Malaysia: office space developers need to adjust supply to market conditions

The fundamental that bears watching for the office market is rents, and rents are a function of business profitability.

Ultimately, the general levels of profitability of businesses in any city sets the sustainable level of rents for that city and it also explains the different levels of rent that prevail for different cities.

The current average level of Grade A office rents in Kuala Lumpur can be pegged at RM6.50 to RM7 per sq ft per month, and the long term initial yield or return for Grade A office space is about 7%, on a net property income basis. From time to time this yield has compressed to lower numbers, pushing values up, but over the long term, the market seems to return to the “equilibrium level” of seven when the exuberance dies.

The existing office space in Greater Kuala Lumpur or the Klang Valley grew from 76.38 million sq ft in December 2004, to 99.62 million sq ft, by September 2012, i.e. adding 23.24 million sq ft or a high 2.91 million sq ft a year on average between the intervening eight years, according to figures from Napic.

Occupied space on the other hand increased by 1.95 million sq ft a year on average.

The office submarket, from an overall point of view, is in a state of oversupply. 23.85% of total space being vacant is certainly a high figure when a normal percentage ought to be between 5% and 10%.

Apart from this, there are 16.86 million sq ft of incoming space (under various stages of construction) and a further 5.21 million sq ft of planned supply, which are space that has been approved for development but for which construction has not commenced as yet.

This, however, could balloon to a substantially higher figure if all the new office space in the contemplation (now or in the near future) from major commercial projects, especially the ETP related projects, are taken into account.

In 2013, and the years to come, the challenge for developers (institutional and entrepreneur-driven alike) of office space is to make extraordinary efforts to adjust their supply to conditions in the market, or to find specific niches, new demand of the required magnitude stemming from the ETP projects notwithstanding.

The green agenda with its 10-odd percentage of added cost and lower annual running cost needs a higher rental to ensure long term sustainability and this question is yet to be confirmed as yet in Kuala Lumpur although early evidence from the first few green buildings indicate such possibilities.

Having said all that, it must be remembered that the office market cannot be looked at, solely, through the lens of total numbers. The market exists in various submarkets, depending on location and product type and each segment has specific demand and supply dynamics of its own.

A flash back to the Asian Financial Crisis of the mid-1990s and the Global Financial crises instruct us that the office market in particular, and unlike the residential subsector, is inclined towards higher degrees of volatility, and it did sink below replacement cost in the first crisis and stayed below that level for many years, whilst in the second crisis it took a dive of 20%, and has not recovered to previous peaks, five years hence.

The Klang Valley office market is by far the predominant office market in Malaysia. Penang, by comparison has only 9.03 million sq ft of equivalent, modern, existing space and Johor Baru, 6.21 million sq ft, but the fundamentals that drive those markets are similar.

The retail sector is also driven by income from rents and rents for this sector are dependent in-turn on retail turnovers and it is this that bears the closest study and monitoring.

Turnovers depend on the multitude of shoppers, including tourists, and their propensity to spend. In Kuala Lumpur the long-term rental return on average for Grade A shopping centres used to be about 8%, but this is on a structural transit towards 7% as shopping centres become a more mainstream asset.

Real Estate Investment Trusts or REITS which are at a high point in investor interest on account of a confluence of factors including the spill-over from continued, quantitative easing measures in the developed countries, are also being led by REITs with a bias towards the retail sector. The new, stapled structure for REITs that is to be introduced by the IPO from KLCCP properties, with its total portfolio of RM15bil, may add a further boost to this asset class the timing, in the introduction of such a big portfolio, insofar as the REIT industry as a whole is concerned, could be a major positive for the industry.

The retail submarket (modern shopping centres) in the Klang Valley is relatively stronger than the office market, but it also has shadows of looming oversupply as more centres from the pipeline come onstream. But a well-managed retail centre by its inherent higher sophistication (than an office building), has better strength, to tide over temporary downturns because once a shopping centre captures the loyalty of a target segment of clientele, usually through a prolonged period of astute mall management, it is extremely difficult for new comers to dislodge it.

Last year’s buzz in the retail subsector in the Klang Valley was the addition of new malls such as the Setia City Mall and the Paradigm Mall and the introduction of fresh brands such as H&M and Uniqlo, two fashion brands that have come into the country and have started to shake up that segment.

Other sectors such as food and beverage and cineplexes are doing well in most of the shopping centres.

The hotel subsector is ruled by the twin, and interrelated income fundamentals i.e. the room revenue and occupancy rates. The value of a well-managed five-star hotel can be pegged at about RM1.5mil a room with a net yield of between 7% and 8%.

In the agricultural sector, oil palm plantation values, as indicated by asking and concluded prices, and since the heightened period of volatility in palm oil prices since five to six years ago, are still not clearly settled within a range to enable an easily predictable typical value.

We know that values, for the top, well-managed estates have gone up from the RM15,000 per acre benchmark of the past, but the new benchmark level, as to whether it is in the low RM20,000 or the higher RM20,000 is as yet to be clearly established.

Better clarity may come when global conditions in the bigger commodities market and underlying demand from the big emerging markets are also more settled.

Source: The Star Online

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