A look at what transaction activity suggests for the future of office
Article10 mins31 October 2022
The current flexible work trend creates a conundrum: if workers are only present in the office a few days per week and a commercial office building investment will surely suffer as a result, why has transaction activity remained robust?
For income investors seeking a reliable, attractive income stream, understanding the dichotomy between widely held beliefs and on-the-ground data is central to grasping office sector opportunities.
It has long been our view that the office is not dead. While we acknowledge the cyclical impacts of declining economic growth induced by the pandemic, we feel that localised supply and demand interactions will be the major driver of office investment returns in the immediate term.
As the pandemic took hold in early 2020, Australia’s office workers were thrust into the unknown of working from home (WFH). Our central business districts became ghost towns, with many office workers enjoying WFH freedom and the relief of avoiding the daily commute. Questions regarding the financial viability of the office sector as an investment class quickly followed.
In October 2021, the Australian Financial Review published a story announcing that the big office return is underway - and it’s filled with uncertainty. More recently, smh.com.au questioned the benefits of a return to the office and detailed why bosses are giving up on the traditional five-day week. Many CEOs now accept that the hybrid home/office model where staff gather together two or three days per week in workplaces is a permanent change to their operations.
There has been a softening in some key office operating metrics, including vacancy rates, incentive levels and rental growth, especially in the prime market CBDs of Sydney and Melbourne. Although importantly, there hasn’t been any material decline in the level of investor demand for office assets.
The mainstream media's narrative that the office market is set for structural decline is in direct contrast with the quantum of capital being deployed to the sector. All the evidence suggests that post-pandemic, high-quality office assets located in major urban localities remain central to the investment activity of major institutions.
There are two ways to support this proposition with evidence. Firstly by examining transaction activity and then by scrutinising the capital values at which deals have occurred.
Activity in transaction markets
Commercial real estate transaction volumes across all major sectors bounced back strongly in 2021, reflecting pent-up investor demand and a desire to access the real asset qualities of the sector.
On a rolling 12-month basis, the value of all deals to March 31, 2022, totalled $53.9 billion, according to Cushman & Wakefield. This exceeded the previous record of $51.9 billion set in calendar 2021. Industrial spaces (31% per) and office property (29%) accounted for almost two-thirds of the total.
According to Cushman & Wakefield, with $6.5 billion in transactions in the first quarter of 2022, Australia’s commercial real estate investment sector also had its strongest start to a calendar year.1
This figure surpassed the previous first-quarter record of $6.3 billion set in 2018. The first three months of 2022 were also notable in that the office investment market accounted for 42% of all commercial real estate deals, up from 14% in the December 2021 quarter.1
The future looks even more encouraging. Cushman & Wakefield’s head of research, John Sears, believes the outlook is “increasingly positive for Australian commercial real estate markets, as local investments continue to provide attractive returns compared to many fixed-interest and overseas investments”.1
If the future of the office was as dim as the media portrayed, these transaction values would be far lower. Instead, they’re at record levels.
Prime capital values
JLL estimates that for Sydney’s CBD, prime capital values have increased by about 9% from the start of the pandemic, while Melbourne has experienced a positive, albeit lower, increase of about 3% over the same period.2
Recent transactions suggest continued growth in activity within these markets. This view is concurrent with that of industry researcher JLL, whose analysis suggests that capital value forecasts for all capital cities were revised upwardsduring the first quarter of 2022, with Perth being the exception.2
Additionally, JLL forecasts capital growth in prime office across all capital cities through to 2024. The below graph indicates a positive outlook for capital values across the major prime Sydney and Melbourne CBD office markets in isolation.2
Source: JLL, DXAM
Nationally, however, there remains significant office deals yet to complete. This will test pricing levels and buyer depth, especially with interest rates rising from their ultra-low levels of 2020. We are looking closely at any implications for asset transaction pricing which might emerge due to factors like upward pressure on debt funding costs, broader concerns about inflationary expectations and the implications of geopolitical conflict.
The bigger picture, though, has already revealed itself. The office sector is very much alive and kicking. Instead of the pandemic rendering the office obsolete, it has demonstrated the resilience and popularity of well-leased prime office properties.
There is now widespread recognition of the value of teams gathering in one physical location. Physical proximity engenders valuable collaborations and spontaneous connections with colleagues, and we know companies pay a price without it.
We also now understand that prime office assets with relatively higher levels of amenity are best positioned for corporate tenants to attract and retain staff in a competitive labour market.
And finally, we know that commercial property investors increasingly recognise these facts.
The view that high-quality office assets with strong tenant covenants, lease-term coverage and ESG credentials are likely to be winners over the medium and longer term is now widespread. This view dictated our Dexus AREIT Fund portfolio decisions in the sector throughout the pandemic.
AREITs are adopting these lessons and adapting their portfolios accordingly. Taking advantage of healthy pricing and capital demand, AREITs have sold approximately $6 billion in assets since the pandemic began, at an average premium of 2% to book value.
AREITs are consolidating their portfolios and recycling capital into their growing development pipelines. This is an ‘out with the old, in with the new’ approach to office investment and capital allocation, designed to position portfolios to benefit from the themes detailed above that will underpin future investor returns.
Source: Macquarie Research, DXAM3
It is already clear that the office is not dead. There is growing evidence that well-located prime assets will be the most in demand, delivering attractive, reliable returns.
For investors in commercial office property, a highly selective approach based on quality is already paying dividends. In the years ahead, we expect those dividends to increase.
[1]Australian Financial Review, 13 April 2022 “Office investment rebound drives $6.5b of commercial property deals”[2]JLL Research 1Q22 Office Data, DXAM
[3] Macquarie Research, DXAM
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