What should office property investors expect in the Year of the Pig?

28 February 2019

The Australian economy performed well in 2018 – growth accelerated, unemployment fell and construction activity remained strong. It was a busy year for commercial property as well. Beginning with largest ever takeover in corporate Australia – the $33 billion sale of Westfield to global property giant Unibail-Rodamco – the year ended with a major office property transaction, when Canadian pension fund Oxford successfully outbid private equity giant Blackstone for control of the $3.4 billion Investa Office Fund. Office sales hit $16.6 billion in 2018, slightly lower than in 2017, but a solid performance nonetheless.

At the same time, headwinds in the form of volatile capital markets, falling prices in residential property and a slowdown in residential construction have the potential to impact the office sector looking forward.

Office property investors are understandably questioning whether 2019 will bring a continuation of the returns they saw in 2018 – and in our view, the answer is yes.

We believe there are no serious signs that office property is suffering, and we expect that 2019 will be characterised by the same themes that drove returns in 2018 – population growth in Sydney and Melbourne, investment in infrastructure, an improving mining sector, and strong demand from offshore buyers looking for a safe home and a positive yield differential between property and interest rates.

We expect office property markets to remain largely positive across the country and believe Sydney and Melbourne to again emerge as clear winners. Brisbane and Perth have been the weaker of the major CBD office markets over the past few years, but we expect both to continue to stabilise, consolidate, and improve. Canberra and Adelaide on the other hand are likely to remain a tale of two cities – with quality, well-located office property at a premium in terms of rents and value, and older, less attractive assets continuing to struggle.

Sydney and Melbourne office property continues to perform

Vacancy rates in Sydney and Melbourne office property are currently at historically low levels, and market consensus is that, like interest rates, they will remain lower for longer – at least over the next few years.

Sydney CBD office property vacancy was 4.1% in January 2019 – its lowest level in 11 years – and we expect that it will decline still further to a level closer to 3.6% during 2019. Population and job growth are the major drivers of demand and underpin the strength of office markets. We expect that both will remain strong, which means that the current tight supply conditions will most likely continue. The office market contracted by approximately 100,000 sqm in 2017 and 2018 and the outlook for 2019 is a further contraction of 25,000 sqm. Effective rents in Sydney were $657 per sqm at 31 December 2018, but we believe could end the financial year closer to $760 per sqm.

Despite the strength of the market as it stands, and the fact that yields are already trending down towards historical lows, we still believe that there is room for modest yield compression and rental growth. Leasing in office markets remains tight, and tenants are responding in a number of ways: by locking in extra space at current rents where possible, by using space more innovatively in order to reduce workspace ratios, as well as actively seeking properties which allow for greater flexibility in workspace layout.

Vacancy rates in Melbourne office property are slightly lower than those in Sydney – 3.2% at January 2019, and likely to stay around this level as strong demand combined with the current limited supply of new stock converge to keep vacancies low. We expect vacancy to continue its downward trend until the end of 2019, when the influx of 400,000 sqm of new space will impact vacancies, which we expect to rise to an estimated 6%.

Perth and Brisbane office property consolidates and improves

Slow and steady improvement is the overarching theme for both Perth and Brisbane office property, despite the fact that vacancy rates in Perth remain stubbornly high – 18.5% at the end of January 2019. Both cities returned to prime net effective rental growth in 2018 after five years of declines, and we expect this improvement to continue.

Employment in the mining sector is picking up, and we are starting to see demand for office space strengthen as well. There is evidence that tenants are taking their sub-lease space off the market, and CBD rents are expected to hold up at between $280 and $293 per sqm.

Acquisitions in Perth were also up during the 2017-18 financial year, and demand for quality office assets is strengthening as mining improves and buyers focus on the significant yield differentials between Perth and the stronger markets of Sydney and Melbourne. Foreign buyers have been particularly active in the Perth market – six of the eight properties purchased during the 2017-18 financial year were bought by foreign buyers. Demand from Chinese buyers has dropped off, but the gap has been filled by flows from both Hong Kong and Singapore.

Looking forward, there is some news on the supply side as well. Chevron announced in June 2018 that it will build a new 29-storey, 52,000 sqm Asia-Pacific headquarters in Perth. This new building will make up the vast majority of new office supply (estimated at just under 57,000 sqm in total) and will naturally translate into an increase in Premium grade office stock. This is a positive sign of an improving local economy overall, but is likely bad news for secondary assets, which are already struggling and may deteriorate further during the year.

In Brisbane, better-than-anticipated demand for Premium grade office space saw the second highest level of absorption of all office markets over the past 12 months – almost 47,000 sqm in the Brisbane CBD. Vacancy rates fell, albeit to a relatively high 13.0% (as at 31 January 2019). On the supply side, Brisbane differs significantly from Perth – to the extent that stock is being taken out of the market to the tune of 35,000 sqm in the year to July 2019. Ultimately, we expect that the improving outlook for resource markets generally will continue to push vacancies down during 2019.

Investment in Brisbane office property remained solid – $1.1 billion of office space changed hand, 80% of which was sold to offshore purchasers. In our view, sales activity is likely to continue – as an example, Mirvac recently announced that it will sell 50% of its 80 Ann Street property to British fund manager M&G Property’s Asian property fund for $418 million.

On the demand side, a robust infrastructure pipeline is expected to generate both jobs and business confidence – and Premium office space has already felt the benefits. Vacancies in Premium grade space were 9.5% as at 31 December 2018 whereas A grade vacancies were higher, at 11.7%. Rental levels have followed to a certain extent – with modest recovery in gross effective rents across most grades since 2015 – and we do expect this trend to continue in both Premium and A grade stock.

Metro office broadly positive

Metro office stock differs from market to market, which makes it difficult to talk about metro office property as a whole in detail – but it’s fair to say that we continue to be positive on metro office property generally.

Our view is backed up by Colliers, which states that metro office property markets will be key to long-term growth in Australian cities. Population growth in Australia is among the highest in the developed world, and as our CBD office markets are not large enough to accommodate growing numbers of workers – particularly given demand for residential property and hotels in the same space – metro office markets will need to fill the gap.

At the same time, metro office markets are the beneficiary of increasing rents in CBD office space and a lack of affordable space, which is driving tenants into more affordable markets – in particular those well-served by transport links, and/or located on the fringe of CBD areas.

Decentralisation also remains a primary theme for both government and large corporations – and this trend is only growing stronger as rents in CBD office markets rise and infrastructure, in the form of improved transport in some CBD markets, makes metro office property more appealing. Areas with good amenities and transport links have already benefitted. Properties like the Australian Technology Park in Eveleigh on the edge of the Sydney CBD, will soon house 10,000 Commonwealth Bank staff moving from Sydney Olympic Park, where transport and amenities are not as good.

On Sydney’s north shore, rental growth is evident in the fringe office markets. North Sydney had 6.8% vacancy as at the end of January 2019, Macquarie Park was 4.8% and St Leonards 6.1% – and we expect that these vacancy rates will continue to fall. St Leonards in particular should continue to strengthen, as the area around Royal North Shore Hospital becomes a health hub, and transport and amenities improve. There is no new office supply coming into the market in St Leonards over the next 12 months, and this will provide further support for vacancy rates – and rental levels with them.

In Melbourne, the city fringe, inner east, and outer east office vacancy rates are all below long-term average levels. The city fringe in particular has the second lowest office vacancy rate in the country, after Parramatta in NSW, at just below 3.5% – largely driven, as in Sydney, by tenants looking to move from outer suburban markets or to escape the higher office rents in the CBD.