Pandemic has turned the table on office landlords

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MELBOURNE CBD office is likely to remain a tenants’ market for the foreseeable future with the vacancy rate most likely above 10% currently and is yet to peak. At the same time, the steady flow of capital to commercial buildings will increasingly favour high quality and securely leased assets.

Speaking to the Australian Property Institute REIV’s State of the Market event in Melbourne, Colliers national director, valuation and advisory services Peter Volakos said a large amount of sublease space is not yet counted in some estimates of empty offices across the city, and a number of developments are expected to come online in the coming years.

He said there is probably close to 200,000 sqm of sublease space that is “more or less on the market being quietly discussed”, and which would “quite easily” take the Property Council of Australia’s figure of 8.2% beyond 10%.

“We’ve also got 200,000 sqm of space still under construction over the next three years. Over 100,000 sqm of that will be delivered over the next 12 months, so if you consider that we’re not going to have positive net absorption again this year, you had that into vacancy, you very quickly get to something like 12%, and I think that’s where we’re forecasting and we’ve got to consider to be a reasonable peak level of vacancy for the Melbourne CBD.”

Melbourne’s CBD vacancy rate one year ago, according to the Property Council, was a low 3.2%. Despite the increase over the past year, it remains the tightest office market in the country.

Volakos notes that even with 475,000 sqm of offices under construction in the CBD alone at the beginning of 2020, the peak vacancy forecast was 5%. Still, developers remain more active than expected.

He said the last time Melbourne’s vacancy was around 12.0% was 1999.

“It’s going to be better for tenants than for landlords in the foreseeable future, that’s for sure.”

While face rents at the moment are stable, this is only because tenants have been heavily incentivised tenants.

“35% is the new 30%. I think everyone in the market understands that,” Volakos said. In some instances, anxious landlords holding larger tranches of vacancy or in weaker parts of the market are more willing to do deals to grab tenants and offering incentives “significantly above 35%”.

“Then you’ve got other landlords that might be in the eastern core, that might have a great premium product and that aren’t so anxious and aren’t doing those deals.

Property Council data showed Melbourne office occupancy was still at a low 24% at the end of February – half of that of Sydney, which had the nation’s second-lowest rate of 48%.

He said a Colliers survey of workers “wasn’t all positive” in feedback on working-from-home.

“There is certainly a lot that people miss from working in the office – collaboration, impromptu conversations, the ability to meet in person, to generate ideas, the ability to just walk over to someone’s desk, the ability to meet clients, the ability to do what we’re doing today.”

He said the need with co-workers and clients could potentially become an employee and talent retention issue.

The hub and spoke model that has been often discussed during the past year is more feasible in the Sydney market than in Melbourne, Volakos said, due to Sydney’s cost of rent, difficulty in getting around the city, and its established metro market. He said it is unlikely to catch on in Melbourne, although there will be instances of it. The state government is currently running pilots in the suburbs of Footscray and Werribee.

Office values hold their own

Volakos said early modelling during the onset of COVID suggested there was probably a 0% to 6% impact on office real estate values depending on the strength of the cash flow, and the style of the property, with “SME-heavy buildings” – those tenanted by small-to-medium sized businesses – would be impacted more than long-WALE assets.

“We knew that from the beginning and that’s played out throughout the course of the year and it’s held fairly true as sales evidence has started to emerge.”

“You really can’t get a risk free return in government bonds anymore, you can’t put money in the bank – anything fixed interest is giving you no return – so something long WALE with a modern real estate asset is one of the go-to investments for a lot of institutional and private owners.

“Where there’s short-term risk throughout this period, they’re penalising the asset. Where the asset’s got good, secured income from good covenants throughout that period, they’re pinning the ears back. That’s where we’re seeing the difference.”

Long WALE and government-tenanted buildings are “the sort of asset everyone wants to buy but no one wants to sell.” Owners are receiving unsolicited offers.

Yields are still low across the board. Premium-grade buildings show yields of 4.5% to 4.75%, while yields for A grade assets range from 4.625% to 5%, and B-grade buildings 5% to 5.5%. However, an increase in the risk premium for secondary-grade buildings over prime stock is starting to emerge, and demand for assets is becoming more nuanced.

“Pre-COVID, there was very little difference in demand for prime assets and secondary assets. There was capital cross the board, value-add was very competitive, and that risk premium for secondary assets was pretty small.

“More money is flowing into safer and secure assets, both in terms of the quality of the improvements and the cash flows.

“It’s another cycle, really. It’s in some ways not completely different to other cycles. The key thing that’s underpinned it this time around is that we haven’t had a withdrawal of capital and liquidity from the market and that has really been what’s saved property values.

“In terms of valuations writedowns, it hasn’t been anywhere near as bad as, say, what it was in the GFC.”

Offshore clients continue to seek out Australian investments. Major 2020 deals in Melbourne were dominated by offshore capital, including GIC partnering with Dexus to buy the iconic Rialto building, and then taking a half share in 222 Exhibition Street.

TC Capital acquired 350 Queen Street, while German giant Deka Immobilien splurged $450 million on 452 Flinders Street, and AEW picked up 505 Little Collins Street.

“They love Sydney and Melbourne, they love the way we’ve handled the virus,” Volakos said.

“If you look at what’s happening around the world, putting your money into Australia at the moment is seen as a really favourable thing to do, and a low-risk thing to do.

“There’s obviously a big advantage for offshore investors with local teams and local platforms – there’s quite a few of those.”