Office has long been the backbone of super funds’ property portfolios, but can it overcome the challenge of working from home? Florence Chong speaks to institutional investors to see how their portfolios are impacted.
The COVID-induced work-from-home (WFH) phenomenon and the subsequent entrenchment of hybrid working has wiped hundreds of millions of dollars from the value of shiny office complexes in the central business districts of Australia’s capital cities.
The drop in value is nowhere near as savage as that seen in the United States, where office blocks go begging and some owners are handing the building keys back to their banks.
In the latest round of annual results, Australia’s largest superannuation funds have reported losses in value ranging up to 15 per cent of their portfolios, stemming mostly from office exposure in the US.
Office has long been the backbone of super funds’ property portfolios. The asset class was long relied upon to deliver reliable and solid incomes, secured on long leases and with increases tied to CPI.
But despite lockdowns becoming distant memories, office occupancy remains stubbornly low – 61 per cent in Sydney, 47 per cent in Melbourne and 46 per cent in Canberra in the first quarter of this year, according to the Property Council of Australia.
The soft market sees landlords actively competing for tenants, with incentives ranging from free office fit-outs to rent-free periods. The current level of elevated incentives is around 30-38 per cent in Sydney and 38 per cent in Melbourne.
Super Funds React to Office Challenges
Brett Chatfield, Chief Investment Officer at Cbus Super, told [i3] Insights: “Property had a negative return last financial year with headwinds primarily in the office sector. The weak office sector was balanced by a better performance by some of our retail and industrial assets as well as the benefit of development profits from residential projects.
“Our focus for many years has been on building a diverse and high-quality property portfolio to provide ballast during times like these. We are slightly underweight on office compared to the industry index, and we hold significant high-quality assets where valuations have held up much better than the lower end of the office market.
Chatfield adds: “Our office exposure is largely in Australia, which means we’ve avoided many of the significant issues in places like the US. That said, across our total property portfolio we have had some material write-downs at an asset level, including annual capital declines exceeding 10 per cent, particularly regarding office assets.”
Our office exposure is largely in Australia, which means we’ve avoided many of the significant issues in places like the US. That said, across our total property portfolio we have had some material write-downs at an asset level, including annual capital declines exceeding 10 per cent, particularly regarding office assets – Brett Chatfield, Cbus
At December 31. 2022, Cbus Super’s allocation to property totalled $7.59 billion. On a look-through basis, the fund’s portfolio has a 40 per cent weighting to office. Its assets are premium office with a 10-year lease expiry.
AustralianSuper has written down its entire property portfolio by five to 10 per cent. An AustralianSuper spokesman told [i3] Insights that office was the worst-affected sector.
The country’s largest fund has a property portfolio worth $15 billion, of which one-third is in office. The AustralianSuper spokesman says its US assets have contributed to the bulk of the write-down.
In 2015, in its first wave of offshore expansion, AustralianSuper bought a portfolio of seven office buildings in the US capital, Washington, and neighbouring Maryland, from Brookfield – and also invested in shopping centres in Hawaii through QIC.
The spokesman says: “We are restructuring our portfolio, which includes a shift towards logistics and industrial assets.”
Australian Retirement Trust (ART) has escaped a big write-down because it stopped buying office buildings long before COVID.
Ian Patrick, ART’s chief investment officer, says that despite challenges in the office sector, the fund’s diversification of its property portfolio into alternative property sectors such as industrial property, US residential debt strategies and aged care has helped balance outcomes.
ART has a property portfolio of $14 billion. The portfolio is balanced, with no more than 25 per cent in each real estate sub-sector in which ART is invested.
Although it still has a significant holding in CBD office towers, ART has been scaling back on office exposure over the past five years.
Currently, its portfolio of premium office, which is well-tenanted, has been marked down just 1 – 2 per cent. In other words, value has been maintained.
But office buildings with shorter leases have been written down by between 10 – 15 per cent.
While reluctant to “engage in prognostications” about future returns, Patrick says that over the course of the next 12 months, it is likely that real estate returns could be in the “high single digit negative returns”, meaning somewhere between negative 5 – 10 per cent, as a function of valuations really having peaked early last financial year.”
He says: “Valuations are expected to come off, say 10 – 15 per cent, but this will be offset by (rental) incomes, so the total return will be in the range of minus 5 – 10 per cent. I think there may be another 10 per cent decline in the valuation of commercial property to come – and that’s on a global basis.”
Two Speed Highway
Winston Sammut, Investment Manager with Sequoia Financial Group and a long-time analyst of the listed property market, told [i3] Insights: “As far as valuations of commercial property go, we appear to have a two-speed highway.
“The listed REIT market’s securities are trading at around a 30 per cent discount to their Net Asset Value (NAV), implying that valuations of commercial property they own are overvalued in their accounts.
“In the unlisted market, valuations have not yet been fully-adjusted downwards to take account of the higher interest environment that prevails. Most-recent valuation metrics do reflect lower numbers, but having regard to the current cash rate and to at least two more cash rate increases to come, valuations need to fall to a greater extent.”
[Real estate] valuations are expected to come off, say 10 – 15 per cent, but this will be offset by (rental) incomes, so the total return will be in the range of minus 5 – 10 per cent. I think there may be another 10 per cent decline in the valuation of commercial property to come – and that's on a global basis – Ian Patrick, Australian Retirement Trust
Sammut notes a lack of “meaningful transactional activity” in the office market, although Dexus’ recent sale of an A-Grade Sydney asset at a 17 per cent discount to its book value points to the level at which buyers are willing to transact.
Says Sammut: “This is at lower levels than where values currently sit.
“In my observations and experience, values should fall as interest rates rise unless there is a commensurate increase in rental incomes which, with the background of working from home and lower occupancy, may be difficult to achieve.”
Chatfield says Cbus has a detailed and robust valuation policy, an approach which is important to ensure equity for members.
“We have a valuation committee in place run by personnel who are operationally independent from those managing the assets. Frequent revaluation cycles are typically at least quarterly, and independent valuers are used and periodically rotated,” he says.
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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.