Sydney & Melbourne offices sweet returns

IF Sydney and Melbourne office investments were a sweet, it would be Willy Wonka's Everlasting Gobstopper. According to Macquarie Real Estate Outlook 2007, strong rental growth in these markets shows no sign of loosing its flavour.

According to Macquarie Bank’s head of research Rod Cornish globally the office cycle is the strongest in almost 20 years in some markets and Melbourne has had the strongest three consecutive years of leasing demand in at least 35 years.

At the same time, Brisbane and Perth have experienced the lowest vacancy rates on record.

Cornish said it was only three years ago, the office sector was in the doldrums and there were even reports it would never recover.

“Despite the negative outlook, we took the opposing view, forecasting a strong office upswing. We have since been proved correct as investors enjoyed a thrilling ride. The question is now how much longer will it run for?

“We believe the strong leading indicators and demand drivers – the global economy, business conditions and the global share market will outweigh the moderating drivers – predominantly the slowing US economy – leading to a longer cycle than typically seen in the Australian CBD office markets.

These are some of Macquarie Bank’s “Crystal Ball” predictions.

Net absorption is expected to remain strong in Sydney certainly for 2007 and 2008. Whilst Sydney CBD office has lagged the resource influenced Perth and Brisbane, the state economy has started to turnaround and Sydney will improve and perform later in the cycle.

Net absorption is expected to remain solid through to end 2008, balanced against this is low supply. Sydney is constrained by a lack of available sites, with developers needing to demolish buildings pushing out the construction cycle even further.

“As a result rental growth will accelerate with strong business confidence and world economic conditions continuing to drive the market. That said, rents may not rise to the full extent they should.

“Despite the strong global economy, growth has been relatively soft compared to other markets, due to the weaker state economy. Yields have continued to firm but are still above prior cyclical levels. While significant weight of money has contributed, the yield/rent relationship still holds. With a stronger rental growth outlook, a further firming of yields is expected this cycle,” he added.

In Melbourne, where it is currently cheaper to get office space compared to Brisbane and Perth, continued new supply will to some extent counter balance the high levels of demand but stronger rental growth is forecast.

“We believe Melbourne could surprise on the upside. Demand indicators in Melbourne have been exceptionally strong but rents have been slower to react due to supply. Now this is starting to turnaround and while further supply is likely it won’t be to the extent of the last few years,”

“This alongside strong demand, although not at the exceptional 35 year highs we’ve seen recently, will support higher total returns to investors. With significant rental growth in Brisbane and Perth, Melbourne now holds appeal as the most affordable major office market in Australia,” Cornish said.

Melbourne’s net absorption will remain solid into next year but with a moderation in some demand drivers, such as business investment, will be felt from end 2008.

“We expect strong rental growth over the next couple of years. Yields are expected to firm further. Currently average prime yields are still above levels achieved at the peak of the cycle in the late

1990s. Analysis on a real basis with 10-year bond yields and rental expectations also highlights the scope for further firming,” Cornish said.

Nationally, the report said development will mark the next phase of the office cycle.

Cornish said investment yields have tightened, making it harder for listed investors to compete.

At the same time, in some markets, the scarcity of institutional grade assets together with exceptional rental growth is making development more feasible for investors.

Direct development by listed investors, such as LPTs and REITs, to bring on stock for a long-term hold will increasingly be a popular route to acquire assets.

“The strength of office markets has taken many developers by surprise and the construction cycle, apart from Melbourne, is taking place later relative to previous cycles.

“Additionally, until now, rents had not been at levels to make developments feasible. Construction costs have risen early in the cycle, driven by a previously strong residential cycle, powerful global economy and demand for resources,” he added.

According to Cornish, the office market is highly cyclical, with out performance in returns occurring every 10 years: at the end of the 1980s (1986-1989), at the end of the 1990s (1997-1998) and the current cycle (where total returns in 2006 edged ahead of the retail sector for the first time since 1998).

“And clearly, office performance still has further to run this cycle. While we are not expecting the office market to peak this year, there are typically certain signs that mark the next phase of the cycle that investors need to be alert to.

“Historically, there tends to be three to four years of strong demand in each cycle. With supportive global and domestic macro conditions, we forecast the office cycle to run for longer than typically evident presenting an opportunity to investors in some markets,” he concluded.

Australian Property Journal