Leasing incentives emerged in the late 1980s and have become an entrenched feature of Australian office markets. Historically, they were expressed as months rent-free over a ten-year lease (gross or net depending on the market).

The level of incentive offered was intrinsically linked to market conditions. Higher vacancy creates competition between owners and a more generous incentive package for a tenant. In contrast, tight market conditions generate competition for space and lower leasing incentives.

The correlation co-efficient determines the degree to which two variable’s movements are associated. We have observed a high degree of correlation between vacancy and incentives. Between 1995 and 2008, the relationship was above 0.90 in Adelaide, Melbourne, Sydney and Perth.

The financial crisis inserted volatility and uncertainty into the commercial property sector and led to emergency levels of incentive relative to the prevailing vacancy rate. A disconnect emerged in Sydney and Melbourne, while the vacancy / incentive relationship behaved normally in the other CBD office markets.

Source: JLL Research

Source: JLL Research

Why the vacancy-incentive disconnect?

Reasons for the disconnect between vacancy and incentives range from:

• The occupancy profile of Sydney and Melbourne – Financial services and professional services are the lead industry sectors occupying space in both Melbourne and Sydney. The financial services sector is less relevant in other CBD markets where construction, mining and/or government organisations are significant occupiers.
• The ownership profile – The other big difference is the ownership profile in Melbourne and Sydney where a high proportion of prime grade assets are owned by institutional investors. The ownership profile of Brisbane is similar. These groups are perhaps in a better position to fund large fit out costs particularly if the tenant is not a large public sector organisation or corporate.
• The increasing prevalence of the tenant representation and advocacy profession post GFC

All of these factors were put forward to explain some form of structural shift in the relationship between vacancy and incentives. However, the influence of market conditions appears to be re-asserting itself as the explanatory variable of incentives.

In the Sydney CBD, a shortage of contiguous space and competition for space has exerted downward pressure on leasing incentives. It can be argued that incentives have tightened much quicker than market participants envisioned 12-18 months ago.

Melbourne appears to be in the same place that Sydney was 12 months ago – tightening vacancy had yet to precipitate a moderation in leasing incentives. However, the leasing market momentum in Melbourne and high pre-commitment rate for new developments under construction (72 per cent) could see Melbourne CBD incentives decline much quicker than expected.

The proposed structural shift in the relationship between vacancy and incentives may have been cyclical after all.

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