Valentin Stobetsky, Director of the Office of Real Estate Development, Knight Frank Russia and CIS
Rent rates in business centers are influenced by various factors, from the state of the real estate market (supply and demand) to the state of the rented quarters (finished, shell & core, etc.). Knight Frank outlines the following basic parameters:
- quality of office quarters (class A, B+, B-);
- stage of construction (readiness of the facility);
- leasable area;
- size of the leasable area;
- duration of the lease agreement; and
- class of the leaseholder.
We note that the list does not include location, and this is because of a conscious decision to separate it from the quality of the facility. Despite the peculiarities of the development of the Moscow office real estate market (graded per transportation rings from the center to outer Moscow), we think that thanks to good transportation and pedestrian accessibility, a high quality office building now can be fully recognized as class A even if it falls outside the Boulevard or Garden Ring.
Insufficient parking spaces, together with the difficult transportation situation in the city center, has altered the preferences of the majority of tenants. For them, proximity to the Kremlin is no longer an important factor; the convenience of the journey to the office during working hours and the quality of the office space provided is more important. These components are fortunately combined in many office complexes in the TTK neighborhood and even the MKAD (Moscow Ring Road) area (e.g., Krylatsky Hills and IKEA Business Park).
A Bet on Quality
An important factor that influences the rent rate is the specific class (A, B+, B-) to which a building belongs. A gradual toughening of consumers' requirements for quality office space has resulted in the necessity of introducing corresponding changes to the classification system in a given sector. In 2007 consultants adopted a new, updated classification system for office real estate facilities; this system included stricter construction requirements. Consequently, the rating for many buildings was lowered. High quality office buildings are divided into three groups: A, B+ and B-. A series of mandatory and desirable criteria determines to which class a building belongs. The average rate at a class A facility is 30-40% higher than at a class B+ facility, although there are price fluctuations in both classes.
From the Ditch to the State Commission
Apart from the class to which a facility belongs, rental rates are also fundamentally influenced by the readiness phase of the facility. If the developer puts the facility on the market in the early stages of construction, the leaseholder has the opportunity to rent it at a substantially lower price.
We divide each stage of construction into three tentative groups/cycles (ground work, erection of the shell, and handing over of the facility to the state commission). The first two cycles, as a rule, last for three or four quarters; we assume that the third cycle does not last for more than one.
Based on the results of our analysis, we came to the following conclusions:
- rates at the initial stage of construction are lower than rates at the final stage by an average of 50-70%; and
- because of an excess of demand over supply, some developers intentionally set high rates even at the beginning stage of construction. Their rates at the initial stage are lower than the rates at the final stage by only 15-30%.
Thus, developers of high quality facilities can be divided between those who gradually increase rental rates and those who initially set high rates. Additionally, as a rule, the top floors in high-rise buildings are not offered on the market until the final stage of construction, when the rental rates are at their highest. The rates on these VIP-areas exceed the rates on lower floors by 60-80% for facilities in the first subgroup and by 40-60% for facilities in the second subgroup. In some high-rise buildings, the difference between the two in the first subgroup can reach 100-110%.
The Bigger, the Cheaper
There is an inverse correlation between the size of the area for rent and the rental rates: the larger the area, the lower the rates. Proprietors, as a rule, divide their facilities into 5-7 groups: 500-1000 sq. m., 1001-2000 sq. m., etc. There is a 20-30%.difference in rates between the first group (500-1000 sq. m.) and the last (10,000-12,000 sq. m.).
The duration of the lease also greatly affects the ultimate rent rate. The correlation in this case, as in the previous one, is direct (the greater the duration of the lease, the lower the rates). Each additional year leads to a 1-5% (on average) fall in the annual average rates. We should also consider the fact that such a decrease in rates is only possible if the duration of the lease exceeds the minimum, which is currently five to six years.
All leaseholders in high quality office facilities can be tentatively divided into one of two groups: the "significant" and all those remaining. The significant includes large companies (in most cases international companies), which are able to draw attention to the facility and expedite the formation of a pool of leaseholders. As a rule, this class of leaseholders is offered facilities at a 20-30% discount.
The Higher, the Dearer
In most cases rent amounts are directly linked with how high up a property is in a building terms of storey. But how the storey of a property affects the rent can differ. Since this is a new phenomenon, we consider it worthwhile looking at it more closely.
There are four different strategies:
Splitting a property into several price zones;
A steady rise in prices across several floors;
Establishing a single price for the whole building; or
Setting prices through an auction.
Several owners split a building into four to five price zones, from the lower floors (zone I) to the upper and exclusive floors (zone V). The number of floors belonging to this or that zone depends on the average return objective for the property as a whole. The difference between the rents of zones I and II could come to 20-30%; such a difference can partly be explained by the fact that zone I premises are rented usually by "anchor tenants". The difference between the rents of zones II and V can come to 10-20%.
Another strategy is to raise the rent by three to five percent every two to three floors. Yet another is for the lessor to establish a single rate for the whole building, homogenizing the rents and doing away with the storey affecting the rent rate. From the economic point of view, this approach is illogical because it does not take into account the advantages of certain floors (e.g., the upper floors have better views). Besides, it captures just one target pricing group of consumers.
Such a strategy is used in cases where there are no competing surroundings. However, if there is a similar property in the local area whose owner employs the strategy of steady increases of rents through the floors, he/she could lure away potential tenants of a building with a single rent rate.
Let us imagine that in both buildings floors are being offered with rents of $1200 per square meter per year - in the first building the offered floor is the third floor, while in the second building the offered floor is the seventh floor. All other things being equal, the potential tenant chooses the second building's floor since by paying the same amount as he/she would pay for a floor in the first building he/she gets an added bonus for free - a better view.
If one takes into account the fact that the owners of the buildings have the same desired average rates per square meter for their building as a whole, the second strategy comes out clearly as preferable.
To attain the desired average rates three different methods can be used. In our opinion, the most preferable one is the strategy of differentiating rates depending on the floor - steady increases per zones throughout a building. The second strategy, all other things remaining equal, reaches a greater number of categories of tenants and therefore reduces the risk of having empty premises through not finding tenants. And looking at the strategies from the point of view of the owner, all other things being equal, income would be the same.
There is one more strategy - that whereby rent rates are set through auction, that is, taking applications with desired rates and number of square meters needed, and subsequent choosing of tenants. Such an approach, in our opinion is possible only if the following two conditions are present:
- The situation on the market for real estate represents a seller's market (demand outstripping supply); and
- The building possesses certain special distinctive features (exclusive quality of offered premises combined with a well thought-out building concept).
Presently in Moscow such buildings are few and far between.
If we look at the pricing strategies from the point of view of the owners, it becomes clear that none of them can be considered optimal (or approaching optimal). All other things remaining equal (including having limitations in terms of budget), the tenant will maximize his/her position by choosing the best option of the three.