Summary
The 'natural' vacancy rate in Irish commercial property markets may be twice agents' current published estimates
Implies that the turning point in Irish office market could come sooner than expected
Analysis
Conventional wisdom is that commercial rents rise when vacancy rates are below their 'natural' level, and fall when they are above. Estimation of the 'natural' vacancy rate is therefore critical in calling turning points in the market.
Recent agency reports indicate that the 'natural' vacancy rate in the Dublin office market is 7%. This figure approximates the empirically estimated average for European markets, but seems implausible for Dublin. There are several reasons for this;
On an intuitive level, the natural vacancy rate is expected to be high where letting activity is strong (‘frictional’ vacancy), where leases are long and rents are volatile (appealing ‘option to wait’ ) and where occupier markets are growing strongly (speculative development). Based on these criteria, it is reasonable to expect that Dublin has a natural vacancy rate (at least historically) which is above, rather than in-line with, European norms.
Arithmetically, the 7% estimate also appears off-beam. Over the last 20 years, actual vacancy rates in the Dublin office market have averaged around 10.5%. Over the same period, however, real rents have trended upwards (by around 2.5% pa). This implies a natural vacancy rate that is greater than rather than less than the actual average.
Thirdly any claim that a vacancy rate of 7% is consistent with market equilibrium does not seem well supported by the evidence. In 2004, when growth in nominal rents was zero (and real rental growth was close to zero), the vacancy rate was 15.2%. Similarly in 2007 nominal rents were stable, but the vacancy rate was 10.3% - well above the claimed 'natural' rate of 7%.
So what is the natural vacancy rate in Dublin offices then? Well, based on standard econometric methodologies my estimates range between 11%-16% (depending on model specification). This means that the true natural vacancy rate could be more than double that assumed by local agents.
The implications of this could be profound. Currently, the Dublin office market is heavily overbuilt. Clearly we are now in a recovery period where completions of new space will be negligible and take-up will gradually digest the overhang of surplus accommodation, eventually causing vacancy rates to fall again. This process will be sluggish, due to the probability that demand for office space in Ireland will remain subdued for the foreseeable future. However, the good news is that the 'target' vacancy rate that the Dublin market has to achieve before rents stabilise is higher than previously thought. All else equal, this suggests that rents may begin to recover sooner than some market commentators imagine.
