While the ASX-listed real estate investment trusts (REITs) have held up surprisingly well in the rising rates cycle, the office sector is inducing investor anxiety as the post-pandemic hangover takes effect.
A recent analyst report from Morgan Stanley highlights the looming oversupply problem: the firm estimates that 35,000 of net space was vacated in the Sydney CBD in the June quarter.
The city’s vacancy rate of 14.4 per cent is the highest since 1994, while three per cent of space is available for sub-leasing (the highest rate in three decades).
As always, the pain is inconsistent: the June quarter number was influenced heavily by the Commonwealth Bank, which ceded 27,000 sq m of space in the Lend Lease (LLC) owned Darling Square complex.
Mirvac (MGR) is a rare beneficiary of the Reserve Bank, not because of monetary policy but because the central bank has moved to the Mirvac-owned 8 Chifley Square while its Martin Place digs are being refurbished.
Dexus retains a 95 per cent occupancy in Sydney – the best of its listed peers.
But the overall message is clear. Unless big commercial tenants can coax – or force – workers back to their high-rise eyries, office space will become a buyer’s market as longer-term tenancies expire.
The dangers faced by the office REITs – as well as retail landlords – fly in the face of the sector’s reputation as being boring in a good way, enabling steady income streams from tangible, defensive assets that prove their mettle over the longer term.
Despite the air of quiet desperation, the ASX200 REIT index has declined only five per cent year-on-year and has risen 4 per cent this calendar year. However the sector is about 20 per cent off its February 2020 pre-pandemic peak.
That looks a reasonable reaction to the rising interest rates cycle, given they are inherently geared and face a higher cost of capital.
Over the last 12 months units in the office specialists Centuria Office REIT (COF) and the Australian Unity Office Fund (AOF) have lost 10 per cent and 27 per cent of their value respectively.
Units in the office-heavy mega-REITs Dexus (DXS) and GPT Group (GPT) have fallen 13 per cent and two per cent respectively.
Arguably, the office REITs are moving into value territory, as measured by the share discount relative to net tangible assets (the value of the buildings in the portfolio, less debt).
But this ignores the growing dangers which are becoming all too evident n the bellwether Sydney market.
To date the office sector has held up well in terms of occupancies, rentals and valuations but no doubt there is a lag effect.
Last month Centuria knocked $102 million off the value of 13 of its properties accounting for 70 per cent of its portfolio. This represents a 4.4 per cent decline.
Australian Unity chipped a modest $5 million from the value of its five assets, from $316 million to $310 million.
Dexus reduced the value of 32 office assets by 7.7 per cent. This was part of a $1 billion, 6 per cent reduction across 175 buildings.
In its December 2022 half-year report, Centuria reported 96.4 percent occupancy across its $2.3 billion portfolio, with funds from operation (FFO, the sector’s preferred way of measuring things) easing 6 per cent to $48.6 million.
With a $14.7 billion office portfolio, GPT reported an average 12.6 per cent decline in space demand from its bigger tenants, for the 18 months to June 2022. But smaller tenancies remains popular and management sees a “flight to quality” to space such as fitted suites.
It will be interesting to see what the REITs have to say as they dribble out their June 30 full-year disclosures later this month.
As bond yields presumably stabilise, investors are likely to will focus on defensive REIT sub sectors such as healthcare assets, data centres, childcare centres and self-storage facilities.
When it comes to those eerily empty CBD edifices, we’ll err on the side of caution and have our ‘out of office’ notification on for some time longer.
This story does not constitute financial product advice. You should consider obtaining independent advice before making any financial decisions.
