Rental growth rate in Tokyo's prime office market at its lowest since 2016

Grade A office rents inched up by a mere 0.2% in Q2 2020.

Whilst the full impact of the COVID-19 outbreak has been taking shape in the broader economy, Savills notes that the symptoms of the pandemic may have just started to emerge in the office sector.

According to a recent report by Savills, in the Grade A office segment, quarterly rental growth has pretty much ground to a halt, with the lowest growth rate observed since the end of 2016. Meanwhile, multiple office floors are being returned, albeit only small ones for now. As such, the vacancy rate is likely to inch up further, with gradual, moderate increases expected to continue in the near term.

With less than half of the submarkets exhibiting any sign of growth, Grade A rents increased by a mere 0.2% QoQ to JPY37,840 per tsubo in Q2/2020. Over the year, the uptick in rents was more noticeable, coming in at 4.8%. The presence of growth, however, regardless of the magnitude, suggests that office fundamentals remain somewhat solid during these challenging times, at least for now.

Moreover, with the vacancy rate entrenched below 0.5% since the end of 2018, and with nearly all the significant supply expected this year filled or pre-leased, a sudden and immediate deterioration of the market seems unlikely. That said, with the expectation that any relocations could take some time to manifest, the true test may lie in the quarters to come.

LARGE-SCALE GRADE B OFFICES

Unsurprisingly, rents in the Grade B office market were not spared from the slowdown. Over the quarter, rental growth was very similar to its higher-grade peer, with rents increasing slightly to JPY28,656 per tsubo.

As for annual rental growth, the rate contracted sharply to 3.7% – the lowest rate in over two years. Meanwhile, vacancy is where some divergence from the Grade A market appears. Namely, rates have loosened by 0.4ppts QoQ and 0.3ppts YoY, landing at 0.7% in Q2/2020.

Once again, Shibuya takes the spotlight, with growth over the year standing out in particular. To wit, the submarket now languishes at the bottom over the period – the first time in over a decade – with Minato taking its place at the top for the first time since mid-2017. The widening of vacancy rates was also particularly evident in Shibuya, where they increased by 1.2ppts QoQ and 1.1ppts YoY to 1.3% – the highest in the C5W.

As discussed previously, given that tenants housed in this market segment have relatively weaker balance sheets, and given Grade B offices tend to be in less convenient locations, fragility in this market is likely to emerge before the Grade A market.

OUTLOOK

Despite the debilitating impact of COVID-19 on the Japanese economy, which had already been suffering from the consumption tax hike in October 2019, the Grade A office sector has fared relatively well up to this point. Sudden imbalances in market forces have been averted, thanks in part to tenants made up of cash-rich Japan Inc. companies who have avoided making rash decisions.

This is not to say that the Grade A office market has been immune, however. The sharp slowdown in annual rental growth in Shibuya, for example, clearly indicates a potential tipping point for the sector, whilst this is also backed up by the absence of quarterly growth in most submarkets. All the while, vacancy rates have started to inch higher as a result of tenants returning office floors, albeit the vacated space remains small for now.

Amid the ongoing market uncertainty, like in crises of the past, the strongest will get stronger, and this time around, performance across the office sector is set to diverge based on a few key factors. Firstly, tenant quality or creditworthiness will be vital, especially given the financial difficulties affecting the broader economy.

Indeed, the relatively large upticks in vacancy found within the lower-grade markets could be a canary in the coal mine for what is to come. At the same time, the impact from the paradigm shift in the working environment, such as working from home, will vary amongst industries and corporate sizes, with technology firms likely to be in the forefront of this change.

Meanwhile, in line with this shift, office location will be key. Seeing as the home is now a viable workplace, offices far away from stations or in inconvenient areas could be disproportionately hurt by this new trend, particularly considering well-located offices could now be chosen for the main purpose of increasing productivity and idea generation. Given the above, therefore, submarkets that are able to satisfy these conditions should be able to come out of the pandemic relatively unscathed.

As for office supply, the significant levels expected in 2020 may have caused concern in previous years, but vacancy rates were already stubbornly low and pre-leasing activity had been solid. The timing of below-average supply anticipated in 2021 and 2022, meanwhile, be it by luck or design, is certainly welcome.

That said, a noticeable increase in secondary vacancy is likely in 2021 considering the large supply this year and the market’s delayed reaction to the pandemic so far. The hope is, however, with the relatively low infection rates observed in Japan, the economic recovery can begin in earnest sooner rather than later, with the aim for office demand to return well before the next surge in supply arriving in 2023.

The Grade A market has, therefore, reached a critical moment, and the quarters to follow this year and next should reveal the true impact of the pandemic. Yet, the sector’s relative resilience means that the turbulence in the interim should be manageable.

Photo courtesy of Savills