Headline rents and the biggest challenges for owners of older offices

The headline rent is a closely watched benchmark in commercial property. But it only picks up trends at the higher end of what is becoming a two-speed market. There is strong demand for modern, environmentally sustainable offices and these buildings will outperform, driving headline rents. However, the more interesting dynamics lie below this level, in the second tier.

The headline rent is the highest rent that is achievable in the market, disregarding outliers, for example, exceptional rents paid for small penthouse suites. It is a straightforward and widely understood indicator, and is underpinned by hard evidence of actual rents from recent market transactions.

Despite its usefulness, however, the headline rent has some limitations. Firstly, it is a gross measure that overstates the effective rent that passes between tenants and landlords. Tenants usually get a rent-free period at the start of their lease. This de facto discount is not captured in the headline rent. A second limitation is that, by focusing exclusively on the highest attainable figure, the headline rent ignores most of the pricing information that the market produces.

The average rent is a much less common indicator, and also has its limitations. For example, it can be sensitive to the mix of properties being leased in any period. However, it provides a useful alternative perspective on market dynamics.

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The average rent will always be lower than the headline figure, because it incorporates rents across a full spectrum of buildings – not just the very best. In Dublin’s office market, the differential between headline and average rents has varied in recent years.

In the first quarter of 2017, the headline figure was 66 per cent higher than the average rent on newly leased offices in Dublin 2. As the market tightened between 2017 and mid-2020, this gap steadily narrowed to just 7.4 per cent.

Dublin’s office market softened again following the Covid-19 pandemic, and vacancy rose from 5 per cent to 10 per cent between June 2020 and the end of last year. With tenants gaining more leverage, average lease terms have shortened, rent-free periods have risen and headline rents have edged down from €62.50 per sq ft to €57.50 – a 7.6 per cent decline.

The more complete picture is provided by average rents, which have fallen by 19.5 per cent. A logical consequence of this is that the gap between prime and average rents has expanded again.

Essentially, a two-tier office market is emerging in which the gap between prime and secondary rents will be wider at all points in the cycle

This pattern replicates ebbs and flows that have been observed in office markets across the world for many years. Historically, tenants have become less discerning when occupier markets are tight, bidding up rents on any and all available buildings. This narrows the rent differential between the best properties and less prime offices. Conversely, when the market softens, tenants have traditionally exercised their preference for quality by flocking to the best buildings. This causes the rental gap between prime properties and the common-or-garden stock to widen again.

Environmental concerns

However, these traditional dynamics seem set to change. Office occupiers have become increasingly environmentally conscious and want to occupy ultra-modern, energy-efficient buildings. There are several reasons for this. Business culture has evolved, and corporations have embraced sustainability goals on their own merits. But there are also important pragmatic considerations. Modern, high performance buildings cost significantly less to run. Moreover, to attract capital and the best talent, many organisations now consider having environmentally accredited offices to be an absolute necessity.

This has potentially far-reaching implications for office market dynamics. Even in a strong market, older offices may become difficult to let as they fall short of the environmental standards demanded by modern occupiers. This would reduce the tendency for secondary rents to catch up with prime rents in a market upswing. Meanwhile, in a soft market, the flight of tenants to newer buildings will become stronger than ever. This would exacerbate the rent gap between modern and older buildings in the same location.

Essentially, a two-tier office market is emerging in which the gap between prime and secondary rents will be wider at all points in the cycle. This will give everyone pause for thought. Analysts will have to consider whether vacant older buildings provide relevant competition to environmentally accredited new builds? If not, then the time-honoured inverse relationship between vacancy rates and headline rents will be weakened.

Similarly, we have to consider whether the headline rent remains a representative measure of overall market pricing; the trend that it captures (rents on new stock) may increasingly diverge from the trend that it misses (rents on existing older stock). The biggest challenge falls to the owners of older offices. Given the growth in demand for environmentally sustainable buildings, investors have tricky calls to make about whether, when and how, to reposition these properties to prevent them from becoming stranded assets.