Momentum is building for a recovery in sales activity in the strata-title office market, as end-user demand for new space in core areas increases and rental rates stabilise. Salomon Smith Barney said investor sentiment was starting to improve, with a 10 per cent to 15 per cent pick-up in transactions in recent months, though from a very low base. The disparity between luxury residential prices and office prices had started to lead to a shift in investor focus to the strata-title office sector. Yields for luxury flats were estimated at 5 per cent and those for offices at 7 per cent. The report said Hong Kong's office market was starting to hold attraction for overseas investors. A narrowing of the negative funding spread between interest rates and yields had attracted the attention of many United States and European investors. Capital flows into the region had significantly improved liquidity and driven down interbank rates from last year's highs. Also, the declining office-supply profile in Hong Kong made opportunities for capital appreciation here look better in the eyes of an investor than in Kuala Lumpur, Manila or even Singapore, the report said. The brokerage forecast that the supply of new office space should ease considerably in the next three years after seeing an annual completion of 5.6 million square feet of space between 1997 and this year. Between 2000 and 2002, annual completion should average a little more than 1.4 million sq ft, it said. As most of the new space would be built in decentralised areas, this should give traditional business areas more time to absorb currently high vacancy rates of 11 to 17 per cent, depending on the classifications used for grade-A offices. Salomon Smith Barney said that based on the assumption that annual take-up would be 2.8 million sq ft, vacancies should decline to 12 per cent from 17 per cent, under the broader definition of grade-A office as used by Jones Lang LaSalle. Central is expected to be the first market to recover, given a decrease in supply. There will be just one new building, Man Yee Building, in Central and the Central fringe between now and the end of 2000. The brokerage said rents of grade-A space in Central, after falling 40 to 50 per cent from the peak, had stabilised at about $30 per sq ft per month on a net effective basis. 'Based on our discussions with both landlords and leasing agents, conditions are such that rents won't creep up incrementally but gap up,' it said. 'This is due to the reduction of the rent-free period to more conventional levels of two to three months from the oversupply-induced 1998 levels of 12 months or more.' It expected that anyone needing a large block of grade-A space in Central next year would have to pay $34 per sq ft a month and rents would rise further to $38 per sq ft in 2001 due to the absence of new supply. The continued development and emergence of Hong Kong Island East, consisting of North Point and Quarry Bay, as an increasingly viable and attractive business district is putting pressure on the traditional secondary business centres of Wan Chai/ Causeway Bay and Tsim Sha Tsui. Another district could emerge at Cyber-Port in Pokfulam, with office space of 991,000 sq ft in five office towers scheduled to be completed between 2001 and 2003, based on current plans. But the brokerage said the Cyber-Port office space was unlikely to have a material impact on the grade-A office market as the total amount of space was not large. It expected net effective rentals in Island East, already in the $15 to $18 per sq ft range, could easily drift down to $12 next year. Such downward pressure would be limited not just to Island East but would reverberate across all other secondary office districts, it said. Though Wan Chai/Causeway Bay would see the least amount of new office space completed of any district in the coming three years, it should be under considerable pressure from new supply in Central and Island East. Companies in the Wan Chai and Causeway Bay area that were looking for more convenient or prestigious addresses might be attracted to Central by its lower rents compared with historical levels. Those companies needing a convenient location with sufficient amenities and support facilities had more options in Island East, where rents could be up to 25 to 30 per cent lower. Tsim Sha Tsui also would face increasing competition from offices in secondary locations. The 1.6 million sq ft office portion of Wharf's Gateway II was expected to be the only big new supply of grade-A space in the area over the next few years. Wharf has reported that Gateway II's office space is now 40 per cent committed and this would leave up to 900,000 sq ft of space available for lease on completion this year. Despite the lack of competition from new buildings, other existing properties in the area such as China Hong Kong City would not simply let Wharf lure away tenants without a fight, Salomon Smith Barney said. Given the availability of ample, cheap, modern office space in Island East and elsewhere, the brokerage expected that business seeking large new office premises would be less inclined than in the past to choose Tsim Sha Tsui specifically. Rents in Tsim Sha Tsui, now ranging from $22 to $25 per sq ft on a net effective basis, would drop 15 per cent to $18 to $22 per sq ft next year and 2001, the brokerage said. Though location remains the primary consideration, technological advances have greatly changed user specifications for office buildings, particularly in areas such as telecommunications networks, ventilation/air-conditioning systems and power supply. The disparity between similarly classified buildings in these technical areas had widen considerably. The brokerage expected this trend greatly increased the obsolescence rate of existing buildings and would at least slow the growth of, or even reduce, grade-A supply by pushing older buildings out of the grade-A classification or by forcing a faster rate of redevelopment. However, the cost of upgrading buildings might not necessarily justify the marginal additional rental revenue. Some landlords might choose not to upgrade their buildings even if their rental stock became less competitive, it said. Accordingly, Hong Kong's historical vacancy rate, which has been about 5 per cent and one of the lowest in modern financial centres, might move closer to the 10 per cent level of other centres such as London and New York, the company said.