The Singapore Office Market – One year into the pandemic, has the market dynamics mutated?

A year into the pandemic and, although the level of market uncertainties has declined, at the granular level, the degree of clarity is still blurred. The blurriness stems from rather non-deterministic views offered by various industries regarding their attitude towards hybrid work. Hybrid work is one where some employees return to the workplace while others work-from-home (WFH). In addition, the industry and the kind of operations within them would be assigned to different grades of office, locations and business park space are still under to be decided upon by companies. Will back-room operations still be assigned to CBD locations, shifted to regional centres, outsourced to other countries, WFH or a combination of all these options? In a similar way to the Covid virus, the office market is also mutating. We shall look at some of these changes and whether it still makes sense to stay invested in this sector.

Tenant behaviour

There is increasing consensus amongst corporate leaders that the previous one hundred percent office workplace practice will be reduced significantly. However, there is a limit to the contraction because beyond that point, countervailing forces are in motion that push back against WFH. This inference arises from data analysed by Microsoft and produced in a write up titled ‘Microsoft forecasts the next great disruption as hybrid work’. The report states that research has identified seven global hybrid work trends. Of these seven, we believe that the ones impacting office space are:

1. Flexible work will be accepted practice. (-)

2. Move to remote work is endangering innovation. (+)

3. Remote working cannot build authentic relationships that are needed for fostering compassion and comfort amongst employees. (+)

4. Employees with the right skill set can be sourced not only within a country but also outside. (-)

The (+) and (-) symbols mean a positive and negative contribution to the demand for office space, respectively.

The net effect is that general office space usage for most companies will shrink, at least for the medium term. For Singapore, it is likely to contract more out of the concern that business conditions will be more challenging and, given the already tried and tested mode of WFH, companies will attempt to pare overheads by shedding some office space and/or move to either secondary locations or WFH. To get to our view of a likely end state of the office market in a COVID world, we have placed in order the transition stages that the office market needs to go through over the next few years. These intermediate phases are seen in Table 1.

*: Decentralisation does not only mean a move to office buildings outside the CBD. It can also be a move to industrial or business park facilities if the tenant qualifies.

As the overriding concern of many tenants in the CBD office market today is one where they do not have clarity of future business prospects and how their global operations may be restructured to accommodate Covid in the marketplace, attempts to push ahead with plans like decentralisation when uncertainties unbound could propagate decision errors which can be very costly to remedy subsequently.

Presently, most tenants are in the beginning stages of right sizing their office needs. This plan will gradually be executed as leases come due and, given that the percentage of leases due for renewal in Grade A CBD buildings peak in 2021, most tenants will have to either decide to scale their future office requirements this year or defer it to next year if they need more time to decide. If the latter, then we should see many tenants renewing their leases on a short-term basis. With about 16% of leases for CBD Grade A office buildings due for renewal in 2022, the process of right sizing should continue until 2022 before the process tapers and the level of uncertainty eases.

Instead of a single blow coming in 2021, the pressure on landlords will thus be spread over the next two years. This stretching could lower the pressure, giving them room to take remedial actions to handle the coming wave of rightsizing amongst tenants. If an action begets an equal and opposite reaction, then landlords may choose to use these two years to refresh or even redevelop their buildings to position themselves for the next epoch.

Rents

Both the limited supply pipeline and delays in completions of these upcoming buildings in the CBD would further help soften any negative impact of tenants rightsizing. Graph 2 shows the historical as well as the pipeline of ready to operate supply for major office buildings. We have adjusted the future supply taking into consideration the delays caused by the construction stop work orders handed out in 2020. Early in the second quarter of 2021, there was an outbreak of the viral infection in workers’ dormitories, and this created friction to the construction flow process. Further delays could therefore be expected. We have not taken into account this second delay. (We take 6 months plus TOP to represent the time when a tenant can start operating in a new office building. The 6 months is about the time taken to fit out the premises.). As can be seen, the effective move-in supply is very low in 2021 and still below the average 10-year take-up in 2022. Although there is a spike in supply in 2023, it is very likely that some of these may be pushed over to beyond that year.

All this reinforces our view that headline office rents should still have cushion of support for two years or more. However, passing rents may still be biased on the upside because any decline in the headline numbers would be mild and not to levels below what was achieved in the 2017 to 2019 period. Beyond 2023, the direction of rents is as much a guesstimate as what real estate investment managers and valuers had been punching into their spreadsheets (about 2% to 3.5% pa) regarding long term rental growth rates and vacancy levels (about 3% for CBD Grade A offices) before the pandemic. The withdrawal of tired office buildings from the market and the advent of a new landscape of multinational companies from the new economy could then be the substitutive drivers of the market. In other words, when this pandemic subsides, while the overall office market may have less uncertainty, meaning it is still largely functioning as before, the sub-systems within it, namely the behaviour of tenants, has greater entropy. Even if office rents only start to rise again in 2023, the long-term trend line will still be positively sloping. (Please see Graph 6).

For 2021, CBD Grade A office rents may be see-sawing for various grades of office buildings and for different sizes. In our Q4/2020 Office Briefing, we mentioned that there could be a small chance that rents may rise this year. (Please refer to Graph 3.)

A sliver of this possibility of the right tail growing in size was observed in URA’s Q1/2021 office rental index which rose 3.3% QoQ. This significant increase was not likely the result of a sharp drop in rental contracts signed and therefore cannot be attributable to the sparseness of data. Graph 4 shows that the number of rental transactions done for the core office areas are not very dissimilar to the previous quarters.

The latest rental rise has not been lost amongst landlords and almost to a day after the data was released on the 23rd of April, their hope and resolve to keep rents at the status quo rose. One could almost say that the day of the URA rental release was the hinge factor that turned landlords’ sentiments around. However, while sentiments have been bolstered by the recent data release, it may have to be tempered by the fact that from anecdotal feedback, most tenants are looking to right size their office space. This could rein in the rental upside. Nonetheless, this bright spot has illuminated landlords’ mindset to confidently maintain asking rents.

On which grade of offices (AAA, AA or A) may perform better in the coming quarters, we have a contrarian view. Currently, the commonly held belief is that rents of AAA buildings are and should continue to hold up while the level of rental discounts are increasing as one cascade down the building grades. However, what has been observed in the tenants’ market is that they are either rightsizing down or upsizing from co-working locations. On an aggregate level, it is likely that a new sweet spot in office size will emerge. Graph 5 shows that in Q1/2021, rental for Category 1 & 2 buildings (The URA defines Category 1 office buildings as those located in core business areas in Downtown Core and Orchard Planning Area which are relatively modern or recently refurbished, command relatively high rentals and have large floor plate size and gross floor area. The complement of Category 1 is Category 2. Category 1 buildings are therefore quite similar to Savills basket of CBD Grade AAA and AA offices.)

As Category 1 buildings have relatively large floor plates, we would believe that leasing transactions involving units less than 100 sq m would be relatively few. As the URA index uses the medium measure, the 3.3% rise in the URA index in Q1/2021 could have arisen from those sized >500 to 1,000 sq m where rents rose 11.4% QoQ. This range of office size may well be the new sweet spot, at least until tenants no longer need to rightsize and/or those expanding out from co-working space take a larger step to sign on space >1,000 sq m. If this continues, it may ultimately benefit in general Grade AA, A and new Category 2 buildings because their floor plates may either be rented wholly or can be easily modified to suit tenants who need >500 to 1,000 sq m of space. Also, as AA, A and Category 2 buildings have lower rents, it could suit the more cost-conscious tenant.

However, despite the unexpected increase in URA’s office rental index in Q1/2021, we maintain our -5% YoY change for our CBD Grade A (encompassing AAA, AA and A) office rental forecast for 2021. (Please refer to our Q4/2020 Office Briefing where we mentioned in the Outlook section and illustrated in Graph 3 the tail risk of rents rising in 2021.) The Q1/2021 rental increase may still face subsequent headwinds in the coming quarters due to more tenants rightsizing than upsizing.

Investment market

The passing rent profile will correspondingly bear on investment decisions in the short term. If passing rents adhere to that in Graph 6, the Net Present Value (NPV) of a hypothetical Grade A CBD office building will be at a discount from that if there had been no Covid. Because of this discounting, we may be able to predict when CBD Grade A offices may resume transacting. The analysis goes like this. The seller of a Grade A CBD office building before the pandemic (say the year 2019) was willing to transact at an NPV of S$2,188 psf. However, because of the global fallout from the spread of the virus, values declined. If the seller is not willing to lower the price, they may have to wait until early 2026 for values to return to 2019 levels. Under the assumption that headline and passing rents will recover at the rates shown in Table 2, 2024 will probably be the upper limit of the time to wait before investment sales for such office developments restart.

Although it seems that the market may still need about five years to return to sellers prices, it is possible that the investment market may revive earlier because of:

1. The limit to the life of a fund (if any);

2. Opportunity cost to investors for holding onto the investment longer;

3. Excess liquidity looking for an asset class to deploy to.

On point 1, if there is a limit to the life of a fund, COVID has probably been the force majeure that permitted a delay in the disposition of the investment. However, as the pandemic begins to wind down, efforts will be made to vend the asset. On point 2, even if there is no increase in vacancies, this pull back of rents for two years (2020 and 2021), is enough to depress the NPV of a Grade A CBD office building. So even if passing rents ultimately recover and NPVs return to pre-pandemic levels, holding onto the asset would likely weigh down the Internal Rate of Return (IRR). Therefore, for those who invested a few years ago, it may pay to divest. For those who wish to acquire now, the expected IRRs are still likely to remain attractive, but they may have to temper their expectations down with regards to the returns. (Please refer to Graph 7.) This tempering of expectations may happen because the tremendous amount of liquidity in the system will ultimately drive down yields.

Having said that, it is still possible that investment IRRs in the future may return to, or perhaps even better than, pre-pandemic levels, because there exists the possibility that the liquidity may force down terminal rates. This means that rental yields may fall but the exit value goes up more. )

Conclusion

In conclusion, although tenants are in the process of rightsizing their office spatial needs, the negative impact on rents may be softened by;

• the limited supply coming online due to the delays caused by the construction stop work order in 2020 and in 2021, the outbreak of another viral infection at workers dormitories is likely to add further delays and;
• the move to smaller office sizes may ratchet up rents for buildings with floor plates or unit sizes that fall within this sweet spot. While rents for the lower grade of offices may be more affected today, but moving forward, the move to smaller office space may bring these office buildings back in vogue.

For investment sales of CBD Grade A office buildings, the financials still make sense for buyers and sellers to consummate a deal. For the seller, they may use this opportunity to lock in their returns as holding to the asset for a longer duration would affect the IRR of their investments. For buyers, they may have to accept a lower but nonetheless still an attractive rate of return if they enter the market today. Nevertheless, there exists the possibility that IRRs for investments made in a Covid world may revert to or better pre-pandemic levels because the liquidity in the system may be chasing after capital gains and accept a lower rental yield during the holding period. Valuers may ultimately have to lower their discount and terminal rates for their DCF.

In short, while we believe that the office market dynamics have mutated, it is still a viable asset class to stay invested.