Guangzhou will have 2.2 million sqm of Grade A office space coming on stream in the next five years. It is natural that investors have some concern that vacancy rates will rise and put pressure on rents. However, 75% of Guangzhou’s Grade A office stock has been completed since 2005 and rents have proved to be resilient in that time. Our data show that annual rental growth in the past three years averaged 7.1% in the face of nearly 1.5 million sqm of new office space. In particular, in 2011, when a historic peak in annual supply of 630,000 sqm was delivered to the market, net absorption also reached a historic high at 550,000 sqm, with average rents rising by 9.4% y-o-y. On the other hand, in 2012, when leasing demand softened across China, rents retreated by 3.2% y-o-y.

Not surprisingly, part of this high quality office space was built for headquarters or pre-sold to cash-rich domestic Chinese occupiers, who continue to actively purchase bulk office space for self-use. That explains part of the correlation we have observed in China between speculative supply booms and net absorption.

There are two elements we have seen contribute to the surprisingly strong rental performance of China’s emerging office property markets in times of seemingly high vacancy. First is that vacancy in the market tends to be concentrated in the handful of newly completed buildings, while existing buildings in the market are nearly fully occupied. This allows landlords of these stabilised buildings to achieve pricing power and increase rents even when the market level vacancy rate appears to be high. Second, many of the developers of office buildings in Guangzhou have their background in residential development, not commercial real estate. When credit conditions get tight, they would sooner look to sell the office building on a strata-title basis to raise capital, rather than lower rents. This has the effect of reducing some of the competition with single owner, lettable buildings, and reducing some of the rental pressure in the market.

Among owner occupiers, where the company, often a Chinese state owned enterprise (SOE), does not fill the entire building, we have seen a tendency to leave the space empty rather than lower rents. These SOEs are typically cash rich and have the holding power to endure periods of high vacancy. In addition they tend to place a high value on the tenant mix in their headquarters buildings and are ‘picky’ about who they will lease the space to.

With respect to the large future supply of Grade A office for Guangzhou, the market will need both strong demand from domestic corporates, as well as renewed expansion among MNCs. In the last year we have seen multinational firms take a cautious approach to China and their real estate plans, so for now it’s a “Chinese story” of how domestic tenants and landlords deal with the potential oversupply scenario in Guangzhou. As a result, we are currently forecasting a second down year for rents in 2013, although admittedly by a small margin at -0-5%, but reflecting the fact that it will take strong demand for the market to hold up and absorb all of this supply.

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