Dublin’s office market is in a downturn, but just how deep will it be?

This time four years ago, the commercial property market in Ireland was perhaps as strong as it had ever been. Capital values had recovered in the years after the global financial crisis, and office rents had matched, or exceeded, the peaks of the Celtic Tiger years.

About €7.4 billion worth of commercial property changed hands in 2019, according to broker Savills. That was by far the highest level on record and, at the time, there were few signs of the trend changing in the near future. Office construction, driven in part by cheap debt, was continuing at pace.

It’s a very different story now. First, the pandemic lockdowns and the shift to remote working changed the environment; and while last year started well, the European Central Bank then increased interest rates in 10 successive meetings as it combated inflation. Add to those a general slowdown in the world economy and a slew of job cuts in the tech sector, and the commercial property market has entered a downturn.

“Slowdowns are a part of the commercial property business,” said John McCartney, head of research at BNP Paribas Real Estate Ireland. “The key questions are how deep will it be, and how long will it last.”

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Market confidence

Up to now, the issues have not really spilt out into the open, with some notable exceptions.

A German creditor reportedly appointed receivers over the Beckett Building, an office block in Dublin’s north docklands that had been owned by South Korean investors, in September. Last week, a portfolio of commercial properties tied to developer Johnny Ronan’s Ronan Group Real Estate, including Bewley’s Cafe on Grafton Street, went into receivership on the back of loans to AIB and Bank of Ireland. Fortress Investment Group has also appointed a receiver to a smaller portfolio of five development assets tied to Ronan Group.

High-grade offices in the best parts of the city are still doing well in terms of securing occupiers. Older buildings in less desirable locations are more challenged

With some owners holding on to their assets until the cycle turns, it is no surprise that the investment market has slowed to a crawl.

In the third quarter of this year, deals worth about €444.1 million went through, according to Savills. That compared to a record €1.8 billion a year earlier, and was less than half the quarterly average over the previous decade. Given that a handful of big deals can skew the numbers, volume is perhaps a better indicator of the slowdown: only 30 sales took place during the period compared to a 10-year average of 55.

“Up to now, with limited transactions in the market, we are still at a relative early stage in terms of price discovery, particularly in the office sector,” said Colm Lauder, former head of real estate at Goodbody Stockbrokers. “Investors in Irish commercial property entered this period with relatively low levels of indebtedness, so we are unlikely to see a surge in forced sellers. And with fewer sales, that means a lot of buyers aren’t in the market yet, as they are waiting for further visibility on pricing.

Historically, a vacancy rate of about 11 per cent in Dublin overall has been the mark at which rents have been stable

“What sales activity there is, it’s generally on properties valued at around €40 million and below, with European pension funds still in the market for deals of this size.”

It’s a similar story in the rental market. About 265,000 sq ft of office space was leased during the third quarter, according to research from JLL published last month. That represented the slowest three-month period for the sector since 2014, once the pandemic years were excluded.

The average space rented between July and the end of September was 7,803 sq ft per deal. That was down 46.6 per cent against the five-year quarterly average, “a trend that is anticipated to continue as occupiers seek, ‘better space, not more space’”, the broker said. Notably, yields – a key metric for prospective buyers – have increased to about 5 per cent from 3.9 per cent during the pandemic.

Prime headline rents have held close to all-time highs at about €65 per sq ft. That is seen as an indication that would-be tenants are still willing to shell out for high-quality office space when they need it.

[ Receiver appointed to Johnny Ronan portfolio that includes Bewley’s Cafe ]

Shortfall

It also implies an expected shortfall in office supply within the next few years. By some estimates, the capital will have a shortage of high quality office space as soon as 2026, although that will depend in part on where the market goes over the next while.

“Historically, a vacancy rate of about 11 per cent in Dublin overall has been the mark at which rents have been stable,” said McCartney. “It’s about 12.5 per cent now and, given the pipeline of new space coming on stream, it may go to about 16 per cent by the middle of next year.”

An overhang of about five percentage points above the so-called natural vacancy rate would equate to roughly 220,000 square metres (2.4 million sq ft). Given that the market traditionally absorbed a bit more than 110,000 sq m per year, that suggests the backlog would be cleared in around two years, and that rents would then stabilise with a knock-on impact on yields and property values overall.

The potential variable in this equation is how significantly office life is being reshaped in the years since the pandemic.

The office sector is currently the weakest sector, with the largest price declines for lower quality, older and less energy efficient units

Before it struck, an office worker generally needed between 10 and 12 sq m of space. In practice, a company with 1,000 workers needed an office block of between 10,000 and 12,000 sq m – a significant chunk in Dublin, where the total office stock is about 4.35 million sq m.

Now, though, it is clear that companies are reducing the number of desks they want, as more employees work remotely and hot-desking becomes the norm in many businesses.

The question is how small that space per worker becomes. McCartney estimates companies are now taking 1.2 sq m fewer per person compared to before the pandemic. If the required space per worker declined further, conceivably that could lengthen the time it will take the market to absorb the new office space coming on stream.

Add in so-called grey space, where tenants are looking to offload offices they are already contracted to rent, and the question of how long it will take to get the market back into equilibrium becomes murkier still. Among others, Facebook owner Meta, which has culled hundreds of its Dublin staff over the past year, is seeking an occupier for its Fibonacci Square offices in Ballsbridge; and LinkedIn has publicly said it will scale back its plans for a campus at Wilton Place on Dublin’s Grand Canal. About a quarter of all office take-up in the third quarter is estimated to have been grey space.

Yet the vacancy rate is somewhat uneven across the city. It falls to about 5 per cent for top quality buildings in the most desirable parts of the city, according to John Moran, chief executive of JLL Ireland.

Given the stresses in the market, it’s unsurprising that regulators are watching the sector, even if the main banks here play a much smaller role in the industry than they did during the Celtic Tiger.

In its most recent Financial Stability Review published last week, the Central Bank noted that capital values are down by about one-fifth since late 2019. Still, the magnitude of the decline “remains substantially smaller than that experienced” during the global financial crisis, the Central Bank said.

With fewer sales, that means a lot of buyers aren’t in the market yet, as they are waiting for further visibility on pricing

“The office sector is currently the weakest sector, with the largest price declines for lower quality, older and less energy efficient units,” it added.

The problems for owners of those older buildings are obvious. Even if they are in a good location, the surge in new construction in recent years has underlined the downsides of their properties, especially energy costs, which have been front and centre since the spike in prices last year. Add in companies’ focus on their ESG ratings, which their offices play a huge part in, and it becomes very difficult for that slice of the market.

Those older buildings are not only less desirable to tenants: upgrading them or even converting to residential is nearly impossible, given how expensive financing is in the current high interest rate environment.

“High grade offices in the best parts of the city are still doing well in terms of securing occupiers,” said Moran. “Older buildings in less desirable locations are more challenged.”

It’s not just offices where there are issues due to high interest rates. The private rental sector has largely ground to a halt in recent months, given the impact of the cost of capital.

[ Johnny Ronan’s rollercoaster career takes another dip ]

Bright spots

There are some bright spots. The industrial sector is solid, with rents climbing amid a lack of available space. And while retail has had its own problems, there is activity there that had largely been absent in recent years as it grappled with the shift to online shopping as well as the pandemic.

AIB took a haircut of about 17 per cent – equivalent to some €29.75 million – on a €175 million loan it had held against the Blanchardstown Centre in Dublin when it agreed to sell it to UK investment firm Hayfin. It is separately selling a loan tied to the Square shopping centre in Tallaght. Both centres themselves are also on the market.

Retail accounted for about one-third of all investment activity between July and September, according to Savills, equating to some €146 million. Regional shopping centres accounted for a quarter of all volumes in that time, with Davy Stockbrokers acquiring two shopping investments – the nationwide Hexagon Portfolio for €74 million and Marshes Shopping Centre in Dundalk for €29 million.

That is being taken as a positive for the sector. With deals going through, there is an active market again delivering the price discovery that is so important to would-be buyers. And there may be more would-be buyers circling Ireland. Opportunistic investment funds that either bought up assets at bottom-of-the-market prices a decade ago, or chose not to invest in Ireland at the time, are seen as examining the market once again.

“They haven’t done any notable deals yet, but they are certainly assessing the market and running the rule over possible acquisitions,” said Lauder.

Slowdowns are a part of the commercial property business. The key questions are how deep will it be and how long will it last

It appears to be a Europe-wide phenomenon. Blackstone chief executive Steven Schwarzman told Bloomberg News this week that his firm is eyeing commercial property across the continent.

“The deal business is not totally in mothballs, and these things start again,” Schwarzman said. “I think we’re more on that side of the cycle, although it has been somewhat dreary for a year.”

In Ireland, “it is likely to be the second half of next year before activity really starts to pick up once more”, according to Moran. “Interest levels are starting to improve, and that should continue into 2024,” he added.

And while the office market may have slowed down, to a certain extent that may be a case of it regressing to its long-run average, too.

“We’re aligning more to the mean of what a normal Dublin market is,” said Ronan Corbett, head of offices at Cushman & Wakefield Ireland. “The likes of 2017, 2018 and 2019 really weren’t normal.”