Amidst all the enthusiasm for office towers in the latest Real Estate Investment Trust results the chief executive of the Dexus, Darren Steinberg, had a timely note of caution.
“Even with all this economic turmoil around us, demand to date has been very solid,” he told The Australian Financial Review last week.
“But we don’t think it will continue and it will quieten off this year from an occupancy perspective. It has to, with everything that is going on from an economic perspective, both locally and globally.”
It’s not a universally held view, and it is nuanced. Steinberg says his group is well positioned to deal with the economic uncertainty and has forecast another 5 per cent growth in distributions for 2020.
Nevertheless it is a word of caution from the largest manager of office towers in the country. Owners and occupiers should take note.
The owners of the office towers in Melbourne and Sydney have had a great run from what Steinberg calls an “extended cycle.” Vacancy is at near record lows, incentives have fallen, rents have jumped, and, on the back of falling interest rates, values have soared.
The strong returns from the office towers, have been a key feature of the latest REIT reports, particularly when placed in stark contrast to the under-pressure performance of the shopping centres.
GPT Group reported “supportive conditions” in Sydney and Melbourne with like-for-like income growth from its office towers of 6.5 per cent – even allowing for lost income after the sale of Sydney’s MLC Centre – compared with just 1.4 per cent from the shopping centres.
Mirvac’s head of office & industrial, Campbell Hanan, reported “strong operational metrics”, from his relatively youthful portfolio of towers with releasing spreads of around 16 per cent.
Of course, that’s not so good for the occupants of the towers. During 2018-19, Dexus re-leased some 189,000 square metres of space in 267 transactions. On average the new rent in the Sydney CBD was 24 per cent above the outgoing figure struck several years before.
But the balance of power can turn. Office markets do cycle. They change with the economy, with technology, and of course with supply. The current enthusiasm for the sector is not open ended.
The latest vacancy numbers from the Property Council of Australia are tight – just 4.1 per cent in Sydney and 3.8 per cent in Melbourne – but the actual take-up from tenants in the first six months of the year was pretty anaemic with, according to chief executive Ken Morrison, “only minimal pick-up in demand.”
CBRE’s head of research for Australia, Brad Speers, acknowledges that as the economy has slowed through 2019, so the office leasing enquiry has “dropped off a bit, particularly in Sydney”.
Kernel Property, Sydney-based consultants with a focus on tenant advisory, have also noted a lower level of leasing in the first half of the year. Kernel’s Steve Urwin says the market is “awash” with small suites of around 200 square metres, which is very different to the tight market of two years ago.
Colliers International’s forward-looking Office Demand Index is more upbeat, noting a spike of national office leasing enquiry, up 8 per cent, in the June quarter, helped by the result of the federal election. Only Melbourne and Adelaide missed the upturn.
Steinberg has not seen any softening to date. Some leasing has been put on hold, but several large US tech groups are looking for more space in Sydney and Melbourne and following the banking royal commission there has been a strong growth in demand from the rapidly expanding compliance operations.
Dexus logs the enquiries for office space. The historical average is around 40-45 enquiries a week. At the peak of the current cycle, the enquiry level topped out at 55-60, and last week the number was 45.
Charter Hall, which this week forecast another strong year, is the second largest manager of office towers in the country.
Its office CEO, Adrian Taylor, says the tight conditions in Melbourne and Sydney mask some frustrated demand. “Fundamental leasing demand is still buoyant. I am not expecting it to drop off materially,” he says.
For the medium term, Colliers International’s national director of research looks to the Reserve Bank. If the reduction in interest rates, and the focus on infrastructure, could cut unemployment to 4.5 per cent, it would create another 100,000 white-collar jobs a year, and generate an annual demand for another 1 million sq m of office space.
The principal property economist at BIS Oxford Economics, Maria Lee, acknowledges the risks if CBD occupiers become more cautious but argues that the Melbourne and Sydney CBDs have enough pent-up demand to underpin the current tight vacancies, and rental levels, certainly until new supply emerges, in Melbourne over the next 12 months and in Sydney by 2022-23.
“We are pretty positive about both markets over the next couple of years,” she says. “We see strong stand-alone office employment growth in Sydney and particularly in Melbourne.”
CBRE’s Speers is more cautious. He expects that it will be 12 months, and in the back half of 2020, before “genuine growth” emerges in CBD leasing. In Melbourne, some of that growth will be absorbed in a new burst of supply. And in Sydney “rents have reached a ceiling”.
In the medium term, the impact on sales activity and values is likely to be marginal.
Charter Hall managing director, David Harrison, identified the lower for longer interest regime early and confirmed his confidence with another $4 billion worth of purchases in the last two months.
Lendlease chief executive Steve McCann highlighted “a lot of unallocated equity” at his results presentation. “That demand is likely to remain very high,” he says.
Steinberg predicts that yields for office towers will continue to tighten, by around 12.5 to 25 basis points.
“Things are really good at the moment, but we are realists,” he says.
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