Another quarter passes and another tumbleweed blows from the North docklands to St Stephen’s Green with no significant prime office investment trading in Dublin. What is this telling us about the market for business space? To quote Seán O’Casey “it’s in a state o’ chassis”.
Owners of offices are facing a big dilemma, particularly those who are reaching the end of their hold periods and already have an exit in mind. For sure, more office workers are returning to their desks, and employers are fine-tuning the hybrid model to ensure a greater in-person presence between Tuesday and Thursday. However office attendance remains well down on pre-pandemic levels and floorplates continue to be sparsely populated on Mondays and Fridays. In addition to this challenge, investors face another malevolent force, that of increasing interest rates. Both factors are interacting to cause uncertainty and the ultimate landing points are difficult if not impossible to predict.
From a property owner’s perspective, let us start with the revenue side of the equation. As occupancy requirements are not what they were pre-Covid, it is highly probable that, at the next lease event, the tenant is going to require a sweetener from their landlord to stay in situ. This is going to take the form of (i) less space, (ii) a lower rent per square metre or (iii) some other inducement such as a rent-free period or capital contribution to a new fit-out. Either way, the net effect will be to lower the landlord’s rent roll or income. Meanwhile, on the creditor’s side of the coin, a landlord with bank finance (depending on loan tenor) may have little choice but to enter into a refinancing negotiation with its lender. Even without the squeeze on rent roll, the rapid increase in interest rates (from all-in rates of say 3 per cent to 7 per cent) is more than enough to destroy the landlord’s quarterly cash flow.
So this is causing distress, which leads to liquidity, and buying opportunities for investors seeking same? Well no, at least not yet…
Essentially investors do not feel that the prime yield for the very best office blocks in Dublin is reflective of the current risks inherent in this market
Firstly, due to relatively low loan-to-value ratios, we are not seeing the market flooded with assets, and any loan breaches are often corrected with an equity kick. Secondly, there is a strong dichotomy in the office market and the weakness seems to be contained to non-prime assets for now. Ergo, among the office investments that accounted for a mere 12 per cent of market turnover in the second quarter of this year, the only assets that changed hands were buildings in secondary locations and/or those with short tenant income that require substantial retrofitting to bring their sustainability ranking into line with modern occupiers’ expectations.
All of this is taking place in context of a benign economy with full employment and strong consumer demand. However, what happens if major economies begin to wobble and we enter a recessionary period, which an inverted yield curve can often be the harbinger of? As we can see looking through the forward lens of the stock market, the share price of some office Reits (real estate investment trusts) such as Derwent (UK) and SL Green (US) is now implying contagion from the lower end of the market into the top end. This could perhaps lead to further falls in office values, which will inevitably result in fire sales as investors in property funds seek their cash back. This could potentially be even further exacerbated by the nervousness of an already concentrated pool of lenders enforcing their security.
[ Commercial property activity slows to one of lowest levels on recordOpens in new window ]
[ Blackstone pays more than €500m for Salesforce HQ in Dublin docklandsOpens in new window ]
So, back to the tumbleweed, and why is it blowing through the centre of Dublin’s office district, at least in metaphoric investment terms? Essentially investors do not feel that the prime yield for the very best office blocks in Dublin is reflective of the current risks inherent in this market while these two big uncertainties linger, ie stumbling occupancy and climbing interest rates. The market dynamic has switched very much from a seller’s market to a buyer’s market. With base interest rates unlikely to ever be sub 2 per cent again in this author’s lifetime, something has to give and until it does, we will continue to see subdued trading in this once reliable and buoyant subsector.
Kenneth Rouse is managing director and head of capital markets at BNP Paribas Real Estate Ireland.
