Get ready for 2022: The case for an office market recovery

Bruised but not defeated

A year of many records. 2020 was an extremely challenging year for office landlords. The lockdowns and restrictions introduced by the Government in 2020 caused an unprecedented level of economic disruption and resulted in a once heavily populated CBD turning into a ghost town. This left the office market, as an asset class, to face cyclical and structural challenges. Both Sydney and Melbourne recorded their worst demand conditions in history with vacancy levels rising from historical lows to twenty-year highs.

Conditions turning ripe for a cyclical upswing. However, thanks to the Australian Government’s economic stimulus package and virus control measures, Australia appears on track to deliver GDP growth. Over the second half of last year Australia experienced an ongoing build up in economic momentum across many business sectors. Employment, which is the key driver for office demand, has rebounded strongly, with the labour market recapturing all of the jobs lost during the downturn. Our estimates forecast the unemployment rate to move below pre-COVID levels of 5.2% by the end of 2021 and 4.5% in 2022¹, which would be the lowest level of the unemployment rate since 2008.

Tentative signs for stabilising market conditions. As the Australian economy improves, there are also signs emerging that the office market might be entering the early stages of a recovery. In 1Q 2021, the Sydney CBD recorded net absorption of -7,000 sqm, whilst negative this was a significant improvement to previous quarters (4Q20: -57,000 sqm, 3Q20 -94,000 sqm). While demand marginally improved in Melbourne, the market continues to suffer from the impacts of the strict and prolonged lockdowns, recording negative net absorption of -56,000 sqm (4Q20: -68,000 sqm, 3Q20 -70,000 sqm)² . A promising sign in the 1Q 2021 was that for the first time since the start of the downturn, both the Sydney and Melbourne CBD recorded positive tenant take-up across higher quality ‘premium’ stock. This consistent with agents reporting an uptick in tenant enquiries with tenants looking to take the opportunity of softer market conditions to upgrade from their current accommodation.

Sub-lease vacancy…from headwind to tailwind? Sub-lease activity has been a key driver of the declines in occupied stock in 2020, contributing to over 50% of the negative demand with sub-lease vacancy rising to the highest level since at least the early 90’s³. The AMP Capital Research team estimate that large corporate occupiers that sub-let space during 2020, reduced their footprint by 20%+ on average.

As painful as the rise in sub-lease vacancy has been for the office market in 2020, it also indicates that much of the damage and readjustment towards greater workplace flexibility by corporate tenants may have already been done. As the economy and the labour market continue to improve, many businesses may ultimately find themselves in a situation where they require additional office space once they need to hire additional staff or realise staff are required in the office to build team culture.

An example of this are the ‘Big Four’ accounting firms (EY, PWC, KPMG & Deloitte) which over the course of 2020 all put space up for sub-lease. During the height of COVID-19, the Big Four reduced their headcount by ~1,150 staff⁴. A better-than-expected recovery in client demand saw the accounting firms quickly switch from layoffs to a hiring frenzy, posting ~1,000 new job ads in January⁵ on LinkedIn, which increased to ~1,900 job ads by March this year⁶.

During 2Q 2021, companies such as EY, Ashurst and Telstra all withdrew part or all of their sub-lease space in the Sydney CBD, with total sub-lease availability declining for the first time since the start of the downturn⁷. Going forward, we expect sub-lease vacancy levels to decline further as employment conditions continue to improve.

WFH is here to stay…but so is the office

Making room at the kitchen table. As the pandemic took hold and forced most office employees to turn their kitchen tables into work desks, many have welcomed the benefits that greater workplace flexibility provides. More than one year into the pandemic it appears that the novelty of working from home permanently has worn off. According to a study by Gensler conducted amongst Australian office workers already back in August last year, only 9% of employees preferred to work from home (WFH) five days per week; while 41% preferred one to two days; and 21% to work full-time from the office. On average, respondents preferred to WFH just under two days per week⁸. While greater workplace flexibility will also depend on other business considerations such as productivity, collaboration and HR concerns such as mentoring and training of new and existing employees as well as junior staff, indications are that a large share of the office workforce will be working one additional day from home going forward, noting that a great share of corporate Australia already offered flexible arrangements, such as one day WFH prior to the pandemic.

Although one extra day away from the office would suggest a reduction in space requirements of 20%, the immediate impact on office space will be far less profound. Based on our estimates and given relatively long lease terms in Australia, only about 15% of leases are expiring every year, which in theory would limit the immediate impact on total occupied stock to 2-3% per annum⁹.

One structural trend replaces the other. While going somewhat unnoticed the ‘Great WFH Experiment’ has upended another structural trend in the office market that has been with us for a while. The push by corporate tenants for greater office space productivity and densification by adopting modern (but not always better) workplace models through initiatives such as hot desking has seen workspace ratios (sqm per employee) continuously shrink over the past decades. In many cases, this has seen the situation especially for back-office staff, where we estimate workspace ratios of 8 sqm or less not being out of the norm¹⁰. We estimate that the trend of greater workplace density has been detracting about 1.5%+ per annum from occupied space in the Sydney CBD for the past 10 years.

COVID-19 has not only put a halt to the workplace densification trend but is likely to reverse it, as occupiers see the need for their office space to allow for greater team collaboration as well an increased emphasis on employee health & wellbeing including social distancing. The implementation of these initiatives will ultimately require for workspace ratios to increase. Based on our estimates an increase in workspace ratios of 1 to 1.5 sqm per employee would reduce the impact from greater WFH to just over 1% per annum on total occupied office stock in isolation.

Cyclical drivers to outweigh structural ones. Historically, the white-collar component of the workforce which represent the key source for office demand has been growing at 2.4% per annum¹¹. With the labour market recovery and the latest Federal budget firmly focused on ongoing job creation, we expect cyclical labour market drivers to absorb and outweigh the structural challenges faced by greater WFH and for the office market to return back to growth.

Perth…a window to the future? While the many headlines calling for the death of the office market last year have certainly been exaggerated and the impact from greater WFH likely to be far less profound than widely speculated, reality is that even after a year into the pandemic we have no certainty of how the office market will look like in a post-COVID world.

Fortunately, there is now some tangible information available to provide us with some guidance. To the best of our knowledge, Perth is one of a potentially small number of cities globally (with a sizable office market) where over a prolonged period of time there have been only limited or no government restrictions in place whilst also having limited to no local COVID-19 transmissions over the course of last year, where workers were free to return to the office in May last year. Whilst it was slow going at first, as office workers returned to the CBD following the first lockdown, physical office occupancy steadily increased to 77% by October 2020, according to the Property Council of Australia, just 6.5% below the last pre-COVID reading in January 2020 of 83.5%. Unfortunately, following the lockdown in January, after a hotel quarantine worker tested positive for COVID-19, office occupancy dropped back down again¹².

While the experience in Perth is promising and provides optimism that we will see our CBDs regain their previous vitality sooner rather than later, it also highlights how crucial the ongoing virus control and avoidance of further lockdowns is for a sustained recovery in the office markets and the economy as a whole.

All the right ingredients in place for an office market revival

Lead indicators are roaring back to life. As the economy’s remarkable recovery continues and the outlook improves, signs of optimism have returned to the business sector with business conditions reaching a record high in May this year. Each sub-component individually, including profitability and hiring, intentions set a record high and all industries and states are now well into positive territory. Notably, capacity utilisation (a key labour market indicator) remains at high levels of 85.1%, which supports ongoing employment growth, particularly for white collar jobs¹³.

With business conditions being one of the key lead indicators for office demand, if these were ‘normal’ times, we would expect an increase in office demand over the course of 2021. In light of this, the global economy, including Australia, is experiencing uncertain times and therefore it is likely to take longer for office markets to respond in a meaningful way. Once companies feel confident enough to start switching the gear from survival mode (cost cutting) back to growth (investing) the office market could turn around quickly, leaving investors who expect a prolonged recovery caught off guard.

Do not underestimate the speed and magnitude of an upturn. Over the past 40 years, the Australian office market has experienced five major downturns. While all of them had different causes the outcome on demand was relatively similar, and so were the subsequent recoveries. On average the past market corrections have reduced occupied space by about 3.4% in Sydney and just 1.7% in Melbourne. In all cases, market corrections were followed by a strong rebound in office demand. On average, the Sydney CBD & Melbourne CBD recorded an increase in occupied space of 5.6% and 5.5%, respectively, over the two years following a downturn. This also holds true for rents, following all of the five major downturns the Sydney CBD experienced double-digit growth in prime effective rents within the first two of the recovery¹⁴.

Not just a demand story. For the office market, demand is obviously one part of the equation with supply forming the other one. In hindsight, the 2020 downturn could not have come at a less opportune time following years of modest supply levels where a number of projects reached completion in Sydney, whilst Melbourne recorded the biggest stock additions since 1990¹⁵.

The completion of a number of office developments in Sydney and Melbourne is likely to see vacancy levels rise somewhat further over the course of this year with a number of larger projects also to set to enter the market in the following years. Following the market correction last year, medium term supply risks have significantly reduced as several new projects have been scaled back, put on hold or have been withdrawn altogether. Overall, our estimate for additional supply from 2021 to 2025 has already reduced by over 30% compared to our pre-COVID forecast, with moderate supply levels expected to further support an office market recovery over the coming years.

Watch out for 2022. As economic momentum continues to build and the labour market not only recaptures lost jobs but starts to create new ones, we believe the outlook for the office market continues to improve. While we are cautiously optimistic about a recovery in the Sydney office market during 2021, the heightened uncertainty surrounding ongoing virus control, could limit this to what current lead indictors would otherwise suggest. Melbourne, which had yet another snap lockdown in late May and continues to suffer from the harsh and prolonged lockdowns of last year is somewhat behind the curve in comparison to Sydney, but may also see a stabilisation towards the second half of this year.

Looking further ahead, it appears that many pieces are coming together for the outlook in 2022, which is set to mark a turning point for the office market. As the vaccination rollout progresses (slowly but steadily) and the risk of further lockdowns should recede, expectations are for office workers to return to the CBD in steadily growing numbers.

We estimate existing tenant pre-commitments in the Sydney CBD are set to drive in excess of 60,000 sqm of positive net absorption next year¹⁶. This, in combination with the expectation for ongoing job creation and greater office attendance, could drive a solid rise in office demand and a subsequent drop in vacancy which we expect in turn should see the market return to positive rental growth, similarly to previous cycles.

^1. AMP Capital estimates
². JLL, Q1 2021.
^3. JLL, Q1 2021; AMP Capital
^4. https://www.afr.com/companies/professional-services/pwc-cuts-show-virus-has-removed-shame-of-redundancy-20200811-p55kkk; https://www.afr.com/companies/professional-services/how-the-big-consultants-are-cutting-costs-amid-covid-19-20200414-p54ju1
^5. https://www.afr.com/companies/professional-services/big-four-firms-on-hiring-spree-as-travel-bans-bite-20210122-p56w3r
^6. https://www.afr.com/companies/professional-services/loyalty-broken-by-pay-cuts-pushes-big-four-staff-to-industry-20210226-p5769p
^7. JLL, Q1 2021; AMP Capital
^8. Gensler Australia Workplace Survey
^9. AMP Capital estimate
^10. AMP Capital estimate
^11. Deloitte Access Economics, AMP Capital
^12. Property Council of Australia
¹³. NAB Business Survey (May 2021); Bloomberg
^14. JLL, Q1 2021; AMP Capital
¹⁵. JLL, Q1 2021; AMP Capital
¹⁶. AMP Capital estimates