The office market’s dirty secret

What has not been disclosed are the terms of the deal, sparking debate about just how much lease incentive Cbus Property had to provide to encourage Coles to make the move.

Whatever the figure, it will be substantial, certainly in excess of half of all nominal net rental payments to be made by Coles over the next two decades.

Lease incentives, initially a payment to the tenant to cover the cost of a new fitout, have been a controversial feature of Australian office deal making since the collapse of the early 1990s.

Following COVID-19, when office vacancy rise to levels not seen since the 1990s, incentives have jumped to new highs.

In the Melbourne CBD, the tenant of a prime office tower can expect an average lease incentive equivalent to 48 per cent of total net rental payments for the term of the lease, according to CBRE Research.

Which looks like half price.

Much of the incentive goes on tenancy fitout, and that cost, like everything in construction, has risen by about 40 per cent since COVID-19.

In the Docklands case, the building will be extensively reworked for the Coles team with plenty of staff facilities.

But in many cases the lease incentive is now so big that it exceeds the cost of the fitout. Landlords are adding rent abatement or regular rebates.

Which raises one simple question: why not just reduce the rent? Elsewhere round the world, that is the way the office cycle works.

But not in Australia. Well before COVID-19, one of the country’s largest office landlords, Dexus, tried to simplify the system but was outbid by rivals offering full incentive packages, and backed away from the initiative.

For many, lease incentives are accounting jiggery pokery that hide the true – depressed – value of the nation’s office towers, and the true value of other metrics like funds under management, by pretending that the stated rent is the actual income.

Steve Urwin, a director of independent tenant advisers Kernel Property, points to one Brisbane deal where agreement had been reached on a yet-to-be built tower at an incentive equivalent to mid-40 per cent of the total gross rental payments.

Then the landlord revised the deal, “to assist our valuation” by increasing the rent and, in compensation, raising the incentive.

“How can the ‘true value’ of an asset change by the landlord simply increasing the rental and increasing the incentive to balance?” he says.

The valuers would argue that little had changed. The new rental would be capitalised into an increased top line but should be balanced out by the increased costs of the incentive subtracted from the bottom line.

The debate can become very technical, with argument over whether the cost of lease incentives should be included in the terminal values on which discounted cash flow analysis is based.

Real estate investment trust analysts also question whether the trusts are subtracting as much in lease incentives as they should.

Ultimately the capitalisation rate, or yield, should reflect the structure of the lease incentive. Which is why Australian office buildings tend to be valued on higher yields – in essence lower prices – than comparable towers elsewhere.

Today’s graphic, from CBRE Research, shows that prime lease incentives do vary with the strength of the market.

(Just to complicate the debate, lease incentives are calculated differently around the country. In Melbourne and Perth they are a proportion of net rent – that is after outgoings – but elsewhere they are based on gross rent.)

Lease incentives should also vary as the markets change and the CBRE numbers do reflect a small reduction in the prime Sydney figure as the amount of vacant space has reduced.

However, some analysts argue that the general level of lease incentive has risen over the decades, jumping when vacancies rise but sticking as vacancies fall.

The managing director of office leasing for Colliers, Cameron Williams, says a step change on incentives is under way in the core of the Sydney CBD as the market tightens.

“Often one or two vacancies overhang a market, and once they are dealt with, prices adjust very quickly,” he says.

Dexus reported its average incentive in its own portfolio was 26.4 per cent in the December half, down from 27.9 per cent in the first half of 2024.

But don’t read too much into the change. According to the group, it is due to a higher proportion of leasing in Sydney and lower incentives on deals in Brisbane and Sydney CBD core premium.

The Dexus accounts also showed the cost of lease incentive. The group spent $86 million in maintenance and leasing cap ex in the first half, 18 per cent higher than in the first half of 2024, due to “the impact of higher incentives from deals struck in prior periods flowing through the portfolio”.

The GPT Group also reported a substantial increase in maintenance and leasing cap ex, up 29 per cent year on year.

GPT, reporting on calendar 2024, noted an average gross incentive of 35 per cent for the 12 months, up marginally on 2023.

Mirvac noted “signs of tightening incentives” … in core markets, but also reported an increase in “other non-operating items” due to the amortisation of incentives.

Perhaps the issue to watch is the way lease incentives are creeping into other sectors of property.

At the half year, Dexus reported a surprisingly high 21 per cent average incentive in its own logistics portfolio, up from 16 per cent a year ago, due to “higher incentives in the Sydney market”.