The natural characteristics of product differentiation, cyclicality and illiquidity make real estate markets less transparent than they should be, particularly in a downswing.
Because two buildings cannot occupy the same site, commercial properties are all unique. This product differentiation creates a value-adding role for agents who are good at selling the merits of particular buildings. In good times, this involves communicating a positive macro narrative and promoting asset-specific attractions such as location and building specification. However, because commercial markets are cyclical, times cannot always be good. And, when the cycle turns, the advocacy role suddenly becomes more challenging. In this moment, because property is an illiquid asset, numerous deals will be in progress. To keep these alive, the agent’s instinct is to accentuate the positives.
A common tactic is to focus on gross rather than net demand. Dublin office commentaries have traditionally emphasised “take-up” – a measure of how much space has been leased or bought by owner-occupiers. Recent reports correctly highlight that take-up rose by over 60 per cent in 2022. This is good, but it is not the whole story. Vacancy is the key determinant of rents and, while take-up is necessary to drive vacancy down, it is not sufficient.
For vacancy to fall, occupied space must rise. However the increase in occupied space (‘net absorption’) is generally only a fraction of take-up. There are two reasons for this. Firstly, some lettings involve movement within the market. To illustrate the effect of this, consider an organisation moving from a 5,000sq m to a 2,000sq m office. Gross take-up of 2,000sq m will be recorded, but total tenanted space will fall by 3,000 sq m. This explains how vacancy can rise even when gross leasing activity seems respectable.
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A second reason why absorption generally lags take-up is subletting. If an occupier subleases from an existing tenant, this space is counted in take-up. But there is no rise in occupied space as the property was already tenanted.
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Any market has a baseline of “churn” and subletting, but both become more pronounced during a slowdown. With fewer new entrants and expansions, movers naturally account for a higher proportion of lettings, widening the gap between take-up and absorption. This is compounded if movers are downsizing, as often happens in a downturn. Reflecting the global headwinds of 2022, most large Dublin office lettings involved movement within the market. Downsizing was not prominent per se. But occupiers who might prefer a smaller office are often bound into long leases, and the surge of space becoming available to sublet suggests that de facto downsizing strategies are already in play.
Leaving aside random judgments about which buildings to exclude, the notion that vacant older stock does not drag on prime rents is logically dubious
More than 230,000sq m of new office space was delivered in Dublin last year – the most since 2008. This was somewhat offset by demolitions but, given current churn and subleasing trends, over 450,000sq m of take-up would have been required to digest the additional stock. Ultimately, 248,000sq m was achieved. This was a solid performance, and testament to the broad base of occupier demand that exists beyond tech. But it could not prevent vacancy rising from 10 per cent to 12.4 per cent. This year will be the same, with a similar amount of new space scheduled for delivery, and with demand conditions remaining challenging.
Desperate attempt
With vacancy rising, some commentators have attempted to define older buildings out-of-scope when calculating the vacancy rate. The premise is that many of today’s vacant buildings do not meet contemporary occupiers’ environmental requirements. As these are not competing with modern properties, it is argued that they are irrelevant to prime rents and they should therefore be excluded from the vacancy-rate calculation.
Dublin’s office market is in a downswing. Vacancy has been rising for 30 months and, axiomatically, this will drag on rents
This is a crude and slightly desperate attempt to understate vacancy, and it is fundamentally ill-conceived. Leaving aside random judgments about which buildings to exclude, the notion that vacant older stock does not drag on prime rents is logically dubious. Many of today’s vacant offices are, indeed, Grade C. To let them, rational owners will cut rents. This creates a headache for the owners of Grade B buildings, who have to counter-cut to preserve their competitive advantage. In turn, this passes the problem to Grade A owners who must react to reduced asking rents for the better Grade Bs. Building quality is a continuum, and because every property competes with its next nearest substitute, prime rents eventually respond to vacancy movements at any level in the market.
Dublin’s office market is in a downswing. Vacancy has been rising for 30 months and, axiomatically, this will drag on rents. So far, the obvious pressure has been on suburban and older stock. But rent-free periods on prime lettings are lengthening, lease-breaks are being negotiated-in, and prime rents are falling in real terms. There is no point equivocating about this – price discovery and the resumption of normal trading happen faster in more transparent markets.
Instead, analysts should focus on the fact that the current downswing will neither be deep nor prolonged. Given the relatively modest construction pipeline, vacancy should peak at around 15 per cent later this year before falling in 2024 as development slows.
John McCartney is director of research at BNP Paribas Real Estate Ireland.
