Skinny yields on prime office buildings may not be sustainable

Feb 28, 2023

SINGAPORE’S office property market enjoyed a strong run in 2022. But capital values of office buildings here could come under pressure because of high interest rates.

The Urban Redevelopment Authority’s central region office rental index rose 11.7 per cent in 2022, after rising 1.9 per cent in 2021.

The valuation of the Singapore office assets of leading office landlord Keppel Real Estate Investment Trust : K71U +0.55%(Keppel Reit) rose 2.3 per cent between end-June 2022 and end-December 2022 to S$7.2 billion.

Keppel Reit’s Singapore office assets comprise a 79.9 per cent interest in Ocean Financial Centre, a one-third interest in Marina Bay Financial Centre, a one-third interest in One Raffles Quay and a 100 per cent interest in Keppel Bay Tower.

Between end-2021 and end-2022, the valuation of the office properties of Suntec Reit : T82U -0.7%, located in the Central Business District (CBD), increased by 5.6 per cent to S$6.15 billion.

Despite a slowing economy and staff layoffs at leading technology companies, there are reasons to be positive about demand for space at top grade office properties here.

Besides the technology sector, demand for Grade A office space hails from sectors such as banking and finance, private equity, life sciences, trading, reinsurance, chemicals, energy, maritime, and consumer-related companies as well as professional services. Also, some corporates are moving business functions from elsewhere to flight-to-safety destination Singapore amid rising geopolitical uncertainties. And Grade A office space demand is helped by flight to quality among businesses.

Low yields

But prevailing office property yields here may not make sense in a high interest rate environment. The net yield of prime office property can be slightly over 3 per cent today, versus borrowing costs of possibly over 4.5 per cent per annum.

The three-month compounded Singapore Overnight Rate Average has risen from about 0.2 per cent per annum at the start of 2022 to around 3.2 per cent per annum as at value date Feb 24, 2023.

However, capitalisation rates used to value prime Singapore office buildings have remained fairly constant. Should property valuers increase such rates to reflect higher interest rates? Applying higher capitalisation rates can lead to lower property valuations.

Typically, the income capitalisation approach used to value investment properties involves dividing the estimated net property income (NPI) by the capitalisation rate. The capitalisation rate adopted reflects an appropriate investment yield for the said property.

For end-2022, the capitalisation rates for the Singapore office property portfolios were 3.4-3.5 per cent for Suntec Reit, and 3.3-3.6 per cent for Keppel Reit. CapitaLand Integrated Commercial Trust : C38U +1.04% held Singapore CBD office buildings worth S$8.37 billion as at end-2022. These buildings were valued based on capitalisation rates of 3.4-3.8 per cent.



Take a property with an estimated annual NPI of S$35 million. The capital value is S$1 billion based on capitalisation rate of 3.5 per cent. If the rate expands to say 4.5 per cent, to align with borrowing costs, capital value falls by about 22 per cent to S$778 million.

The estimated NPI needs to rise by nearly 29 per cent to S$45 million for the capital value to be S$1 billion if capitalisation rate was 4.5 per cent.

Office buildings appeal to investors seeking hard assets in safe haven Singapore. Investors do not pay Additional Buyer’s Stamp Duty, which applies to home purchases, when buying office space. Also, managing office buildings may not require as specialised skill sets as managing a mall, a data centre or a modern warehouse.

As China opens to outbound travel, there could be increased real estate acquisitions in Singapore, including office buildings, albeit the effect may be muted by strict capital controls.

Moreover, buyers of office buildings now pay higher Buyer’s Stamp Duty. For non-residential properties, the rate on the portion of the value of the property in excess of S$1 million and up to S$1.5 million is now 4 per cent; that in excess of S$1.5 million is now taxed at 5 per cent – up from the rate of 3 per cent.

Yield expansion

While there may be strong rental and investment demand for premier Singapore office buildings, the yield for office space may need to expand substantially. After all, one gets a yield of close to 4 per cent from buying Singapore’s latest six-month Treasury bill.

The capitalisation rates for Suntec Reit’s Singapore office portfolio are much lower than for its office buildings in London, United Kingdom, of 4.4-4.7 per cent at end-2022.

Despite high interest rates, there is appetite for big ticket property deals. Recently, Mercatus Co-operative sold a 50 per cent stake in Nex mall for NPI yield in the high 4 per cent.

Generally, office buildings in Singapore have tighter yields than malls. Still, yields on office buildings may need to expand in order for more transactions to take place.

Office buildings here are still relevant. Today, many knowledge workers commute frequently to the physical office and there is a buzz in the CBD. Possibly, the need for people to meet in person to co-create ideas and problem-solve is even more critical as businesses battle a slowing global economy and high inflation.

The 30-storey office tower of integrated development Guoco Midtown in Beach Road achieved its Temporary Occupation Permit recently. Drawing interest from tenants in diverse sectors, the 709,000 square feet of Grade A office space at Guoco Midtown achieved 80 per cent pre-commitment take-up, a media release indicated in late January.

Some investors will be hoping that the United States Federal Reserve stop hiking interest rates soon and possibly even start lowering rates next year if economic growth needs a boost.

But, the days of investors bingeing on cheap debt to fund property buys may not return for a long time. This can help Singapore-listed Reits, which are constrained by gearing limits, in competing for acquisitions with other purchasers who can gear up more.

Still, all office landlords here need to be mindful that capital values of investment properties, in particular office buildings with skinny yields, are not insulated from the adverse effects of higher interest rates.

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