The tightly held office market in Australia, particularly in Sydney and Melbourne, has had a stellar run in recent years, with strong fundamentals and robust tenant demand resulting in record low levels of vacancy. The last six months, however, has seen COVID-19 containment measures resulting in a large portion of the workforce working from home rather than in a central office.
As restrictions ease and the full impacts of the pandemic come to light, businesses will need to reconsider their organisational structures, ways of working and the spaces they use to ensure a balance between the needs of individuals, teams and the business.
While it’s too soon to tell what the ‘future of office’ will be, and the impact remote working will have on office demand, the office will still play a fundamental role in how companies operate. And as the largest real estate sector, office exposure, particularly high quality and differentiated offerings, we believe will remain a key component of any diversified real estate portfolio.
Office market update
Australia’s office markets have been quick to respond to the economic slowdown resulting from COVID-19 containment measures. The combination of increased supply and a contraction in tenant demand resulted in a significant increase in vacancy levels from recent record lows, to over 10% in Australia’s two largest markets of Sydney and Melbourne at the end of the September quarter.
In line with the soft economic outlook, we expect office demand conditions to remain under pressure for the remainder of 2020 and to stabilise and improve from 2021 onwards. While the major office markets were well positioned heading into the downturn, it is our expectation that their vacancy levels will remain above historical average levels, before recovering from 2022 onwards. Secondary office markets with higher exposure to small business tenants are likely to experience the sharpest increases in vacancy, compared to the core prime markets which are anchored by more stable, corporate tenants and long lease terms.
Transaction activity has also experienced a sharp contraction since the start of the pandemic, particularly in comparison to the strong levels recorded last year. However, New South Wales and Victoria remain the most sought-after office markets in Australia and continue to attract investor interest. Whilst we saw valuers making adjustments to income assumptions early in the pandemic period, capitalisation rates have only just started to soften causing falls in value. However, we do not anticipate this to be to the same extent as during the 2008/2009 Global Financial Crisis, with real estate pricing being supported by the still attractive spread to low bond yields and investors still seeking exposure to income producing investments.
The greatest risk for office valuations going forward is in the assets facing significant vacancy and leasing risk, which is more likely to be in the secondary stock. As investors begin to price risk back in, the spread between prime and secondary asset pricing will increase and as such, we believe that prime real estate remains attractive in the context of broader investment markets.
A resilient sector
There are many factors at play which make it hard to quantify the impact a more agile workforce will have on demand for office space in the long term. What we do know however, is that between technological advances, the growing role of sustainability and wellbeing and the importance of flexibility, collaboration and community in attracting and retaining talent, the office as we once knew it is changing.
The office sector is a resilient asset class though, and as people start to get back into the office and make their choice where to work, the new post COVID-19 workplace landscape will start to take shape and the office market will inevitably evolve to meet these new requirements as it has done before.
In the meantime, whilst we are seeing tenants deferring the decision to relocate, renewing leases to secure their current space while assessing longer-term impacts on how and where their staff will work, there are also indications that the demand from global businesses for prime offices will continue.
Atlassian for example, have advised all their employees that they will be able to choose, 100% of the time into the foreseeable future, where they work. At the same time, they have recently announced they are designing and proposing a $1 billion+ state-of the-art, sustainable, hybrid timber, high-rise headquarters adjacent to Sydney’s Central station. Facebook, Amazon, Google, Apple and Twitter have made similar decisions on varying scales, citing the need to provide an attractive option of working in an office environment for their staff, as well as employee engagement and cultural reasons to maintain (and grow) their office presence.
While the office may look and feel different, it will still play a fundamental role in how companies operate. Opportunities remain for investors who are able to access quality assets that are actively managed with innovative and agile re-positioning to meet the changing needs of businesses and their workforce.
Finding quality assets and management
In times of change, investors have the opportunity to position themselves in portfolios that both minimise the short-term risks, but also position them for growth when it reappears. These portfolios will comprise assets that remain attractive to tenants throughout the market cycle. That of course, includes the office sector – the largest real estate sector and a key component of any diversified real estate portfolio.
For commercial real estate, a non-homogenous, relatively illiquid asset class, it means that bottom-up, on the ground expertise has re-established itself as a critical component of investment metrics.
Looking ahead, there is no doubt that workplace design and the way office space is used will continue to evolve and tenants will expect the support and guidance of experienced managers like AMP Capital to ensure the user experience, amenity and facilities of their accommodation continue to meet their needs as their requirements change, be it for COVID-19 related reasons or otherwise. The ability of an asset to meet these changing requirements will determine attractiveness of the building to tenants and therefore how secure the income stream is and how sustainable the asset’s investment performance will be.
Unpacking active management
Active management is the implementation of innovative and agile strategies that continue to evolve the asset to meet the needs of current and prospective tenant customers. As part of this, placemaking expertise, central to the evolution of retail assets, is becoming increasingly important in the office sector, ensuring assets remain relevant and attractive to tenants and enticing to their workforce.
Take customer experience as an example, which is a key factor for tenant customers’ decision on which office space to take up. More and more, the attraction of working in an office will be based on the user experience - businesses are looking for a sense of community, a building that reflects their brand, culture and purpose.
Amenity is high on the list of what attracts tenants to our buildings. This includes access to childcare, gyms, high quality ‘end of trip’ facilities (changerooms, bike storage and maintenance facilities), concierge services, cafes, and access to flexible working spaces to make the best use of valuable floor space.
Wellbeing and hygiene will also be front of mind for users of office assets as a result of COVID-19 and the role of technology will be significant in providing the level of comfort required for people to return to the office safely. AMP Capital is currently piloting a number of initiatives that will continue to support our tenants in their requirements, such as smart phone frictionless building access and sensors to manage occupancy and optimise operating costs.
Taking an active management approach ensures portfolios are resilient to short-term impacts of market movements and investors can continue to maximise investment returns, and minimise risks, at all stages of the market cycle.
Case Study: An example of a proactive management approach
Over the last two years, AMP Capital initiated an investment strategy to reposition Angel Place, an A Grade office asset located in the centre of Sydney’s CBD. The objective was to elevate Angel Place as one of Sydney CBD’s most iconic, tenant-centric office assets, ensuring it remains attractive to the changing needs of tenants.
The strategy included the refurbishment of the lobby to a premium standard, the introduction of market leading flexible workspaces and an enhanced user experience in the form of concierge services, improved building amenity and increased community engagement.
Completed in 2019, this asset repositioning shifted market perception of the building allowing us to take advantage of a strong leasing market and forward-solving vacancy risks in order to maximise leasing and renewal opportunities ahead of any anticipated market downturn. As a result, a high level of occupancy has been maintained and income returns maximised for investors into the future despite the current market conditions.
The fundamentals of commercial real estate remain
While it’s important for investors to consider how their short-term exposure will fair in an economic downturn, the fundamentals of investing in commercial real estate remain:
- Seek minimal vacancy exposure/risk through long weighted average lease expiry (WALE); and
- Ensure assets are well located, well designed and well managed, to ensure they attract and retain high quality tenants throughout the market cycle.
Portfolios that exhibit these characteristics and continue to meet the ‘flight to quality criteria’, will be best placed to weather the short-term impacts of a market downturn while providing investors growth opportunities as markets start to recover.
Accessing prime commercial real estate is not just for institutional investors. Find out how you can access quality office assets by clicking here.
Subscribe below to Market Watch to receive my latest articlesClaire Talbot, Fund Manager
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