Why Allan Gray has bought Dexus while everyone else heads for the exit

“Office real estate is out of favour,” Hillier says. “This is hardly a surprise, given elevated vacancies, high tenant incentives, falling rents and poor cash flows. Rising interest rates have added further pressure to the sector.”

As one of Australia’s largest office landlords, Dexus Limited (ASX: DXS) is a prime example of a real estate investment trust (REIT) trading at a large discount to its book value and, according to Hillier, this means DXS and other office REITs warrant a closer look.

Dexus's total returns have been so poor, the analyst notes, that “the company's shares have sunk far below the relative levels they experienced during the global financial crisis”.

The boom before the bust

Allan Gray says the seeds were planted in 2019, when conditions in Sydney and Melbourne CBDs were near perfect. Employment growth was averaging 3% across NSW and Victoria, supply was running well below its long-term average at 180,000 square metres per annum, vacancies had fallen to just 4%, and tenant incentives had dropped to a relatively benign 20-25%. Effective rents net of incentives had risen 34% over the preceding three years, and listed REITs were trading at a 20% premium to “already optimistic asset valuations”.

“However, high valuations, rising rents, benign construction costs and low interest rates triggered a wave of development. Supply across Sydney and Melbourne CBDs rose to 370,000 sqm p.a. in the years that followed,” Hillier says.

“As luck would have it, this supply came to market just as COVID-19 work-from-home mandates and flexible working led companies to reassess their space needs. In the years that followed, vacancies rose sharply to 17%, incentives doubled, and rents fell 15%.”

After a surprisingly resilient post-COVID period, office valuations eventually tumbled and investors’ appetite for office REITs took a hit. Today, the external valuation for Dexus's office portfolio has recovered slightly to be in line with its 2019 figure of $14,000 per square metre of net lettable area.

However, instead of paying a premium, Dexus investors are now only prepared to pay an implied $11,000 per square metre; 25% below the externally assessed value.

The structural headwinds all office landlords are facing

Beyond the cyclical reset in rents and occupancy, office landlords face two structural headwinds: inflation and AI.

Higher interest rates weigh on earnings and pressure valuations, and this is “clearly a headwind”, Hillier acknowledges. But Allan Gray offers a counterpoint: the same inflation that lifts rates also drives up replacement costs, which in turn constrains new supply and supports rental growth over time.

Office construction costs have risen 30-60% since 2019, with estimated total development costs, including professional fees, levies and interest, of $11,000-$16,000 per square metre of net lettable area, before land. With replacement costs now well above market valuations, “the economic incentive to develop new office supply is limited”.

The second structural risk is AI and its potential effect on white-collar employment. A material reduction in office-based employment would weaken demand for office space. While Hillier doesn’t dismiss this concern, he notes that “the implications of this scenario would extend well beyond landlords”.

“We do not attempt to forecast this outcome, but it reinforces our preference for higher-quality offices in better locations – where desks are likely to be vacated last.”

“New and innovative ways to disappoint investors”

It’s not just the structural factors weighing on Dexus, with Hillier pointing to a May court ruling, of which “the implications remain uncertain, but the outcome is plainly negative”.

“Dexus also owns a small funds management business that, among other things, managed investor interests in Australia Pacific Airports Corporation (APAC). As part of a process to sell a 9.7% APAC stake, Dexus disclosed confidential information to prospective buyers,” he explains.

The NSW Supreme Court upheld a default notice issued by APAC, which could potentially force the sale of the full 27% stake managed by Dexus.

As Hillier puts it: “Companies can also find new and innovative ways to disappoint investors.”

A contrarian bet on a sector nobody wants

The Allan Gray analyst draws a parallel to the fund’s experience with retail REITs. When COVID-19 forced mall closures, the firm bought Scentre and Vicinity at discounts of 40% to asset value on implied cap rates of 8-9%.

“What surprised us at the time was that investors were far less concerned about the outlook for office,” he says.

“Today, sentiment has reversed, and investors are highly wary of office. Conditions are undoubtedly tough, but we find valuations compelling.”

Dexus is currently among the top 10 holdings in the Allan Gray Australia Equity Fund - Class A at 4.1% of the portfolio, alongside Mirvac (ASX: MGR) at 1.4% of the portfolio, and Hillier believes the REITs are worth holding.

“We do not know when the outlook will improve, but lower valuations have lifted implied yields, potentially allowing us to be well compensated while we wait.”