Are Sydney Premium CBD Office Rents Inflated?

Sydney is the only Australian CBD market where the prime vacancy rate is higher than the secondary grade vacancy rate.

Sydney is the second tightest office market in Australia (10.5%, after Melbourne at 10.4%), but prime grade vacancy is 12.4%, the highest level in Australia, and the highest level since JLL started tracking vacancy by grade in 1994.

Meanwhile, secondary stock is relatively tight at 8.5%. This may seem surprising on the surface, as during times of high vacancy and declining rents, there tends to be a “flight to quality” – where tenants take advantage of available space and generous incentives to upgrade their accommodation.

So why is Sydney’s CBD prime grade vacancy so high in comparison to other Australian CBDs?Firstly, a lot has to do with the make-up of tenants – financial services firms are Sydney’s largest occupiers, and are traditionally occupiers of prime grade accommodation. Since the financial crisis in 2008, financial services firms have been in a process of corporate space rationalisation and consolidation.

Deloitte Access Economics reports that the number of people employed by financial services companies has declined by 5.6% from 2008 to 2013. This is equivalent to 54,000 sqm of office space based on a workspace ratio of 1:14.

The prime grade vacancy rate has been driven upwards of late by the large vacancy in premium-grade buildings. It is at 14.4%, which equates to over 100,000 sqm of office space.

Occupiers of premium space in Sydney are typically investment banks and professional service companies, such as law firms and accounting firms. These tenants have traditionally a high work space ratio. Larger corporations are rationalising and cost cutting, which includes shrinking their average workspace.

Another reason Sydney has not seen the flight to quality that some other markets have recorded is the rental premium that prime-grade buildings demand. There is a 54% differential between Sydney CBD prime and secondary gross effective rents.

To put this in context, in Melbourne the differential is only 35%. Furthermore, premium gross face rents are 36% higher than A-grade rents, well above the ten-year average of 29%.

Due to the above factors, it is likely that in the medium term premium grade stock will continue to have a higher vacancy rate and lag A-grade and secondary rental growth. Premium rents appear inflated. The sub-dividing of floors to attract smaller tenants may satisfy the desired rental returns in some cases, but there is a finite supply of these types of tenants. A reduction in vacancy will need to come from large corporate occupiers and in the current market conditions, getting these tenants to lease more space is a difficult task.

Furthermore, the current demand outlook for the NSW economy suggests Education, Technology and Health will contribute a higher proportion of white-collar workers than previously. These groups are not traditional users of premium grade buildings.

Owners of premium grade buildings will need to decide if they will lower their effective rents to make their office space more competitive with lower-grade stock, or risk longer-term vacancy if the physical market does not improve markedly.

(Image credit: Barangaroo, Lend Lease)

Alex McColl is a Market Research Analyst for JLL, based in Sydney, Australia