24th June 2005

By Sibonelo Radebe

Revamping old buildings may be the safest bet in meeting renewed demand for offices

Cranes are again out in force in SA business centres as investors enter a revived market for office property.

The foundations are in place: economic activity is robust and there is strong demand for working space. Vacancies, which have dogged the sector, are falling - especially in A-grade, central business district developments.

But will everyone still be smiling when the new stocks of offices hit the market in two years?

As has been the experience in the residential sector, some of the new developments will be canned before ground can be broken. Others will become charity cases as a result of factors in the naturally long production cycle of property development. There is a danger of market oversupply.

Property economist Erwin Rode has given the office sector a thumbs-up, saying in his latest property report that it is the "next success story".

Francois Viruly, another property economist, says the decline of vacancies to levels below 10% of total space is a signal that rentals will start rising. And that this is an invitation for developers to return to the market.

He adds that market conditions have changed. Current conditions carry a number of unique features, which could break the risk of another glut.

These include the diminishing dominance of the market by a few big institutions . With the opening up of the SA economy, new players have emerged, including medium-sized ones. And there is a growing list of property funds, which tend to be prudent spenders.

Viruly also points out that it's not like 1999, when interest rates fell from 25% to about 17% over a short period. Rates are now expected to rise.

This may put a damper on the level of new developments, he says.

Building costs are rising at a remarkably high rate, he says, and this could eat into the margins sought by greenfield developers. This, and space limitations, may result in less enthusiasm for new office developments.

Viruly suggests investors consider refurbishment before greenfield development, which can be dragged out by compliance processes, including rezoning and environmental impact assessment.

Developments commissioned now will come on stream in about 2½ years - and at a high cost, says Brian Azizollahoff, CEO of property loan stock Redefine Income Fund. "With construction costs escalating at about 30%/year, development costs in the short to medium term could be about R15 000/m², in contrast to a current cost of around R7 000/m². As a result, these buildings may demand rentals in excess of R120/m²."

He says a more immediate and cost-effective solution could be to recycle older buildings. Rental costs can be contained because the developer requires less revenue to achieve the same return on investment.

Among others, Investec Property Group has been refurbishing offices on a large scale. This includes the makeover of 70 Grayston Drive, Fredman Towers and two buildings to house Discovery Health and Werksmans, all in Sandton.

Investec's commercial leasing consultant, Grant Kirchmann, says refurbishing older offices to meet the demand for A-grade commercial space delivers better returns than new buildings.

He says older offices in Sandton command between R58/m² and R65/m² in rentals, while A-grade offices achieve R75/m²-R90/m². "C-grade space, realising a negative 7% return, can reach a 12%-13% return after refurbishment."

3D Properties, a division of RMB Properties, was established about five years ago to focus on turning around low-grade commercial properties. The division has managed to reduce vacancies in its portfolio of previously neglected buildings by about 50%, from 14,1% to 7,7%. The group is reported to have reduced arrears, of great concern in the low-grade market, by 50%.

More property facelifts and fewer building sites would at least be easier on the eye.

Financial Mail