Long live the office as buyers recognise the value of top quality assets

Mark Mazzarella

Dexus Real Estate Securities

In part 1 of this three-part series, we examined the big questions facing the office sector. The conclusion was simple enough; work from home (WFH) will become more popular as the office evolves but “it is definitely not dying”.

To prove the point, let’s take the counterfactual. If offices were dying, we might expect to see a collapse in commercial property prices as distressed sellers, punished by the pandemic and fleeing tenants, exited the sector.

Nothing could be further from the truth. Commercial properties are changing hands at prices close to, or even above, book value.

In April, Dexus, Australia’s largest office landlord, announced the sale of 10 Eagle Street, Brisbane, at a slight premium to its most recent book value. In Sydney, 1 Bligh Street was also recently sold at a price in line with book value and 60 Miller Street exchanged hands at a small premium to book value (as of 30 June 2020).

Also, in Sydney, Singapore-listed Ascendas REIT recently acquired 1-5 Thomas Holt Drive, Macquarie Park, from AMP Capital. The office campus’ asset value was last disclosed in December 2018 at $246.8m. Not only was the sale price, at $288.9m, well above that figure, it also featured a net property income of 5.9% (before transaction costs).

And in November last year, Mirvac sold a 17-storey office at 340 Adelaide Street, Brisbane, to Melbourne-based property fund manager Forza Capital for $86.75 million. This was one of the first institutional-grade office deals to take place in the city since the pandemic. The building had undergone an extensive refurbishment and sold at an 11% premium to its last book valuation in June and an implied cap rate of 6.1%.

Transactions like this wouldn’t have taken place at such prices if the office sector was on the verge of collapse. In fact, whilst vacancy rates are now above long-term averages, premium and Grade A office spaces are attracting plenty of buyers that recognise the long-term value of high-quality office assets.

Commercial property value is derived from a property’s ability to generate income. Tenant leasing activity is therefore at the heart of commercial property markets.

A recent update from Dexus addresses this by noting: “Tenant enquiry and activity across our office portfolio has been strong particularly for smaller tenancies, and larger occupier briefs are starting to emerge. The significant number of leasing transactions completed during the quarter is encouraging and highlights the demand for quality workspace in well-located CBD assets.”

The development under construction at 555 Collins St, Melbourne, is a good example of the kind of projects attracting high-quality tenants. Owned by Charter Hall (ASX:CHC), the project’s two towers are capable of accommodating 7,500 CBD workers. Amazon was recently announced as an anchor tenant.

Charter Hall’s Managing Director and Group CEO, David Harrison, said that he expects “a flight to high-quality modern office buildings as tenant customers refine their workplace to meet the changing appetite for modern, technology and health/hygiene driven accommodation requirements.” 555 Collins is designed to meet those requirements.

The aforementioned purchase by Ascendas REIT of space in Sydney’s Macquarie Park demonstrates the same effect in metropolitan locations.

Macquarie Park is an established business location with good road and rail links. The property was refurbished five years ago and includes its own cafe, two tennis courts and a swimming pool. Of the three blocks, two have received ratings of 5 out of 6 under Australia’s NABERS regime for sustainable buildings.

Along with Australia Post’s relocation from Melbourne’s CBD to a new building in Richmond, these moves demonstrate how good metropolitan locations with premium-grade buildings will remain attractive. That said, and revealing the complexity of the investing environment, there is now a large building in Melbourne’s CBD available for lease.

A part of the argument for sustained demand for high-quality office space is a change in mindset. Last year, a KPMG survey revealed that 69% of CEOs surveyed in August 2020 planned to reduce their office space over three years. That figure has now fallen to just 17% in the most recent survey. Either the downsizings have already taken place or views around the impacts of COVID on office use have moderated.

With economic indicators pointing to a continued economic recovery, including growing employment numbers, increasing house prices and a rebound in business and consumer confidence, we believe it is more likely to be the latter.

This doesn’t mean commercial property investors can sit back and enjoy the yield. As in every large marketplace, there are variations and income investors need to bear this in mind.

The transactions and figures noted above apply to high-grade commercial property, referred to as ‘premium’ or Grade A buildings, in CBDs and attractive metropolitan locations. Lower quality office assets or those approaching functional obsolescence are likely to bear the brunt of the pandemic-induced reduction in demand for office space.

This is why the prevailing view among market commentators is that prime commercial property values are likely to remain stable.

There is one further consideration. In prime office buildings, space per employee is likely to increase to deliver a more flexible, spacious and health-conscious environment.

According to a Deloitte survey, central London office space needs will fall by up to 15% as people continue to work from home. But reductions in space resulting from more flexible working patterns will be offset by more meeting spaces and reduced hot desking. KPMG, for example, is investing £44m to redesign its UK offices, including its Canary Wharf headquarters, to embrace a flexible working model.

Investors in assets of lower quality than those generally owned by AREITs, however, might want to consider the pandemic’s lasting impact on the underlying values of the buildings in which they invest and the long-term sustainability of the income they deliver.

All properties are not created equal. And not all income is equal. Now is a good time to check whether your income is built on rents from premium and A-grade commercial properties or lower down the quality ladder.

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2 stocks mentioned

Mark  Mazzarella
Portfolio Manager, Real Estate Securities
Dexus Real Estate Securities

Mark is part of the Investment Team tasked with analysing and investing in global real estate-sector equities. He is an Associate of the Australian Property Institute, a Certified Practicing Valuer and a CFA charterholder.

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