As yields in the Seoul office market continue to tighten and push capital values to record highs, investors are increasingly asking where is the upside to investing in Seoul?

With overall rent growth of around 3% per annum forecast for the next five years, potential upside appears limited. However, naturally not all buildings are expected to track the market and some buildings, such as those completed during the current supply cycle, are well positioned to enjoy significantly higher levels of effective rent growth compared with the market average.

These buildings have attracted the majority of market demand in recent years however this has often come at the expense of lucrative incentives packages. In some cases anchor tenants and early movers negotiated incentives as high as five months’ rent free per year of lease (i.e. 25 months of rent free over a five year lease) – well above the market average of 1.1 months per year of lease over the past three years.

Incentives were very uncommon in the Seoul office market prior to 2011, so the obvious question is ‘what happens to effective rents in these buildings when the current leases expire?’ With most tenants signing up for 5-year lease terms, these moments of truth are scheduled to occur sometime between 2016 and 2018.

A broad look at the market over this period shows overall vacancy is expected to decline from the current level of 10% to around 6%. On a building-by-building basis, our analysis indicates that the availability of vacant, contiguous floors is likely to be limited, especially during 2016 and 2017 when only a single, mixed-use building in Gangnam is forecast to complete.

Market factors indicate that opportunities to relocate, particularly for anchor tenants, are likely to be limited, instead tenants will be focused on lease renewals at their current premises.

Having suffered in recent years, landlords of recently completed buildings are likely to relish the opportunity to hold the upper hand in renewal negotiations and recoup the sizeable incentives provided to initially attract tenants to their buildings.

With incentives forecast to hover around 1.2 months per year of lease between 2016 and 2018, these landlords can expect significant rent reversion with the potential for effective rents for renewing tenants to jump overnight by 20-30%, or even more if landlords are able to successfully eliminate incentives completely from renewal deals.

As is often the case though in the Seoul office market, the sometimes ‘sticky’ relationships between landlords and tenants may play a part in moderating rent increases, particularly for deals involving domestic corporate landlords.

For international investors negotiating ‘arm’s length’ renewals, reversion is likely to be strongest. The challenge for investors today is to ensure that potential future rental growth returns are not undermined by further yield compression at acquisition.

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