‘The cream rises to the top’: Investment value in the Brisbane commercial office market
While incentives are high, face rents and valuations remain stable.
With a large portion of our investment portfolio located in Brisbane, MP Funds Management has a deep understanding of the Brisbane CBD office market. Key to investment value in the commercial office market is the clear division in the market between Prime or A-grade versus Secondary stock. Whilst Brisbane’s vacancy is sitting at 13.5%, Prime vacancy is currently 8.1%, as demand for Premium and A-grade assets continues to rise in favour of Secondary stock. MP Funds Management has observed a flight to quality, as major tenants favour high quality assets offering amenity that draw their staff back into the office. Simultaneously, it is evident that secondary stock is experiencing higher vacancy rates, equating to higher risk levels in terms of incentives, leasing deal flow and cash flow, as historically a large proportion of the Secondary market’s tenant base is comprised of SME’s, who have been impacted more severely throughout the COVID-19 period.
Whilst prime face rents remained stable through late 2020 and into 2021, incentives from Landlords have continued to increase as post COVID-19 vacancy rises, with Prime office leasing incentives currently 38.5% and peaking as high as 45%. Despite high incentives, valuation levels continue to remain relatively stable and face rents are holding well, with strong underlying fundamentals in this flight to quality in the Premium market. A low interest rate environment drives the hunt for yield and capitalisation rates also remain stable, if not compressed. Following the impacts of COVID-19, the hesitancy from tenants and delays in major decision making will continue to drive a softer leasing market for the next year, despite seeing a faster than anticipated economic recovery in Brisbane.
Following this rental growth stall there is potential for a future increase in growth off the back of strong interest from mining companies and ancillary industries such as engineering, and strong demand from Federal and State Government. This renewed demand coupled with unprecedented levels of fiscal stimulus spend focused on infrastructure and capital investments, positions the market for growth over the mid to long term.
MP Funds Management believes Brisbane will witness an undersupply of new office development as access to pre-committing tenants (a prerequisite to any new material supply) will decline given the current climate. This trend accompanies low levels of forecast supply in the CBD, with less than 100,000sqm currently set for delivery by 2023. Lower levels of future supply will create upward pressure on rents again and a reduction of leasing incentives overtime, as the existing surplus space is absorbed by the market.
A unique environment drives domestic investment value.
Purchaser appetite for Prime Brisbane commercial office assets remains strong, as attractive yields drive buying confidence pre, during and post COVID-19, stimulated by the global negative interest rate environment. However, as a result of the current COVID-related border closures offshore groups are limited in their access to Australia by geography. As such, recent transactions are dominated by local buyers and represent what could be described as opportunistic cap rates due to the lack of usual offshore buying competition, therein enabling a short-term arbitrage in buying value.
The Gold Tower and domestic buying arbitrage
A recent transaction of note which exemplifies the current arbitrage value due to restricted offshore buying competition is the recent sale of Dexus’ trophy asset – Gold Tower. The asset sold to a local Australian Fund Manager at a rate of c. $10,200 per sqm on a net lettable area of approximately 28,000sqm, this was substantially below the Dexus book value at the time.
The asset was competitively bid during the public sales campaign, and Singapore based Keppel, an offshore institutional buyer, bid $25m above the final transaction value; however, the deal was not concluded as border closures limited their ability to complete their physical due diligence. As a result of requiring certainty of completion, Dexus accepted the lower bid by the Australian Fund Manager, enabling the purchaser to secure the asset at an arguable discount to market, providing immediate advantage and investment value to the buyer.
Gold Tower is 93% leased with four vacancies within the building and negotiations taking place on each of these vacancies. Gold Tower maintains a diverse tenant profile and is primarily occupied by small to large enterprises within small to medium sized tenancies. With historic low turnover of occupants, tenants are high profile, corporate in nature and remain in the building for its premium corporate address. The size and nature of the tenancies minimises key tenant risk, smooths the expiry timeline and reduces risk to the income stream.
As a sign of positive sentiment in the market, the past six months has seen 13 lease renewals and new leases signed in the Gold Tower with over 2,700sqm of positive net absorption during the period since acquisition.
The value in Brisbane
Strong underlying fundamentals drive investment value in the premium commercial office sectors across the eastern seaboard of Australia, and a momentary arbitrage is enabled in COVID-driven border closures, which restricts buying access to the usually prolific offshore buying groups. This unique and short-term dynamic provides nimble and opportunistic domestic buyers, with albeit shallower pockets than offshore counterparts, a foothold to significantly discounted buying and as such, immediate investment value.
The old saying ‘the cream rises to the top’ is reflective of the leasing demand for premium commercial assets, and where risk will be mitigated with investment exposure to the asset class. As vacancy increases overall due to the COVID-driven work from home environment, the flight to quality will characterise the market for the short term, with a lack of new pre-commitments hampering new supply to the market over the medium term and resulting again in positive net absorption across all office sectors.
Whilst the current work from home measures drives immediate structural change, with many businesses required to innovate business models and contract, the evolution is rendering some business models obsolete and others are booming, requiring expansion space.
Brisbane and Sydney comparatively speaking do not trade at parity, Brisbane has historically offered a stronger yield for both institutional as well as domestic residential real estate, which is attractive from a cash flow perspective. A comparable asset to Gold Tower in Sydney would arguably trade for c. 4.5% cap rate. Picking up a quality commercial office asset like Gold Tower at a 6.25% cap rate and gearing conservatively with bank debt to say a 55% LVR would notionally equate to an attractive net cash distribution of c. 8% annually, with a total forecast return in the teens. Annual increases of 3.5% are written into the commercial office leases, further providing attractive accretive value at the investment level year on year.
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