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Saturday, January 14, 2012

Oversupply of Klang Valley office space

KLANG Valley's office space may be heading towards a state of oversupply. The total existing supply of office space is 94.4 million sq ft; 73.07 million sq ft of this were occupied in 3Q 2011. This leaves 21.33 million sq ft or 22.6% of the total space, within the various office buildings, vacant.

While a 5% to 10% vacancy is normal for most buildings, the aggregate 22.6% across the office market is high. Apart from this, there are 18.59 million sq ft of incoming space (under various stages of construction) and a further 18.74 million sq ft of planned supply.

This is space that has been approved for development, but for which construction has not commenced as yet, as tallied by the National Property Information Centre or NAPIC.

There is also the possibility that the 18.74 million sq ft could balloon substantially if all the office space being contemplated now and in the near future, especially the Economic Transformation Plan (ETP) are taken into account.

Demand-supply dynamics

In the years to come, the challenge for developers of office space is to make extraordinary efforts to adjust supply to conditions in the market when their projects are due to come on-stream and to do as much of pre-letting as possible.

For owners of existing buildings, hang onto to your tenants! For regulators and lenders, watch this with greater interest.

Much hope hinges on the roll out of the ETP and how it will create new office space demand, and of the order required, to balance demand and supply.

Nevertheless, the office market cannot be looked at, solely, through the lens of total numbers. The market exists in various sub-markets, depending on location and product type.

Each segment has its own demand-supply dynamics. Rents drive the market and post-Global Financial Crisis (GFC), rental levels have dropped to about RM7 to RM8 per sq ft per month for average prime space.

At this level, the office market for average prime space for office buildings sold en bloc can sustain at RM700 to RM900 per sq ft based on its historical yield expectation of about 7% to 7.5%, but this figure is not carved in stone.

For the market to slip below this level, it will take a severe economic downturn. In short, office values are bouncing along around the bottom. Post-Asian Financial Crisis, values did dip below the replacement cost (as it was then), for a number of years.

In terms of office space, the Klang Valley, with an existing supply of more than 90 million sq ft, dominates, compared to Penang's 9.43 million sq ft and Johor Baru's 7.7 million sq ft.

Klang Valley's retail segment, comprising modern shopping centres, is relatively stronger than the office market segment because consumer spending has continued unabated.

But there are shadows of looming oversupply even in this segment. If inflation accelerates, or household spending is crimped, will there be consumer support?

But a well-managed retail centre by its inherent higher sophistication (than an office building), has better strength to tide over temporary downturns. Once a shopping centre has clientele loyalty, usually through a prolonged period of astute mall management, it is extremely difficult for new comers to dislodge it.

Real estate investment trusts or REITs have a heightened presence after the listing of Sunway REIT and CMMT are anchored with retail properties. The latest addition, the Pavilion REIT is also essentially a retail REIT.

REITs are generally defensive investments and are ideal for lowering volatility in a portfolio of stock and bond investments.

Role of a REIT

They are also particularly attractive during difficult economic periods such as, since 2008. They are more convenient proxies for physical property. For that reason, special tax benefits are showered on them.

But, as was seen during the last GFC, to perform true to form they should also display all their other attributes, i.e. a high degree of transparency, low borrowings, professional property management and the comfort that comes from a high degree of regulatory oversight.

REITs have also to display their ability as a sector, and as individual REITs, to ameliorate its greatest weakness i.e. its dependency on short term financing due to the requirement for it to distribute almost all its earnings, yearly.

During the days of easy money before the GFC, cheap financing was not a major issue, but it now is.

As a quid pro quo for favourable tax incentives, REITs are obliged to promote retail investors, apart from institutional investors, to participate in the REIT.

This will meet the regulators objective of deepening and broadening the capital market, and set the foundation for sophisticated products in the future such as the establishment of a property derivatives market.

Retail investors would also have tenancies that come with considerable visibility. REIT managers should provide information as this is the key driver of REIT proposition and not hide behind the guise of protectionism against competition.

The residential sector of the market, viewed from the perspective of the country as a whole, is fundamentally sound.

Losing balance

In the Klang Valley, where residential properties are generally 4 to 5 times annual household income, certain hotspots have elevated this ratio in recent years. Household income in the Klang Valley is about RM6,000 a month.

While house prices have increased, household income has not. Set against property prices, rental yield has dropped over the years, slipping below the critical 3% benchmark.

This is a cause for concern as yield should range between 3% and 6% (all risks net return) depending on house type and whether landed or strata.

Over the past six months, with the onset of greater volatility in global markets stemming mainly from the European sovereign debt crisis, sentiment has filtered down to the residential market in Kuala Lumpur.

Coupled with tightening measures by Bank Negara for loans, the market has slowed and demand has become subdued. It is hoped that this has taken some heat out of the speculative end of the market.

Keeping a look out

Going forward, into 2012, the issues that bear watching for the property market in Malaysia, are the continuing European debt crisis and the sluggish US economy and its effects on the global economy and the possible slowing of the Asian behemoths, China and India (which have regional implications).

There is also the possible General Elections in Malaysia (and its ramifications), the possible introduction of the Goods and Services Tax (affecting in particular house prices, developers and service apartments) and the possible unprecedented legislative introduction of a new, single mode of housing delivery by way of the “build then sell” system (humungous down-the-line implications).

There is a possibility of further tweaking of rules for housing loans (to possibly also contain household debt) and other possible monetary and fiscal measures (may be negative or uplifting for the property market) that may be put in place should the global economy weaken further.

Elvin Fernandez is the MD of property consultancy firm Khong & Jaafar Sdn Bhd.

By The Star

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