By Joan Muller
Senior writer
This email address is being protected from spambots. You need JavaScript enabled to view it.

THE cost of office rental is usually the second highest item (besides salaries) on a companys monthly expense bill. Yet when companies need to cut expenditure, rental costs are seldom scrutinised.

But this may soon change as tenants increasingly begin to question the terms and conditions of lease agreements. This applies particularly to the leaseback escalation rate, which refers to the standard clause included in all commercial property lease agreements indicating the annual rate at which rentals will increase.

The escalation rate is thus a proxy for the property markets expected rental growth rate, usually over a 10-year period. The current escalation rate used by most landlords averages 10%, a level at which it has been for around a decade.

The question inevitably arises whether an ongoing escalation rate of 10% is realistic while inflation (CPIX) currently sits at about 4%. And this question is even more relevant as the market continues to battle with an oversupply of office space.

Latest Sapoa figures indicate that average office vacancies are close to 12%; three years ago average vacancies were closer to 8%.

The oversupply has put pressure on rentals, so average rental growth of 10%/year is no longer the norm.

For example, in Sandton, north of Johannesburg, average A-grade rentals fell by 10% in the 12 months to end-September 2003. In Claremont, Cape Town, rentals decreased by 25% over the same period.

So while market rentals in a number of nodes are now lower than a year ago, tenants locked into existing lease agreements will still see their rental bill increase by 10% this year.

Property economist Erwin Rode says that this simply doesnt make sense. He says that escalation rates are unrealistically high and a downward correction is now overdue. Its no longer credible to continue using market rental growth forecasts of 10% in viability studies, and property investors should lower their rental growth expectations in line with inflation.

Rodes calculations (using the financial markets inferred forecast of inflation and taking property ageing factors into account) indicate that office rental growth will probably average 4%/year over the next 10 years. So landlords with escalation rates of 10% will show exceptional returns over the next few years. That may be great for landlords and investors, but the flipside is that tenants will lose out.
Angelique de Rauville, MD of asset managers Provest (in the Investec Properties stable) says that tenants are already putting pressure on landlords to adjust escalation rates downwards. However, there are no signs yet of this happening.

De Rauville says that the chances are remote of landlords lowering escalation rates in line with inflation in the foreseeable future. Landlords justify current escalation rates with the argument that though CPIX is down, operation costs such as security, cleaning and maintenance continue to escalate by at least 10%/year, says De Rauville.

However, Francois Viruly, of property consultants Viruly Consulting, says that though most landlords are still not sold on the lower escalation rate story, theyre becoming more flexible in meeting tenants needs.

Viruly says that apart from lower inflation, the rules of the commercial property game have changed markedly over the past few years. As a result a number of property fundamentals are being challenged. Five years ago the rules were five-year leases, 10% to 12% escalation rates and a 20% internal rate of return (IRR). An IRR of 20% has always been the accepted minimum total return required by potential investors to ensure a property investment is worth their while.

Viruly says that these rules no longer apply and investors will have to get used to shorter leases, lower escalation rates and, ultimately, lower returns. Returns on commercial property, the office sector in particular, are being squeezed from all sides.

Viruly says that this creates an ideal opportunity for tenants to try and renegotiate escalation clauses. Chances are that landlords would rather agree on a lower escalation rate than lose the tenant when the lease comes up for renewal a year or two down the line.
Thats particularly relevant to older B-grade buildings, where landlords are battling to retain tenants at the end of their lease periods.