The rise of the virtual office: what does this mean for SA property?
- The pandemic-led disruption to the traditional office business model has resulted in lasting changes.
- Demand for office space has fallen as people embrace the cost-efficient and time-saving benefits of a flexible work model.
- Short-term trends for the office sector include rising vacancies, falling rentals, increasing asset disposals and lower valuations.
- The South African office market, like many office markets across the world, needs to embrace these shifting market dynamics to stay relevant
The impact of the sudden pandemic-led disruption to the traditional office model is clear. Many companies took the opportunity to embrace work-from-home models and review their real estate footprint, leaving once-vibrant commercial centres eerily quiet in 2021.
Even before the COVID-19 outbreak, SA’s office sector was feeling the pressure of a weakening economy coupled with an oversupply of space. Investors in the R220 billion SA-listed property sector1 have cut their exposure to the South African office sector from 18% three years ago to 14% in April 2021. Their total office exposure, including to Australia and Central and Eastern European, is currently 22%. The decline is as a result of listed companies selling office assets to private companies and individuals, and the sector’s relative underperformance. With further asset sales expected, we anticipate the total office exposure will fall to approximately 10% in the next three years.
Rising trends to watch as market dynamics shift
The success of remote working since the start of lockdown suggests a permanent shift in behavior. According to a survey by Regus, this shift is driven by the following factors:
The challenges within the SA office sector are expected to increase in the medium term. This will impact current and future dynamics in the sector in the following ways:
1. Declining rentals
An increase in supply over the last few years, coupled with corporates adopting work-from-home models, has given tenants the upper hand in lease negotiations. As a result, tenants are enjoying benefits such as tenant installation, generous rent-free periods, cash payments and much lower rentals. For example, we have seen rentals for Grade A office assets decrease by 5% in the first quarter of 2021 alone.
Rentals in key office nodes like Pretoria, Johannesburg, Durban and Cape Town have all shown a negative real trend. Based on economic growth projections, we expect rentals will only begin increasing again in real terms from 2025 onwards.
2. Rising vacancies
Over the last four years, vacancies in the office sector have risen. Since the start of SA’s lockdown, vacancies on average have increased by 2%. Large office property landlords, like Growthpoint, have seen a 5% increase in vacancies over the 12 months to March 2021. Unfortunately, low economic growth, combined with oversupply in the medium term, are likely to cause vacancies to increase before excess supply is absorbed.
Vacancies are under further pressure as some of the major corporates are looking to sublet part of their existing space. Additionally, as leases expire, there is likely to be less take-up of that space. This situation is exacerbated by the behaviour of many some smaller business enterprises, who are embracing working from home and meet in public spaces, like coffee shops, to save on rental costs.
The negative impact will be felt more in the B to C grade buildings, since they are older and do not have the longer leases found in many of the newer P and A grade buildings. Given the oversupply of offices, tenants are negotiating better quality space in P and A grade buildings at discounted levels.
On a positive note, SA has seen considerably less office development since 2016. This will be favourable for a recovery in office vacancy rates when the market finally stabilises. Speculative office development has been curtailed for most listed property companies.
3. Accelerating asset disposals
Asset disposals have been concentrated mainly in the retail and office sectors, with buyers being predominately private companies or individuals. Listed property funds sold office assets with a range of vacancy profiles in 2020 and will continue to do so in the year ahead.
The sale of office assets will reduce the strain on the balance sheets of South Africa’s listed property companies, as many companies will use the sale proceeds to pay off debt. This will have a positive impact on these companies, making them more sustainable over the longer term.
Large funds, like Growthpoint and Redefine, have concrete disposal plans for some of their assets.
4. Lower SA office property valuations reflect some of these risks already
Given lower rentals and net operating income now being generated by office assets, most listed property companies have also written down the long-term value of these assets. On average, this has meant an increase in the capitalisation rate (“cap rate”) – the ratio of income required relative to asset value, or price paid for the property – of between 0.3% and 0.5% a year. These rising cap rates, all else been equal, means companies show lower property asset values on their balance sheets. In this way the South African office property book values have already begun to reflect the risks of the sector.
We expect office cap rates will rise by another 0.3% in 2021. As the market recovers from 2023 onwards, we expect cap rates will stabilise.
The office market is not dead – its role is evolving to meet tenant needs
As flexible office working becomes a growing part of the South African office landscape and the relevance of suburban offices increases, corporates need to re-think their office strategy. We expect most corporates will embrace flexible working arrangements, reduce rental costs and improve employee work-life balance.
We do not expect that work-from-home will completely replace the traditional office market yet, as offices will remain a place to conduct meetings, establish corporate culture and train staff.
South African office market capex requirements will actually increase, as will property asset management intensity, given changing demands from tenants. Property landlords will need to retro-fit and develop offices to meet tenants’ new needs.
The pandemic has rapidly accelerated the rental and vacancy trends that were already in place, and property companies most prepared for these trends will continue to outperform in both the short and long term. The office sector will see an operating model recalibration, with some conversion to residential, reconfiguration and sub-letting.
Critically, office property owners’ ability to adapt their business models to changing dynamics will be key for their success.