Although office rents will ebb and rise cyclically, new 99-year leasehold suburban office space will be coming up at higher development costs (since land prices were high). Landlords for these developments will have to ask for rentals that will hithero be considered record levels since many of these areas have never had purpose built multistorey office buildings. Transitional offices will come in to fill the gap for those whose budgets are constrained, those whose business models require large headcounts or for those who perhaps at the moment are operating out of industrial space with questionable legality of zoning use. The writer is associate director of Savills Research & Consultancy