OPINION: THE commercial office sector has certainly been a topical theme of late. Do recent trends represent long term structural changes or a short-term cyclical challenge that we’ve seen before? David Burgess, Co-Head of Real Estate at Elanor Investors Group, shares his latest insights.
Since the onset of the global pandemic, work from home (WFH) has been seen as a major structural challenge affecting the commercial property sector. But what is actually happening on the ground is distinctively different to the headlines you read in the newspapers.
Over the last two decades there has been a number of times where the death of the modern office has been called, but it has never eventuated. At one point, not too long ago, it was offshoring of local jobs that was considered a threat to office space. Then there was the thematic of densification where we were going to have more people working in smaller spaces. And, of course, the role of new technologies in making machines more effective than people. WFH represents just the latest in this ever-growing list.
But in looking at 50 years of total occupied stock data – (the total amount of accommodation leased) – office demand has only really pulled back at times of economic slowdowns, with the trend line rising in line with population growth and increased levels of white collar employment over time.
Syd, Melb & Bris CBD Total Occupied Stock vs White Collar Employment
Demand drivers
There are a number of reasons why we strongly believe WFH is not the structural headwind that many are forecasting.
Firstly, looking at data on workers returning to the office, it has tended to stabilise at 70-75 percent. Although, it is certainly the case that not all markets are the same. For example, return to work levels in Perth (91%) and Adelaide (85%) are relatively high compared to Melbourne, Australia’s most locked-down city during COVID-19, which is lagging at 56 percent.
Secondly, in diving into the data, total occupied stock in prime grade commercial property across all CBDs is actually at a higher level now than it was pre-COVID. That means the number of square metres leased is now higher than before the global pandemic across most capital cities. While there may be less people in the office, it has not impacted demand.
Thirdly, office rents continue to grow. This is textbook supply and demand economics. While the rate of growth in demand in the CBDs may have slowed a little over the last few decades, it has been matched by a slowing in the supply delivery which has adjusted to meet the slightly lower growth rates in demand. Add the fact supply has adjusted in response to slowing demand. The result, vacancy levels have consistently remained around an equilibrium vacancy rate of about 8 percent.
From a demand perspective, we don’t see the WFH trend having a major impact that will permanently reduce demand for office space.
Where are we in the cycle
If the changes we are seeing are not structural then the question becomes where are we in the current cycle?
Our analysis shows there is a high correlation between the office market cycle – or more precisely the cap rate cycle – and the inversion of the US yield curve.
What we see in our experience is that during each cap rate softening cycle, we’ve tended to have inflation spiking and ten-year bond yields increasing.
Although we’ve still got the cap rate softening, today we can see that inflation appears to have peaked and, while not certain, ten-year bond yields are also peaking. Historically, these are two preconditions that indicate we’re towards the end of a cap rate softening cycle.
Relationship of Cap Rate Softening Cycles with Inflation and 10 Year Bond Yields
To take this one step further, we looked at 50 years of data of previous cap rate cycles using Sydney CBD as a case in point. This shows there seems to be a very similar duration for the softening cap rate cycle, which tends to last approximately two years. What we also see during these softening cycles is the cap rate, on average, softens 30 percent – we’re currently at 21 percent.
What’s next?
What does all this mean? In our view, we believe we are currently tracking to the same trajectory of prior cycles. In other words, while we still have a little way to go, we believe we are 18 months through a two-year cap rate softening cycle based on those indicators and the historical data.
We are emerging into a zone where prime commercial office is becoming an attractive buying proposition; and that is certainly what we have heard over recent weeks from institutional buyers across the region. Australian office is very much back on the radar.
What makes this exciting for investors, is what happens when we emerge from this cycle. Based on past experience, the average 5-year return following a softening cycle is 10-13% p.a. when buying just after the peak.
However, as always, while we can learn from the past, every cycle is different. The nuance we see being different in this cycle is actually a favourable tail wind – very low office supply across the country. Rising construction costs, increased interest rates and the softening cap rate has made it difficult to make new office developments viable and so we are now seeing this impact both current and future supply looking ahead through to 2027.
WFH is no doubt a major change for employees, employers and the office sector. But we’ve seen many similar challenges over many decades. We expect to see in the next couple of years strengthening demand meeting with limited supply, fueling the next wave of rental growth and delivering strong total returns to commercial office investors over the next few years.
By David Burgess, Co-Head of Real Estate at Elanor Investors Group.
