In Depth: The Ratio of Rates

The rental rate in business centers is influenced by various factors, from the situation in the real estate market (the level of supply and demand) to the condition of the premises being rented out (furnishings, shell and core, etc.). Knight Frank allocates the following key parameters:

The quality of the office premises (class A/B+/B-);

The stage of construction (the readiness of the premises);

The floor/level on which the area is being rented;

The size of the rented area;

The length of the contract;

The class of tenant (anchor, etc).

We note that the list does not include the location, which is connected with the conscious division of its influence and the quality of the premises. Despite the specificity of the development of the office real estate market in Moscow (on the transport rings from the center along the Moscow suburbs), we consider that high-quality offices with good transport and pedestrian accessibility may now be recognized as class A premises even if it is outside the Bulvar or Garden Ring. A lack of parking spaces together with the difficult transport situation in the city center has changed the preferences of the majority of tenants. Now, it is not how near you are to the Kremlin that is of greatest importance, but how convenient it is to travel to the office in working hours and the quality of the premises. These components are successfully combined in many office complexes in the area of the Third Ring Road and even the MKAD (Krylatsky Kholmy, IKEA Business Park).

The rate for quality

One important factor influencing the rental rate is the allocation of a certain class (A/B+/B-) to the building. The gradual strictening of consumers’ requirements for high quality office space has led to the need to alter the classification of premises in this segment. In 2007, consultants accepted a new, modified, classification of office real estate premises, in which stricter requirements for office construction have been put forward. As a result, the class of many buildings has been lowered. All high-quality office buildings are in one of three Groups: A, B+ and B-. For each class there is a number of obligatory and desirable criteria. On average the rates for class A premises are 30-40% higher than the rates for class B+ premises, although with both classes there is a range of rates, some high and some low.

From the foundations to commissioning

Another significant influence on the rental rate is the readiness of the office premises. If the developer puts the premises on the market during the early stages of construction (zero cycle), tenants have the opportunity to rent premises at a significant discount. We have divided the stages of construction into three groups/cycles: zero cycle, erection of a box, delivery of the premises for state commissioning. The duration of the first two cycles, as a rule, is about 3-4 quarters; and we suppose that the third cycle takes no longer than a quarter. As a result of this analysis we come to the following conclusions:

Rates at the initial stage of construction are on average 50-70% lower than at the closing stage;

Because of excess demand over supply some developers intentionally establish high rates even at the initial stage of construction. For theses, the rate at the closing stages is only 15-30% lower than during the initial stages.

Thus, developers of high-quality premises are divided into those who adhere to the strategy of a gradual increase in rental rates, and those who initially establish high rates. Moreover, in high-altitude premises, as a rule, the top floors are not put on the market until the finishing stage of construction when the rental rate for the premises reaches its maximum. Rates for such VIP areas exceed rates for ground floor by 60-80% for premises in the first subgroup and by 40-60% for premises in the second subgroup. In some skyscrapers in the first subgroup this difference can reach 100-110%.

The bigger it is, the cheaper it is

There is another rule that the bigger the area, the lower the rate. Proprietors, as a rule, divide offered areas into 5-7 groups: 500-1,000 sq.m, 1,001-2,000 sq.m, etc. The difference in rates between the first group (500-1,000 sq.m) and the last group (more than 10,000-12,000 sq.m) is 20-30%. The length of the contract also has a big influence on the final rent rate. The correlation is a straight line as with the previous cases (the longer the contract, the lower the rate). Every additional year of rent reduces the average annual rate by an average of 1-5%. It is worth noting that such a lowering of the rate is only possible with a minimum period of rent, which is now 5-6 years. All tenants of high-quality office premises can be roughly divided into two groups: significant ones and others. Significant tenants include large companies (in most cases international) which are capable of drawing attention to the premises and facilitate the formation of a pool of tenants. As a rule, premises are offered to this class of tenants at a discount of 20-30%.

The higher the more expensive

In most cases there is also a straight correlation between the rate of rent and the level/floor of the rented area. Proprietors approach the establishment of rental rates depending on the floor differently. As this tendency is new, we think it should be considered in more detail. There are four differing strategies:

Division of the premises into several price zones;

A smooth increase in the rate every few floors;

A single rate for the whole building;

Establishment of the rate by carrying out an auction.

Some proprietors divide a building into 4-5 price zones: from the ground floors (zone 1) up to the last, VIP floors (zone 5). The number of floors in this or that zone may vary depending on then target average rate of the premises. The difference between the rates of zones 1 and 2 can be up to 20-30%. This is partly explained by the fact that premises in zone 1 are usually rented by an anchor tenant. The difference in rates for premises in zones 2-5 can be in the range of 10-20%.

Another strategy is a smooth (within the limits of 3-5%) increase in rates every 2-3 floors. In some cases landlords set a single rate for the whole premises, thus averaging the average rate of the premises and eliminating a correlation between floors and the level of rent. From an economic point of view this approach is illogical, as each floor is graded differently (the top floors are the best). Moreover, only one price group of consumers is covered. Such a strategy is used when there is no competition near a premises. However, if there is a similar premises in terms of quality in the area whose proprietor is adhering to the strategy of a smooth increase of the rate, it can a share of potential tenants with a uniform rate. Let's assume that in both buildings the single rental rates of $1,200 per sq.m a year are offered but in the first premises it is say on the 3rd floor and in the second premises it is say on the 7th floor. With other things being equal the tenant will choose the second building as for the same price it is getting better premises. Now lets assume that two proprietors of premises have set an identical desirable average rate per sq.m for the whole building. In this case the second strategy seems more preferable. You can achieve your desired average rate in maybe three different ways. In our opinion, the most preferable strategy is to differentiate the rate depending on the floor – a smooth increase and zonal breakdown. This strategy, with all other things being equal, covers more categories of tenants and lowers the risks of areas remaining unrented. Another strategy is to establish the rate of rent through an auction, i.e. receive applications with an obligatory instruction of the desirable rate and metric area and then choose the pool of tenants. Such an approach, in our opinion, is possible only in the event that two obligatory conditions are observed:

The situation in the real estate market represents a seller’s market (excess demand over supply);

The premises possesses outstanding/distinctive characteristics (exclusive quality in combination with a well-thought out concept of the building as a whole).

In Moscow there are very few such premises. If you consider all the pricing strategies from the position of the proprietor it is clear that none of them can be considered optimum (or close to optimum). With all other things being equal (and with budgetary restrictions) the tenant will maximize their serviceability, choosing the best variants from the three available.