Chanticleer
The big property groups love talking about their premium assets. Unfortunately, they need markets to settle down before investors are willing to listen.
Get a bunch of big-name property CEOs in front of a room full of investors, and where does the discussion head?
You guessed it: office property.
When will the bloodshed stop? What’s happening with all-important capitalisation rates? What about lease incentives? Can second-tier properties be easily converted into something else such as apartments, or have their green credentials easily upgraded to create value?
Investors are trying to work out whether it is time to buy bombed-out office property owners. David Rowe
That’s where the discussion went at Citi’s annual investor conference in Sydney on Wednesday. Charter Hall’s office CEO, Carmel Hourigan, Mirvac boss Campbell Hanan and Dexus CFO Keir Barnes bore the brunt of the attention thanks to their respective office portfolios. Fellow panellist Elliott Rusanow from Scentre Group could only joke that he was glad he was an office tenant, not a landlord, in the current market.
While forecasting cap rates is fraught, Hourigan said they were probably headed higher in the next six to 12 months. “There will be some softening off that continues. I think the end [cap] rate is a bit higher as [interest] rates continue to move up,” she told the room of investors.
But as Hourigan and her fellow panellists were at pains to point out, not all office buildings are created equally, which is something we also heard a lot in the August reporting season.
In Sydney, anything between Martin Place and Circular Quay – the sorts of buildings where you will find most investment banks and law firms – is red-hot. Floor space is tight.
Charter Hall’s Carmel Hourigan.
Only three blocks west, there is available floor space in “abundance”, according to Mirvac boss Hanan.
Hourigan says it is the same story in Melbourne – she is focused on the east end of the CBD, while Docklands on the other end is where office owners are struggling to sign up tenants and having to offer big incentives.
“In the past, I think the language office players have used consistently is flight to quality, flight to quality, flight to quality,” Hanan says.
“What I would now say is it’s a flight to quality and a flight to location, and location becomes increasingly important in these environments.”
He says most tenants will move to a better location for the same rent – that’s the way the industry works. It’s cyclical; periods of oversupply create vacancy, which creates more lease incentives, which has traditionally drawn tenants into better office buildings.
Mirvac’s Campbell Hanan. Peter Rae
What happens to the buildings that are tough to rent and should be worth less, longer term? Can they be converted into apartments, for example, and meet demand in the residential market?
That’s where the conversation has headed in offshore markets.
Hanan says it is not as easy as it sounds. He says office buildings have big floor plates – basically a lot of space on each floor, which allows for a lot of employees – while residential buildings have smaller floor space to maximise window space; residents want at least one window per room.
He says it is also expensive to retrofit a building at a time when capital is more expensive than it used to be. So, an office building would have to be “incredibly cheap” for it to make sense financially, and valuations are nowhere near that level.
Why not? Because balance sheets are OK, which means there are not a lot of property owners having tough conversations with their banks and being forced to sell. Australia’s big property groups largely learnt from the global financial crisis, reduced gearing and locked in longer-term debt to provide a buffer in tough markets.
The other way office owners can add value is by boosting their buildings’ green credentials – and there are specialist investors and investment funds raised to turn buildings green.
But Hourigan says that is also “incredibly hard”. Not all buildings are suitable, values would need to come right down, and if it was so easy, then everyone would be doing it already.
But for now, investors are discounting just about everything across the office property sector, which tells you that interest rate uncertainty is the big problem, not location or even the impact of work from home.
That widespread fear about interest rates and where they end up has largely scared off investors en masse, which only maintains the buy/sell valuation gap that constipates activity, particularly at the top end of the market where we’re told space is tight, rents are strong and valuations should be high.
So what can investors expect in the near term? There will probably be more portfolio refining – similar to Dexus selling 44 Market Street in Sydney at a 17.2 per cent discount. Yes, it is a Sydney CBD office, but it is not in that core Martin Place to Circular Quay corridor so was sold.
Will that help close the gap between share prices and book values? Maybe slightly. But it is hard to see it reopen the deal floodgates or solve the valuation problem until the interest rate outlook becomes clearer.
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