Finding value in commercial property

17th May 2018By: Switzer

Broad macro-economic factors, like the overall health of the economy, interest rates, population growth and investment in infrastructure, just to name a few, affect all real estate markets. In addition to these broad factors, there are specific dynamics at play which influence returns in metro markets and help explain the value differential between CBD and non-CBD property assets. Understanding this differential and investing accordingly is key to success in metro markets.

Sydney and Melbourne’s CBD spill-over

When demand in CBD markets is strong, vacancies fall, and rents begin to rise. In most cases this phenomenon prompts some rent-sensitive tenants to move from CBD office property to metro markets, driving demand in these markets.

This is exactly what has been happening in the past few years in Sydney and Melbourne, as population growth and infrastructure spend have driven CBD values up and increased the relative attractiveness of metro office markets to occupants.

According to the most recent data released by Colliers in their Metro Office First Half 2018 report, investment returns in metro office markets are at their greatest levels in over ten years, and annual effective rental growth in North Sydney, St Leonards and Chatswood in Sydney, as well as St Kilda Road and the Melbourne City Fringe has been particularly strong, over 15% p.a to March this year.

At the same time, the ongoing theme of withdrawal of office stock for residential conversion has seen supply in both CBD and metro markets fall, and the significant investment of the State Government in infrastructure has added to the attractiveness of metro markets. It is likely that Sydney’s North Shore and St Kilda Road in Melbourne will be major beneficiaries.

Rents in the premium end of the CBD market are now at levels of $1000 per square metre or more, again pushing more tenants towards metro markets, particularly as the Sydney Metro Rail development is likely to improve CBD access.

Parramatta fully priced, lower north shore offers more

The south and southwest of Sydney, Liverpool and Blacktown have been major beneficiaries of government investment in infrastructure and the push to move government departments from CBD locations into the less expensive metro markets.

Looking forward we expect this trend to continue in line with population growth, and new development is already flowing through, particularly in Parramatta, which has been a major beneficiary of de-centralisation.  In fact, according to Colliers, Parramatta is currently more tightly occupied than the Sydney and Melbourne CBD markets, a situation likely to continue until 2019-2020.

The flipside of increased demand is rising prices, so finding value has become more difficult in some markets. In our view, Parramatta is now fully priced, and other metro markets, like St Leonards on Sydney’s lower north shore, offer more opportunities and upside.

St Leonards has struggled over the past few years as office space was removed for residential conversion – negatively affecting the residential/office mix and making the market less attractive to office tenants. Looking forward however the story is more positive. Residential conversion has slowed and the redevelopment of Royal North Shore hospital has led to a re-positioning of the area as a health hub – in 2019, the NSW Department of Health will move to the area.

According to Colliers, demand for space in St Leonards is becoming apparent, and in the six months to end March 2018, St Leonard’s vacancy decreased from 12.6% to just over 11%. B grade buildings experienced the largest growth in net face rent, 18.8% over the same time period. Our expectation is that this theme of declining vacancies will continue.

Queensland is showing green shoots, but has a way to go.

Queensland metro markets have not done as well over the past year as narrowing rent differentials between CBD and metro markets prompted tenants to move from outlying markets into the CBD. The result has been rising vacancy rates and downward pressure on rents in metro markets – and it’s fair to say that until rents move up in CBD markets, metro markets will remain less attractive from a price perspective.

At the same time, there are opportunities for asset-specific buying, even in the weaker pockets of the market.  As an example, Centuria’s unlisted funds division recently purchased an office asset in Nundah. This property is 100% occupied, 81% by the Queensland Government, and has an overall WALE of 9.4 years. The distribution yield is expected to be 6.5% this year, increasing to 7% the following year – proof that strong returns are possible from the right asset.

There is some evidence in fact that vacancy rates have peaked and will begin to fall over the next few years. According the Property Council of Australia, net absorption hit a record of 86,000 sqm for the 18 months to July 2017, and increased transaction volumes and further yield compression is expected. Backing this up is the number of recent transactions in Brisbane CBD, fringe and suburban markets.

Canberra has greatly improved

Property investors have historically classified Canberra, both CBD and metro areas, as non-core, given that most corporations operate satellite, rather than permanent offices out of this market.

Over the past few years however, there has been significant investment into Canberra on the back of growing demand for private sector consulting to government. Large service providers like PwC and KPMG have opened significant offices and the result has been a pickup in demand, falling vacancy rates and upward pressure on rents in the Canberra metro market.

In addition, there has been a significant uptick in occupier demand from smaller consulting groups servicing the Federal Government, who typically can’t co-locate in properties also occupied by the Federal Government. The Centuria Metropolitan REIT’s assets at 54 and 60 Marcus Clarke Street, Canberra, have been direct beneficiaries of this trend.

To the south, Adelaide screens as one of our best value states  

Adelaide is a stable, income driven market that can offer investors opportunity for capital growth when driven by a capable asset manager – and there are plenty of positive indications on the market.

Recent elections that ended the 16-year reign of the Labor Government may generate positive attitude towards future business investment in Adelaide. Businesses may also be attracted to Adelaide as it is leading the field in connecting the city core with a super high-speed internet line, and we expect this will drive back office investment and creative and digital investment in the market.

Additionally, property investors are attracted to SA as it’s highly proactive in reducing the barriers to entry for real estate owners by stepping down stamp duty considerably over a three year period (ultimately to zero). All of these factors contribute to our current view that Adelaide is showing some of the best value in the country, making a strong case for inclusion in a diversified portfolio such as CMA, or where we see opportunities in an unlisted syndicate.

Highlighting this approach is our asset at 1 Richmond Rd, Keswick; a five-level office building  3.5 kilometres southwest of the Adelaide CBD. When we acquired this building from the SA Government there was a significant (50%) impending vacancy, as the key tenant prepared to move.

To make the asset attractive to tenants, we arranged a refurbishment of office spaces, lobby and painting, and these improvements enabled us to lease the majority of the space to a high quality new tenant, the Naval Group, with no downtime. The asset is now 100% occupied, with the Naval Group having extended its lease and further leases to SA Power. The asset has a WALE of four years, and highlights the importance of an active management approach in markets with more shallow tenant pools.

To our west, Perth may finally be on the up and up

The big debate around Perth is whether it has hit the bottom of the cycle. In our view it’s certainly bottomed, with clear evidence of a green shoots recovery in progress, which makes it an attractive countercyclical market. Perth swings rapidly, so investors looking for a property to deliver capital growth exceeding inflation should look for a WALE to carry the property through any further cyclical turbulence.

At the same time, in what has been the weakest of all CBD office markets, rents remain under pressure, but yields are now holding up. According to Colliers, there is more stability in the market and vacancy rate rises are moderating.

However, there are definite indications that economic fundamentals are improving. Unemployment statistics were positive in the second half of 2017, and further improvements are expected as more positive data comes out of the mining sector. The general feeling about mining and resources is more cautiously optimistic than it has been, and some larger corporations, like Chevron, which had been shedding large numbers of staff over the past few years, are starting to employ again. This is good news for office space.

Given our view that we are near the bottom of the cycle, CMA recently purchased two office assets in Perth; both 100% leased with long WALEs to institutional grade tenants, including the West Australian Police and IAG Limited.

Asset specific buying can offset weak market fundamentals

Our investment strategy hinges on identifying properties which will perform for investors –in terms of yield as well as the potential for capital gain. In this respect we are market agnostic in the belief that even weaker markets offer opportunities for an astute buyer and active property manager.

When assessing properties we take current market fundamentals and outlook into account, but in terms of individual properties, there are a number of factors we seek to assess.  These include :

The weighted average lease expiry (WALE) of the property.

Whether a long or short WALE is more attractive depends on the plans for the property.

There are two instances in which a short WALE can be attractive. The first is when the intention is to develop the property, in which case vacant possession early can be a good thing. The second is where we believe the market is undervalued but improving. If this is the case, then a short WALE offers more opportunities to actively re-lease space as it becomes vacant at higher rents and on more favourable terms.

Where the intention is to buy and hold an asset, a long WALE is generally a positive because it provides reassurance with respect to rental income.

The tenant profile.

A long WALE is one thing, but a long WALE to a Bluechip tenant, like the State or Federal Government, for example, is even better. In addition, tenants who require specialised and expensive fitouts, like the police force, for example, are likely to sign a long lease and remain committed to the property.

At the same time, because we actively manage our property assets with a focus on improving rental income and the potential for capital gain, a property with a short WALE in an improving market can provide scope for improvement through leasing as well as upgrades.

Properties which are fit-for-purpose.

This sounds self-evident, but it is an important concept in metro markets.

Metro markets typically have smaller tenants, which don’t necessarily require, or want to pay for, the kinds of amenities and function that is expected in premium office space in CBD markets. Smaller tenants – in many cases service providers to the immediate local area – look for a property which suits their needs, in a location best suited to their customers; and one that is well-run and well-maintained.