Office space: High demand and strong prospects must be balanced out against supply

Given the strong demand for housing in Saudi Arabia, other segments of the real estate market are often overlooked. However, as with the residential market, the fundamental demand conditions seem to favour growth across all segments of the market. While it has been a tough 24 months for the office sector, long-term development prospects look extremely healthy.

Indeed, Saudi Arabia’s strong economy is one reason many analysts remain confident in the longer-term investment potential of commercial office space in the Kingdom. Global Investment House, in a 2012 GCC real estate report, notes that all of the economies it studies, Kuwait, the UAE, and Saudi Arabia are experiencing oversupply in the office market, but that the last two are well placed to attract new business and revive demand, “a trend we see materialising sooner in Saudi Arabia given its more stable economic outlook”.

Strong Base

The Kingdom’s economy suffered little from the global financial crisis. GDP has grown at 6.77% in 2011 and showed little sign of slowing down. Throughout 2012 GDP growth averaged around 6%. This in itself should provide a welcome fillip for developers of office space, but is further sweetened by the nature of this growth. Much of the current expansion is driven by the private sector and is becoming less reliant on hydrocarbons revenue. According to a press release statement by David Robinson, IMF mission chief for Saudi Arabia, “The very strong macroeconomic outlook is a result of prudent economic management. Apart from the oil market, the Saudi economy is generally well insulated from the euro area crisis: non-oil exports to the euro area are relatively small, and financial cross-border spillover effects appear minor.”

This strong economic base is also supported by an attractive business environment. Saudi Arabia now ranks 22 globally in the World Bank’s Doing Business Index for 2013, an improvement of one place on 2012. The country scores well on taxes, investor protection and registering property in particular. This bodes well for encouraging the establishment of new companies in the Kingdom and demand for further office space. This latent demand is also reflected in the country’s foreign direct investment (FDI) figures. The FDI stock for Saudi Arabia had reached $170.4bn in 2010, an increase of 19.7% on 2009, according to the Saudi Arabian General Investment Authority (SAGIA). This trend, which has seen FDI increase more than five-fold since 2005, is reflected in the number of companies bringing FDI into the country. According to SAGIA, 808 new companies brought FDI to Saudi Arabia in 2010, raising the total to 6478, an increase of 14.3% on 2009.

Job Creation

This suggests that, taken in isolation, demand for office space in the country has been gaining in strength over the last five years. Labour market statistics also back this up. Indeed, between 2000 and 2009, the labour market has grown by almost 50%, according to the Central Department of Statistics and Information. According to the ninth five-year development plan of the Ministry of Economy and Planning, the labour market added some 840,000 jobs between 2004 and 2008, growing at an average annual rate of 2.8%. If this growth follows the general pattern of the labour market, in which 30.6% of all employment is in clerical positions, would mean that at least 250,000 new office jobs were created in this period. With the economy continuing to grow, this additional requirement for space should persist. Indeed, a new programme for Saudiisation, Nitaqat, which was introduced in late 2011, hopes to increase Saudi participation in the private sector workforce even further. The October 2011 edition of the SABB HSBC Saudi Arabia Purchasing Managers’ Index, which measures activity in the manufacturing and services sectors, showed companies increasing employment for the 13th successive month.

Demand Grows

Emphasis on the private sector will likely please private developers, who should increasingly be able to find a market for international-standard Grade A office space. This is likely to mean a market based on leased space, rather than public sector departments buying space or commissioning construction of their own buildings. These trends are noticeable in the local market, with a flight to quality and higher standards in office properties. According to Mohammed Al Samhan, general director of the real estate investment department of the General Organisation for Social Insurance (GOSI), “There has been a change in the structure of demand for office space. People are shifting up a grade and this creates additional demand. I believe the use of villas as office space will also change.” This is affecting pricing in the market. According to Global Investment House, in 2011, “Riyadh saw some increase on average rents due to tenant upgrades as new, higher quality supply was made available.”

Balancing The Market

Private sector job growth may support this trend. However, despite strong fundamentals for demand growth, the short-term scenario for the office segment is less rosy. Indeed, the pipeline of new office buildings that have been brought to market over the last five years have led to a position of oversupply in both Riyadh and Jeddah. According to Al Samhan, “As for offices in Riyadh, you have oversupply. It is now a tenant’s market and not a landlord’s. Most property owners are now renting below targets from their feasibility studies.”

The commercial office sector in Saudi Arabia is in a better state than some of its regional counterparts, but given the optimism surrounding the residential and retail segments, office developments are currently seen as a less attractive option for developers. The capital, Riyadh, had 1.9m sq metres of office space at the end of the third quarter of 2012, according to global property services firm Jones Lang LaSalle (JLL). The vacancy rate in the city as a whole had reached 15%, with the figure increasing to 17% in the central business district. While this is far from ideal, it compares well with the region. According to JLL, Riyadh had the lowest office vacancy rates at the end of third-quarter 2011, and compared extremely favourably with Abu Dhabi (20%), Muscat (25%), Kuwait (40%) and Dubai (44%).

Looking Ahead

However, vacancies are expected to creep upwards as more supply is brought to the market over the next two years. According to Global Investment House, an additional 818,000 sq metres of office space will come on-line in Riyadh between 2012 and 2014. This represents 25% of total available office space in the market at the end of 2011. Jeddah is expected to see a similar supply glut. Global Investment House predicted a 31% increase (159,000 sq metres) in office space in 2012 alone. As such, prices, which were slowly picking up following the global financial crisis, may begin to soften once more. As of the end of 2011, average annual office rental rates in Riyadh were SR790 ($210) per sq metre, while they were SR680 ($181) per sq metre in Jeddah, according to Global Investment House. However, at the top end of the market, prices had been picking up throughout 2011. According to JLL, Grade A office rents in Riyadh rose 13% in the third quarter of 2011 to SR1400 ($373) per sq metre. In Jeddah, grade A and B rents stood at SR900 ($240) per sq metre during the same period, according to JLL.

As has been suggested, this strengthening in rates was largely the result of a flight to quality. However, with substantial supply hitting both markets in the coming 24 months, rental rates are expected to drop significantly once more, and the double-digit yields in the central business districts – estimated by global property services firm Colliers International at 10% in 2011 – will fall. Nonetheless, many developers remain sanguine about this state of affairs.

Investors such as the Public Pension Agency, which owns the King Abdullah Financial District, is in the market for the long term and is confident that by slowly feeding supply to the market it can gain good returns. For these types of investors, the fundamental long-term health of the sector must be solid.

As Alpen Capital predicts in its 2012 GCC construction report, “Our outlook for the commercial office real estate and construction markets of Saudi Arabia point towards a positive future on the back of rising population, high liquidity, low interest rates and a booming economy.” When the growing labour market and the business-friendly environment are taken into consideration, it is hard to argue with this assessment.