Investors’ pursuit of attractive risk-adjusted returns along with strong tenant demand and a limited supply of up-to-date office premises in Copenhagen are making many investors and developers consider speculative office construction, i.e. office starts without having secured any pre-lets.
Crisis loosening its grip
Irrespective of recent years’ massive momentum in the occupational and investment markets, we have seen only a very limited number of speculative office starts since the onset of the financial crisis in 2007-2008. Over the past ten years, relatively few speculative schemes have come to market, with an added office supply far below the level that market trends would arguably have been able to support.
The investor community’s reticence is a natural corollary of dearly bought experience from the years before, during and after the financial crisis. Back then, a cocktail of all-time low vacancy rates and climbing rent levels was one of the factors triggering that up to 40% of new office starts were built on speculation. As a result, the ensuing years of lower employment figures and higher vacancy rates hit speculative building schemes exceptionally hard as a high proportion was scheduled for completion in 2009-2010.
Several parameters herald increase in speculative newbuilding
Employment trends held up against the office supply and demand of the post-crisis years indicate that in 2010-2017, the net decline in the supply of available office premises in Copenhagen and environs fell substantially below the level to be expected. Office take-up levels were therefore below the level arguably warranted by the increase in employment figures.
This effect has the markings of hidden demand, reflecting the difference between the change in the quantity of actually registered office vacancies and the theoretical change in vacancies based on changes in supply and demand, as reflected in employment figures.
If the estimated change exceeds the actual change, the change in actual office vacancies is smaller than it should have been, based on the increase in employment and the resulting office demand. To allow for the fact that supply, all other things being equal, is expected to adjust to demand, albeit with a lag due to the time perspective of building schemes, we have in our estimate factored in the hidden demand accumulated in the period.
Among other things, the hidden demand indicates that in today’s market a large number of businesses are on the verge of outgrowing existing office premises, but unable to find premises matching their requirements in terms of size, efficiency and location.
Paradigm shift in office use
In recent years, however, we have also seen a slight paradigm shift in regard to office use and the layout chosen by businesses. Increased focus on efficiency and flexibility has served to drive down the area requirement per employee – which helps to reduce the hidden demand. This trend is clearly confirmed by our market observations and ongoing dialogue with both landlords and tenants, but it does not suffice to fully account for the estimated hidden demand.
In addition, the aforesaid calculation does not take into account the number of businesses currently occupying office leases that may well match in terms of size but are functionally obsolete in terms of flexibility and efficiency.
This demand may also be classified as hidden, but it is not measurable to the same extent as the demand driven by and estimated on the basis of increases in employment levels.
The short supply of up-to-date office buildings is gradually translating into uptrending rent levels. Copenhagen is therefore already seeing the first examples of new office lets at rent levels exceeding DKK 2,000 per sqm p.a., excluding taxes and operating costs. This contrasts starkly with recent years’ flat trend in office rental prices in and around Copenhagen – a trend that has also served to put a dampener on the market for speculative building.
As at Q1 2018, the office vacancy rate in Copenhagen and environs stood at 5.7% and 9.1%, respectively, marking a 7-year low.
These rates cover also a large proportion of old and obsolete office leases and properties. In fact, the overall office vacancy rate may therefore well be even lower.
Yield compression and price hikes may make speculative building lucrative
In the office market, recent years’ yield compression, lack of investment opportunities and substantial capital placement requirements have caused investors to become more risk-tolerant, moving further out the risk curve, for instance in terms of a higher number of property investments at more secondary locations and investments in earlier phases of the development process.
This trend has manifested itself in the residential market in particular, where strong population growth and a pronounced housing shortage have prompted a very considerable number of residential building starts in Greater Copenhagen. As a result, developers have allocated substantial resources to this segment of the market.
However, we see signs of residential supply catching up with demand. Residential newbuilding activity will therefore, all other things being equal, slow in the years ahead, discontinuing its currently brisk pace. This trend may shift resource allocation to other segments of the market, including speculative office construction.
Against the backdrop of today’s market conditions, we believe that the risk-adjusted return offered by speculative building fully matches the return offered by completed office buildings, always provided that in the development process you understand and know how to accommodate the requirements of today’s offices users in terms of location, affordability and layout.
We expect investors and developers to seize this opportunity to initiate speculative office building schemes in the years ahead, mainly in the Copenhagen non-CBD office market and in the proximity of infrastructure hubs.