With Industry super funds having already written off 10-15 per cent in the value of their office portfolios, the question being asked is how much further those values will drop.
The jury is still out.
Consensus of opinion is hard to come by because of the degree of uncertainty hanging over the sector, savaged by the work-from-home phenomenon, the most entrenched of the COVID legacies. This continues to play out even while the likely direction of the current interest rate cycle remains debatable until inflation has been tamed.
Some say the office market is facing a double-whammy impact: a structural change in office usage as employees continue to opt for hybrid working, along with the current high interest rates and high finance costs.
In dollar terms, the loss in value so far runs into billions of dollars, with the steepest decline recorded in the year just gone.
According to the MSCI/Mercer Australian Core Wholesale Monthly Property Fund Index, the office sector unsurprisingly was the worst performer on an annual basis. This index is used as a proxy for the wider office market.
In its first annual results for 2023, the data firm says total returns for office funds came in at minus 10.6 per cent, driven by a fall in value of 13.9 per cent. The largest sector in the index is made up of wholesale office funds, holding some $41 billion in assets.
Ben Martin-Henry, Head of Real Assets, Asia-Pacific, at MSCI, told [i3] Insights that the value of office held by these funds has come down from a peak of $32 billion in September last year to $26.9 billion in the latest valuation period to December 31, 2023.
The office sector began to face challenges at the onset of the COVID-19 pandemic. However, the impact on valuations was not immediate, and while there were early indicators of a downturn, the initial effects were not as pronounced as those we are seeing now – Ben Martin-Henry, MSCI
Martin-Henry says: “The office sector began to face challenges at the onset of the COVID-19 pandemic. However, the impact on valuations was not immediate, and while there were early indicators of a downturn, the initial effects were not as pronounced as those we are seeing now.
“Although there was a period during the pandemic when capital returns dipped into negative territory, they eventually rebounded. The decline experienced at that time, however, was not as steep as the downturn observed more recently.”
Martin-Henry says the decline may be slowing but he would be surprised if valuations have hit bottom. “Australia’s main valuation periods are June and December. If we discount the September quarter, then you can say the pace of decline is slowing.”
As valuations are predominantly based on transactions, this is contributing to the conundrum. There has been a dearth of sales in office buildings post-COVID. In fact, Martin-Henry says the level of transactions in office is the lowest since 2011.
Tom Broderick, Head of Office and Capital Markets Research, Australia at CBRE, says that as soon as pricing starts to stabilise – something he thinks will happen soon – transactions will pick up.
“The concern from investors is that they are buying assets while pricing is still falling,” he says. “If investors get confidence around prices stabilising, you will see the return of the office market.
“The biggest impact on valuations is the interest rate environment, which has pushed yields higher. In terms of valuations, the issue that valuers have had in the last 12 to 18 months has been limited transactions. It is hard to know where benchmark pricing is at.”
In Sydney, for example, just three major deals have occurred, all at the discount. These are not, he adds, what he would describe as ‘the best core assets’.
The concern from investors is that they are buying assets while pricing is still falling. If investors get confidence around prices stabilising, you will see the return of the office market – Tom Broderick, CBRE
Office landlord Dexus has sold two assets – both at a double-digit discount. 44 Market Street went at a 17.2 per cent discount to book value, followed by 1 Margaret Street at a 16 per cent discount. Both properties are in the Sydney CBD.
Office is currently the most unloved sector in property – a reversal of fortunes for an asset class that had long formed the backbone of superannuation funds’ real estate allocations because office was considered a “set and forget” asset. Owners of blue-chip office assets were assured by CPI-indexed rental reviews, and vacancies were rarely a major issue. COVID turned those long-held assumptions on their head.
Leasing and occupancy levels have not returned to pre-COVID levels. There is now an expectation that as Australia comes out of the high-rate cycle, transactions along with valuations will pick up across the property market. But unlike logistics or retail, office may continue to struggle.
The slowdown in office is a direct result of COVID because occupancy levels have been low. The good news is that occupancy is starting to pick up.
Broderick says the return-to-office rate in Sydney at the third quarter of last year was sitting at 75 per cent across the week and at 83 per cent of pre-COVID levels on peak days (Tuesday to Thursday). The equivalent numbers in Melbourne were 56 per cent across the week and 63 per cent on peak days.
This is in sharp contrast to the smaller markets. Perth’s weekly average return to office rate was 91 per cent, peaking at 94 per cent. Brisbane also had a higher office attendance than Sydney or Melbourne,
Broderick says that while the leasing market has improved around the country, Melbourne ‘is one market where we are still seeing large tenants reducing space’. In other capital cities, it seems that companies have “right-sized” their office footprints. This, he says, will relieve pressure on the leasing market.
Smaller markets like Brisbane and Perth have observed strong rental growth in 2023 due to solid leasing demand. The core precinct of the Sydney CBD has also performed well. However, given rising vacancy rates, Melbourne has observed negative rental growth over the past 12 months. Melbourne’s vacancy level is around 15 per cent, Sydney’s 11.5 per cent, Brisbane’s 11.6 per cent, Perth’s 15.9 per cent and Adelaide’s 17 per cent.
In its latest survey, the Property Council of Australia says the national office vacancy rate has risen to 14.8 per cent – the highest level in almost three decades and 50 per cent higher than the average. It notes, however, that the worst vacancies are recorded outside the CBD core in capital cities.
As office owners look for signs of improvement in outlook from office attendance and interest rates to fall, they have to wrestle with the reductions in valuations on their property portfolios. The asset class now weighs heavily on the rest of their exposure to real estate.
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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.