Beware the misleading lease demand in Singapore office sector

Current net take-up rates are most probably distorted, warns Maybank Kim Eng.

It's a matter of when not if a "hollowing-out" will occur, in which the worsening state of lease demand will be revealed, according to the investment bank.

Here's more from Maybank Kim Eng:

Expectations of a bottom. Office plays have done well YTD, despite persistent global economic concerns and the fact that spot Grade A rents have been declining since the start of the year. This may be partly due to the fact that while negative rental reversions have set in, the impact has been manageable, with hopes of the market bottoming out by this year.

Office REITs lead the pack. CapitaCommercial Trust (CCT) and KREIT have seen their share prices go up by 34% and 37% YTD respectively. Along with other S-REITs, the run-up may be partly explained by yield compression, as office REITs’ yield spreads over the 10-year government bonds remain attractive at about 470 bps. DPUs have also shown to be fairly resilient, due to a combination of cost controls and in some cases, the presence of income supports.

Demand is still anaemic. Leasing demand continues to flow in dribs and drabs, with demand for large floor plates still glaringly absent. Financial institutions (FIs) have already committed to significant office space in the past 2-3 years. With the sector now undergoing fat-trimming and consolidation, FIs may in fact be sitting on excess space due to reduced headcount, which may lead to more shadow space. We do not see companies from other industries to have similar appetite for office space to pick up the slack.

Not seeing the full picture. We also believe the current net take-up rates are distorted by the fact that some FIs have yet to fully run-out their leases at their original locations. Eventually, there will be an actual hollowing-out, and their previous landlords will have to find replacement tenants. Examples include DBS’ exit from DBS Towers by end-2012 and the expiry of Citigroup’s lease at Millenia Tower at end-2013. The secondary space will face competition from new Grade A schemes, e.g. Asia Square Tower 2 and CapitaGreen.

Landlords may cede bargaining power. A number of recently completed Grade A developments have yet to achieve over 90% occupancy. E.g., the 1.3m sq ft MBFC Tower 3 is currently ~70% occupied and the recently completed One Raffles Place Tower 2, with an NLA of 335,000 sq ft, is just ~60% pre-committed. With decent supply on the horizon, we expect tenants to assert greater bargaining power, which may lead to further decline in spot rents.

We expect Grade A office rents to soften by another 10% by end-2013 to average at around SGD8.30 psf. As the price gap narrows, we also expect Grade B rents to correct by 10% to average at SGD7.20 psf in end-2013. While we recognize the impact on office REITs’ DPUs may be minimal, we see little room for organic growth. We prefer retail and industrial REITs.