Office REITs: Focussing on what we know

July 31, 2020
Office REITs: Focussing on what we know

COVID-19 has brought with it widespread shutdowns that have required many Australians to work from home. Is a perfect storm brewing in Australia’s Office REIT sector? In this note, Dion Hershan, Head of Australian Equities, looks at the outlook for the domestic office real estate market. 

No-one ‘knows’ the future demand profile for Australia’s office market in a post-COVID world. Uncertainty has probably reached peak levels and there a wide range of potential outcomes. That being said, the book-ends (a return to normal conditions vs permanently dispersed workforces) appear unlikely.

We think it’s more useful to instead focus on what we ‘do’ know. Here are the pertinent facts:

  • Vacancy rates pre-COVID were hovering at around 30-year lows in Sydney (5.0%) and Melbourne (3.4%) – what in hindsight had been a bull marketi;
  • The ‘tightness’ had caused a surge in net effective rents, with Sydney up +86% (13.3% 5-year CAGR) and Melbourne up +52% (8.7% 5-year CAGR)ii (refer Chart 1);
  • Valuations (i.e. cap rates ) have firmed in the past five years, as the ‘reach for yield’ has driven demand for prime office assets. Over that period, cap rates in Sydney have declined 180 bps to 4.5%, while in Melbourne they have fallen 190 bps to 4.8%;
  • High asset prices (having doubled in the past five years) were running at 2-3 times the physical demolition & construction replacement costiii (refer Chart 2), and;
  • Construction activity has picked up markedly in response. Supply is set to grow at around two times the long-term growth rate from CY20 to CY22 (refer Chart 3).

In summary, unlike shopping malls (where the trend to online retail has now accelerated), the office market appeared to have everything going right for it before the onset of COVID-19. The pandemic’s impact has exposed major vulnerabilities, however, which remain poorly understood.

The key variables determining the future demand profile are simple to call out, but very complex to accurately forecast:

  • Unemployment (negative)
  • Business failures (negative)
  • Work from home (negative)
  • Social distancing/work space ratios (positive)

As equity investors, we remain underweight the REIT sector (-430 bps active). Uncertainty for the Office REIT sub-sector will take some time to resolve, but we think the asset class will fall further from the peak, with the depth and speed of rental and asset value declines to surprise on the downside.


[i] JLL, Macquarie Research, YCM: Sydney and Melbourne CBD Prime (Premium + A-grade) vacancy levels as at 31 Dec 19
[ii] Ibid: Net effective rents include incentive levels. 5-years ending 31 Dec 19
[iii] Colliers, Goldman Sachs Research, Quantity Surveyor: Premium Sydney Replacement cost Dec 19, approx. $27,000/sqm includes $9,000 demolition & construction, $14,000/sqm land, $4,000 other (finance, leasing)
[iv] JLL, Macquarie Research, YCM: including data up to 30 June 2020
[v] ibid: including data up to 30 June 2020
[vi] JLL, Macquarie Research, YCM: supply numbers are shown on a net basis