Office demand recovery on cards as employment growth picks up in cities DEMAND for office space collapsed pretty much across the board last year. Office employment fell as a result of major initiatives to cut staff in both the public and private sectors. That's why the net absorption of office space in the first half of this year was negative in all cities bar Canberra. But the aggressive cuts of last year are over, again with the exception of Canberra, where the new government's "efficiency dividend" is slated to increase to 2.5 per cent with cuts to 12,000 public servant jobs. Overall, we are through the worst of the weakness in demand. While net absorption will remain soft in the second half of this year, next year will be stronger. The long-term shift in the structure of the economy towards the services sectors means this is the first year in a long time that office-related employment has been weaker than other sectors. In fact, employment in office buildings fell in the year to May. Hence the underlying demand for office space - which we define as the amount of additional space required to cater for growth in the workforce employed in dedicated office buildings at existing workspace ratios - was negative. The fall in net absorption is fully explained by the fall in office employment. It's not because of "activity-based working" environments or tightening workspace ratios. It's because employers have been cutting staff. State government initiatives cut employment through the middle of last year, while in the private sector there was another major round of cuts in the second half of last year. For many businesses, it was a question of survival. For others, including the mining and banking sectors, cost reductions were a means to improve profits. Sydney, still locked into a "basket case" mentality, was the most aggressive. The five years after the global financial crisis saw little productivity improvement, leading to concern across the board. For the last few years, we've seen a parade of politicians, economists, corporates and industry groups trumpeting the need to improve productivity. For business, this wasn't a theoretical concern - it mirrored initiatives in their own companies to "cut the fat." And they paid off. Over the last two years, labour productivity has risen sharply, with employment growing much more slowly than output. Business Australia is now pretty lean and mean. However, there is only so much that can be achieved through initiatives on manning practices. Future sustainable productivity improvements will need to be based on the introduction of labour-saving technologies, through investment. But non-mining business investment remains weak in what is a soft economy. We think that low capacity utilisation will continue to delay the next round of investment, probably for another two years. Until then, labour productivity will reduce, with employment growth picking up towards admittedly soft output growth. Economic growth, now running below 2.5 per cent, will remain soft. But with a strong uptick in mining production and residential building picking up in some cities, there is little risk of a sharp downturn. The other side of the coin is that, with mining investment falling, growth will only pick up pace as non-mining business investment comes through. There are differences between sectors as the structure of industry changes, notably between mining and net non-mining-related activities and regions. In terms of output, the fall in investment in the mining regions will be offset by growth in production. However, we employ a lot more people in the construction phase than in production. That will have an impact on employment and services, including office users in the major cities. Activity will now tilt away from resources towards non-mining regions. Overall, I think we've seen the low point in office employment, and hence underlying demand and net absorption of office space. Office demand will pick up from here. In fact, it already has. The staff cutbacks were last year, with sharp falls in office-related employment in the second half of the year. A recovery has already begun with positive office employment growth in most cities in the last three quarters. However, that hasn't yet translated to leasing demand. Given the lags in the process, net absorption will stay soft in the second half of this year before picking up next year, slowly at first and then more strongly. That has different implications by city. Brisbane and Perth face a medium-term oversupply as strong construction comes on stream in the face of weak demand. Adelaide will take time to absorb the recent additions to supply, while Canberra will remain oversupplied. With little new development, the Sydney market will improve until the Barangaroo office buildings come on stream. Demand in Melbourne is weak now, but the little space that comes once the economy recovers will be absorbed quickly. The markets are out of sync, creating traps and opportunities for developers and investors. Be careful out there. Frank Gelber is chief economist at BIS Shrapnel.