Property
Are businesses reducing real estate footprint?
V Sanjugtha 
Developing countries like Malaysia benefit from the outsourcing of services which calls for more office space
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The global office market is facing shrinking demand owing to businesses downsizing and the rise of co-working and shared office concepts. As this trend spreads across Asia, how will it affect the 31.82 million sq ft of vacant office space in Greater Kuala Lumpur?

To aggravate the situation, a total of 13.34 million sq ft of incoming office space will boost supply to a whopping 139.42 million sq ft in the next three years.

Fernandez asks what happens to the void in the market when tenants leave older buildings

Khong & Jaafar managing director Elvin Fernandez warns that the Grade A buildings currently flooding the market and reporting good take-up rates are merely reporting attrition as most tenants are previous occupiers of the less efficient Grade B buildings or legacy buildings that are decades old and offer fewer facilities for the same rental rates.

“What happens to the void in the market when they leave these older buildings? The owners will not be able to find new tenants easily in the current market and are left with an occupancy rate of about 50% or less,” he tells FocusM.

Real estate pundits believe the emergence of co-working is a boon as it will mop up some of the excess space in the market, but in the long run the pressing question is will it disrupt demand and contribute to sloppy absorption rates?

Currently, absorption rates in the market are about 300,000 sq ft, as opposed to the 2-3 million sq ft experienced about three years ago.

The lure of co-working is the flexibility it offers when a long-term lease in a building may not be feasible. This allows for staffing increases and decreases, especially for smaller companies that are bootstrapping but looking to potentially double or triple in size in a short span of time.

Fernandez, however, is pessimistic over the direction of this trend, citing only a “smallish” impact on the market which is oversupplied by more than 30 million sq ft.

Savills Malaysia executive chairman Datuk Christopher Boyd says the shared workspace concept will eventually be “massive” in Malaysia. He sees it applying to not only start-ups but corporations too, which may rent a core office space in the conventional manner but opt for a certain amount of additional space in a shared office.

This arrangement allows for fluidity in work space, for example to accommodate ad hoc projects.

“The greater flexibility you have, the more space you would want to take up,” he notes.

However, Boyd believes that in developed economies such as Australia and the US, there is the tendency for such work dynamics to have a fundamental effect on the development of office space in the market.

“In Malaysia these particular trends are of less concern as overall demand for office space will increase in line with the government’s objectives,” he explains.

The shared workspace concept will eventually be in vogue in Malaysia, predicts Boyd

Boyd is confident that the government’s Economic Transformation Programme (ETP) will create more office jobs in the near future. Nevertheless, he did not discount the shrinking office space requirement per person is increasingly prevalent.

“Traditionally, this (office space per person) was always 120 sq ft but this size is on its way down. A rough guide would be 100 sq ft per new job, but it could inch down to 80 sq ft or maybe even less,” he adds.

Knight Frank Malaysia executive director of corporate services Teh Young Khean opines that the serviced office and co-working operators will continue to grow in the coming years as the concept is popular and cost efficient, especially for start-ups and SMEs.

“Technology is changing the real estate industry and this has led to the popularity of co-working, serviced office. Nonetheless, I am still a strong believer that corporate office space will continue to be in demand depending on the nature of the business or services offered,” he explains.

According to Teh, the corporate office still serves as an important place for people to integrate for business and work. But with some organisations adopting flexi working arrangements, it may affect take-up of space.

A report by CBRE which looked into how job automation will reshape corporate office demand in the Asia-Pacific states that office-based job growth is forecast to weaken from an annual rate of 3.1% over the past five years to 2.6% over the next five years.

Professor Dr Ting Kien Hwa, head, Centre for Real Estate Research, Faculty of Architecture, Planning & Surveying, Universiti Teknologi Mara, agrees that job automation and mobile working arrangements do reduce office space requirements. However, he also believes that such practices are less prevalent in developing countries than in developed ones.

“Developing countries such as Malaysia benefit from the outsourcing of services which needs more office space,” he says.

Ting notes that these changes in work dynamics are unlikely to affect the demand-supply equilibrium for office space in the Klang Valley in the short term.

He notes that InvestKL has been successful in attracting multinational companies (MNCs) to set up new offices here. InvestKL is a specialist investment agency set up by the government to attract and facilitate investments from MNCs, and encourage them to set up their regional headquarters in Greater Kuala Lumpur.

He adds that the government is also promoting global business services such as Knowledge Process Outsourcing, Shared Services Outsourcing, Business Process Outsourcing, engineering construction services, and the aerospace and halal food industries which could contribute to higher demand for office space.

 

The co-working force awakens

A check on Malaysian Global Innovation & Creativity Centre’s (MaGIC) website shows a listing of 47 companies offering co-working and shared office services. It is believed there are more operating throughout the Klang Valley.

There has been a steady rise of co-working services offered in Singapore, Thailand, Indonesia and India. In Thailand and Indonesia, offices on the holiday islands of Bali and Phuket have sprung up to cater to the “offices with a view” concept.

In Singapore, the co-working market grew by 31% from 306,000 sq ft in 2015 to about 400,000 sq ft last year. Based on CBRE’s estimates, the market will grow by an additional 80% to 718,000 sq ft this year. The report also forecasts that of the portion of space located in offices, the proportion of co-working to office stock will more than double from 0.3% last year to 0.7% by year-end.

Interestingly, there has been a steady increase in the size of new co-working space opening up in Singapore. The average size of a co-working facility was just 6,800 sq ft last year, but all projects due for completion this year are reportedly significantly larger.

While traditional sectors are still viewed as the main drivers of office demand, co-working has worked to boost the subdued office market in Singapore.

Will the trend pick up in Malaysia? Co-working space provider, Common Ground for instance, opened its first venue in a 17,000 sq ft penthouse, reaching full occupancy within its first four months of operation. The company has since announced its intention to up its ante to three new premises boasting a total capacity of 1,200 seats over 76,000 sq ft of commercial space.

At a glance, co-working can be argued to rob the market of demand for office space. However, its target occupiers differ from those of the traditional office segment.

Traditional office landlords appeal to medium and larger-sized corporations which take up bigger spaces and generally sign longer lease agreements. This contrasts with the co-working space providers which cater to the rising pool of start-ups and small to medium enterprises, which have smaller and more fluid requirements in terms of size and lease duration.

 

A demand issue

Savills’ Boyd believes the problem in the office market is more of a demand issue than one of oversupply. He notes that the office market in the country has generally been in a state of surplus, with occupancy rates rarely reaching 90%, unlike Singapore and Bangkok which often see occupancy surpassing the 95% mark.

“We usually see a cycle of seven years of relative oversupply, followed by a short period when occupancy rises above 90%, and then it slides back down to the 80% region,” he says.

Ting agrees the sector is challenged by a lack of demand. He believes the overhang can be reduced if the economy and government transformation programme are able to generate economic activities that create more demand for office space.

“More so if InvestKL is able to attract more MNCs to set up regional headquarters, international procurement centres and regional shared services here,” he adds.

Knight Frank’s Teh notes that the loss of large space occupiers such as players in the oil and gas, and banking and financial sectors have contributed to the space surplus.

“Coupled with more new stock entering the market, this heightens competition amidst a widening gap between supply and demand,” he says.

Fernandez points out that the construction of an office building takes about four years during which economic conditions would have changed.

Previously, the construction of office buildings was largely undertaken by private developers, but institutional investors are increasingly on the scene.

This, Fernandez notes, poses a challenge to halt or alter plans to suit economic conditions as, unlike private developers which can make swifter decisions, institutional investors are not so flexible.

Implications of lower rental rates in office market

As supply of office space grows in an already surplus market, there is pressure on rental returns. As rent is the driver of capital value, the potential selling price of commercial real estate assets are at risk of taking a beating as rent dips.

Based on an Effective Gross Rental Rate Model (see table), Khong & Jaafar managing director Elvin Fernandez says effective gross rent below RM8 per sq ft (psf) in a Grade A building in Kuala Lumpur translates to a below-cost situation.

He explains that the construction cost for a Grade A building in KL comes to circa RM1,000 psf. At an effective rental rate of about RM8 psf per month, assuming a three yearly growth of 5% and an expected yield of 7%, the capital value of the building is RM1,070 psf. The model is based on an allowance for outgoings or cost of running the building such as maintenance fees at about RM1.40 psf per month, which brings net rental to RM6.60 psf per month or RM79.20 psf per annum.

“This shows that the Malaysian Grade A office market in KL is operating at about cost, if rental is around RM8 psf. The problem is can we get such rates? This of course excludes the fit-outs and rent-free periods currently being offered as sweeteners in the market,” he says.

According to Fernandez, if rental drops to RM6 psf, capital value would decline by about RM250 psf, translating to a below-cost situation.

“In other cities, when you have RM800 psf, you actually have a better market and investors will expect returns of about 6%. Singapore, for instance, has never been in the situation where the best possible rental is just enough to cover costs,” he points out.

He attributes this situation to the continuous state of oversupply that has plagued the KL market, making it weaker than its regional counterparts.

Citing the example of 2005 when the economy was booming, Fernandez notes that office space was transacting at circa RM1,500 per sq ft, on the expectation that rents would catch up. As supply was not in an exceedingly surplus situation, developers were able to achieve this.

“But to achieve a capital value of RM1,500 per sq ft, rent needs to reach the RM10 per sq ft level, but it never did. Instead it turned around and is now lower than RM8 per sq ft,” he notes.

Professor Dr Ting Kien Hwa of Universiti Teknologi Mara predicts the demand for office supply will remain subdued due to the scaling down of various oil and gas companies. He is concerned that the unused space translates to lack of productive activities, adding to slack resources.

“Property owners will suffer from loss of rental income and stagnant office capital values. Vacant office buildings are poor investment to institutional investors, leading to less property investment fund flows in the investment sector,” he warns.



This article first appeared in Focus Malaysia Issue 257.