The Sydney CBD office market currently holds the title: ‘strongest rental growth in the world for 2017’ of all office markets monitored globally. However, with notoriety comes scrutiny, so what happens if we peel back the numbers underpinning Sydney’s rental growth story? To set the scene, the prime grade office market in Australia consists of two sub-sectors: Premium and Grade A. If we delve into the numbers, what can we learn about the Sydney CBD office market? And what are the key trends perpetrating these individual grades?

Sydney CBD has witnessed average prime gross effective rental growth of 44.4 per cent over the past five years. If we break this down by individual grade we discover that Grade A assets have witnessed growth of 57.8 per cent whereas premium assets have only increased by 22.9 per cent. In the first quarter of 2017, the rent differential between premium and Grade A reached its lowest level since 2Q00 – an AUD 135 per sqm p.a. variance.

What are some of the aspects driving this convergence?

Firstly, incentives. Incentives play a large role in the Australian office market and are highly sensitive to market conditions. If we break down incentives by grade, over the past two years, we see evidence of a shift between grades. Prior to 2015, average premium incentives were lower than Grade A. However, the tables turned in 1Q15 when premium incentives increased to 39 months’ rent free (on a ten year lease) – 4.9 per cent higher than Grade A incentives.

Let’s consider the physical market backdrop underpinning this rental growth story by looking at the divergence in vacancy by individual grade. In 1Q17 the vacancy rate differential was the widest it has been in 20 years. Premium vacancy has tracked at historical highs from 3Q13 through to 1Q17 averaging 12.7 per cent over this period. This has mainly been due to significant new supply and tenants moving and contracting between premium assets. Grade A, however, has more than halved to 4.9 per cent. This has led to competitive incentive levels to maintain occupancy rates and secure cash flow. Since 2015, premium and Grade A incentives have tracked downwards. However, premium incentives still remain higher in comparison to Grade A as at 2Q17.

Are there signs of change?

As we move further into 2017, signs of change are emerging. Premium quarterly rental growth of 6.1 per cent was reported in 2Q17, whilst Grade A was 4.6 per cent. This is in line with a sharp reduction in premium vacancy over the quarter from 14.3 to 9.3 per cent as we start to see tenants take advantage of the value proposition being offered for premium grade assets.

The current physical environment consists of limited availability of Grade A contiguous space and availability of high quality and efficient space amongst premium assets. Also withdrawals of stock for infrastructure and office re-development continue to diminish Sydney CBD stock levels. Therefore, premium space may continue to become a viable option for tenants needing to re-locate from lower grade assets, but stay located within the Sydney CBD.

We expect to see upward pressure on prime gross effective rents from mid-2017 to 2020. However, the growth trajectory of premium and Grade A may start to diverge. Will we see the rent differential revert to historical benchmarks? Only time will tell.

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