Some major city office towers could take another 10 to 15 per cent hit to their valuations, making them the weakest links in a commercial property sector that remains under pressure from higher interest rates, Morgan Stanley’s Tim Church says.
“Office has probably got another 10 per cent or 15 per cent to go, particularly for some of the more challenged assets with poor tenancy profiles and in non-prime locations,” Mr Church, Morgan Stanley’s chairman and co-head of investment banking in Australia, said.
Morgan Stanley’s Tim Church says investors now prefer logistics over office buildings. Peter Braig
“When a sector is unloved, getting allocation to capital for it is really problematic.
“Put yourself in the place of the investment committee. There is no one sitting in an investment committee saying ‘I want to deploy more capital into office’. It’s the last thing they would do. They’d rather go into logistics.”
There has already been considerable carnage in the office sector as it grapples with a higher cost of debt – which has raised the return hurdle higher, forcing values lower – and weaker demand. Vacancy rates in Sydney and Melbourne are at near three-decade highs, while the work-from-home trend has created uncertainty over longer-term requirements.
Through the August earnings season, portfolio values overall for office towers held by ASX-listed property players fell about 6 per cent for the June half, taking the 12-month decline to 7.9 per cent, according to Morgan Stanley analysts.
But valuations on some deals in the direct market have registered even sharper falls. Three weeks ago, a prominent Sydney office tower at 1 Margaret Street was sold for $293 million, a 16 per cent discount to its previous book value.
Reluctant sellers and opportunistic buyers are in a stand-off over pricing. The stalemate has put a hard brake on major deals, and the volume of office tower transactions has slumped by three-quarters to $4.9 billion in the year to date. The bid-ask spread for major office assets is at a record 30 per cent in Sydney and Melbourne, according to MSCI.
And yet, there could be more pain to come, especially in the office sector, Mr Church says.
The veteran banker, who began his working life as a cadet valuer in the property sector four decades ago, will set out a sobering outlook for the commercial property sector at The Australian Financial Review Property Summit on Monday in Sydney.
That outlook is informed by an expectation of rates remaining higher for longer, which would put pressure on asset values in commercial property unless they can be offset by rental growth.
“With inflation still bubbling along, we’re going to linger for longer at those rates. We’re not going to see this rapid decline back to near-zero interest rates. We’re going to have these elevated rates for a while,” Mr Church said.
“With persistently high CPI – that is above RBA consensus – the challenge will be that elevated rates linger for longer. It means the bounceback won’t be as quick.”
Since a peak of 17.5 per cent in early 1990, rates have trended down to a low of 0.1 per cent during the pandemic, giving strong support to property returns, which Mr Church likened to a downhill ski run.
“We’ve had 33 years of downhill skiing. We’re now at the bottom of the chairlift. The chairlift is broken, the skis are off, and we’re climbing up a mountain in our boots, and it’s really hard work. And guess what, we haven’t hit the slopes yet. We’ve got a bit of pain to go,” he said.
That outlook – which Mr Church dubs “the big chill” – is nevertheless leavened with some notes of optimism, as top tenants make a beeline into a CBD core of prime offices, which command higher rents. Broader trends through commercial property are also apparent, as the market capitalisation of industrial giant Goodman swells, overtaking that of Westfield owner Scentre, while that of Dexus, a major office tower owner, has also fallen, compared with pre-COVID.
Further ahead, Australia’s strong migration rates coupled with growing amounts of undeployed private capital – local super funds alone are forecast to manage $10 trillion by 2040 – will remain strong drivers for real estate.
Amy Pham is a portfolio manager at Pengana Capital Group. Louie Douvis
Pengana Capital portfolio manager Amy Pham, who oversees a high-conviction property securities fund, agrees the commercial property market is in a new era. It follows three decades of falling rates underpinning cap rate compression – an industry metric that signals tighter investment yields, which conversely push up prices.
“Now that easy money is gone. We are in a new investment paradigm whereby it’s going to be higher for longer,” she said.
“You’ve got to be in a sub-sector that has favourable drivers in order to offset the cost of debt.”
Logistics ticks that box for Ms Pham as does some retail, where lease structures set rental growth above inflation. So do so-called alternatives – such as healthcare and childcare assets, data centres, retirement villages and build-to-rent – which benefit from secular trends and address the necessities of daily life.
“In an environment where you’ve got these headwinds coming through, what you want is resilient earnings,” she said.
David Harrison, who leads property fund manager Charter Hall, is more sanguine about the office outlook, noting that asset values do not usually fall to the levels implied by the discounted stock prices of their listed owners.
Charter Hall’s David Harrison.
“In every downturn few if any really modern prime buildings ever trade. Only the ‘old boilers’ are going to be sold and surprise, surprise, the old boiler buyers want to appear to be buying at discounts. Whether they really are discounts or fair value or even above fair value, only time will tell,” he told the Financial Review.
“My view is that if you’re in a tough sector like office, stick with modern longer WALE [weighted average lease expiry] assets where market rent growth is likely. Stay away from older assets that need huge capex to avoid obsolescence.”
Mr Harrison also said fewer modern offices would be developed in the current cycle, helping to reduce vacancy rates and supporting demand for the top towers.
“New and modern buildings will have very high occupancy towards 98-100 per cent, whilst older buildings that have not been upgraded will struggle to get above 80 per cent occupancy and some will be demolished or converted for residential and hotels.”
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