Office sector holds steady despite softening Sydney demand

The Australian office sector has been a strong performer in global commercial real estate for the better part of a decade, delivering an average return in excess of 10% over the past eight years¹. Worldwide, office space is a highly sought-after asset class, accounting for almost 60% of property transactions², due in no small part to its homogeneity, and the depth and liquidity of the market.

Looking ahead, however, into the outlook for the Australian market for 2020, we start to see some cracks emerge around the demand story, particularly in the Sydney market. The impacts of slowing economic growth, falling consumer confidence and global economic rumblings are beginning to influence demand across Australia.

The Property Council’s January Office Market Report reflects these dynamics, with vacancy rates in Sydney ticking upwards for the first time in nearly three and a half years. On its own this doesn’t necessarily represent a seismic shift – from 3.7% to 3.9%, but it is important when considered in the context of a decade-low net absorption rate (which gauges demand in the market)³. Sydney’s office market might not be in crisis, but demand is clearly softening.

Lower demand is being driven by two factors, the first being rental affordability. Rents in the secondary office market grew by nearly 60% over the past five years⁴, and as a result tenants have been forced to do more with smaller footprints than they had traditionally occupied. The second factor has been a period of consolidation in the premium end of the market, as the large global tenants who typically occupy these spaces look for cost-saving measures and begin to withdraw briefs that they had previously had in the market.

Although these demand factors will affect operating income, valuations won’t necessarily follow suit. Instead we’re forecasting cap rate compression in the order of at least 25 basis points across most of the CBD markets, as the low cost of capital continues to fuel the US $360 billion currently chasing commercial real estate transactions around the world⁵. Whilst that capital supply remains strong, pricing should be resilient to lower demand from tenants.

Pockets of more attractive opportunities still remain in Sydney; we see strong potential for growth in value-add prospects in particular, such as redevelopment of older buildings and looking beyond the CBD to areas such as North Sydney, Parramatta and the inner southern suburbs.

Moving forward, demand will remain a concern for the sector, but the good news is that outside of Sydney prospects do look brighter. The Melbourne market remains relatively robust and Brisbane and Perth are now showing signs of sustained recovery. Across the country vacancy rates are still at record lows and absorption remains relatively strong across most of the other major established markets.

In our view Sydney and Melbourne should still provide the strongest returns into the near future, but the performance of these markets will be subdued in comparison to the past five years. Across the sector our expectations are for returns in the order of 6-9%, which would be a respectable result in a low return, low growth market. Beyond 2020, we are forecasting a cool-down in office pricing and further softening in demand, followed by a late recovery in 2021-2.

It’s worth remembering that we’re coming out of a period of extremely strong growth that was always going to prove difficult to sustain indefinitely, particularly given recent deterioration in the broader economy and current global uncertainty. As a global city, Sydney tends to feel these headwinds more than most.

¹ MSCI/IPD Total Return Index
² Real Capital Analytics
³ Property Council of Australia Office Market Report, January 2020
⁴ JLL Real Estate Intelligence Service
⁵ Preqin Dry Powder Report