Inner Brisbane Office Market Update Spring 2019

September, 2019

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The Inner Brisbane office market is performing well, with vacancy declining, rental rates increasing and yields tightening over the past year

Market Overview

This paper reports on the Inner Brisbane office market (defined to include the CBD and Fringe markets).

  • The Inner Brisbane office market is performing well, with vacancy declining, rental rates increasing and yields tightening over the past year.
  • The Inner Brisbane vacancy rate has declined considerably over the past three years. The reduction in vacancy has recently been the result of
    stronger leasing demand, particularly from the State Government, flexible office space providers and firms involved in major projects being constructed across Brisbane.
  • There is a large supply pipeline for the Inner Brisbane office market, with the majority of supply proposed for the Urban Renewal sub-locale of the Fringe market.
  • Rental rates have increased over the past year. Rents for B-grade properties have increased most significantly, with owners having been forced to improve building amenity to be competitive in the market and to meet tenant expectations.
  • The Inner Brisbane investment market had a strong 2018, with the second highest volume of sales recorded on a per annum basis (only behind 2013). Activity in 2019 remains strong.
  • Yields have tightened over the past year. Offshore investors have been setting new yield benchmarks and have been particularly active in the CBD market.
  • There has been a negative reaction to the new Foreign Land Tax Surcharge by foreign owners. However, we expect that demand will continue from these buyers given the fundaments for foreign investment demand in Australia remain positive.
Source: Property Council of Australia (Vacancy Rate – as at July 2019) & m3property Research (Avg Prime Gross Face Rents, Yields & Incentives – as at June 2019)

Authors

Casey Robinson

Director

View Profile > QLD
Michael Coverdale

Director

View Profile > QLD

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Key Influences

Cash Rate and Government Bond Rate

The low cost of debt and low returns on government bonds drive investor demand for commercial property. The official cash rate is likely to undergo another two cuts and bonds rates are expected to remain at low levels over the remainder of 2019 and beyond.

Inflation adjusted returns are stronger for property than other asset classes (such as bonds and equities) meaning investors are likely to increase their allocation of property within portfolios and decrease their allocations towards bonds, which currently have a negative net return if you hold the bond to maturity.

Business Confidence

Confidence in the corporate sector influences tenant decisions to relocate, expand or contract. Business confidence is currently weak and is expected to remain weak over the coming two years, largely due to concerns surrounding global economic conditions. This is expected to keep corporate Australia in a phase of cost-cutting.

Employment

Growth in white-collar employment boosts demand for office space. The number of persons employed in the core white-collar industries across Brisbane is expected to increase by circa 69,100 persons between 2018 and 2023.

The number of persons employed in White Collar industries is forecast to increase by 21.36% between 2018 and 2023 in Brisbane

Sources:
RBA (Cash Rate and Bond Rate)
IBISWorld (Business Confidence)
BIS Oxford Economics (Employment)

Notes:
Cash Rate and Bond Rate figures are five-year annual averages. The past five year figures represents the period from 2014 to 2018 (calendar years)
and the next five year figures is for the 2019 to 2023 period.
Business Confidence is a five-year annual average. The past five year figure represents the period from 2015 to 2019 (financial years) and the next
five year average is for the 2020 to 2024 period.
Employment data is for the Brisbane Region and includes the number of persons employed in the industry.

Leasing Demand

Leasing activity has strengthened over the past year, as evidenced by net absorption figures. The State Government has been a key absorber of space, as have co-working and other flexible office space providers and construction and engineering firms.

The public sector workforce continues to grow

m3property have tracked the relationship between State Government public sector employment and net absorption for a number of years. There is a moderately strong positive
correlation between the two factors, as demonstrated by the following chart.

Source: Property Council of Australia, Qld Government, m3property

The positive correlation between public sector employment and net absorption is logical. When the economy is strengthening, it is both likely that the public service will be growing and also that demand for office space will be stronger due to firms looking to expand or diversify their services. The relationship also highlights how sensitive the Brisbane office market is to increases or decreases in the footprint of the public sector.

The State Government was extremely active in the Brisbane office market over the past year signing a number of leases as well as lease renewals.

Flexible office space providers continue to expand

Flexible office space providers have continued to expand their presence in Brisbane, and this has been a key contributing factor to net absorption and declining vacancy over the past 18 months (particularly given the space absorbed by these firms has been through new space requirements, i.e. leaving no backfill space).

Some examples of new providers in Brisbane include major international chain WeWork (which now has three locations and circa 15,000 square metres of space in Inner Brisbane), Hub Australia, Christie Offices and Victory Offices.

Flexible office space providers typically seek locations that are close to public transport, often in character/heritage buildings, with high-quality fit-out, large floor plates and long-lease terms.

We expect that more space will be absorbed by flexible office space providers over the short-term. However, demand is starting to show signs of slowing, with active space requirements reducing and some requirements being put on hold (source: Property Daily).

Major infrastructure projects driving office demand

Construction and engineering companies have increased their presence in the Brisbane office market. There are numerous examples of companies contracted on the major projects underway across Brisbane increasing their office footprint or with a current requirement for increased space to cater for new projects. Some examples of this include:

  • Multiplex Constructions – has a requirement in the market for 1,200 to 1,500 square metres of space after being appointed as the Head Contractor for the Queen’s Wharf Development.
  • Transurban – recently signed at 300 George Street, doubling their floor space. Transurban are currently developing the Logan Motorway Enhancement and operate six roads / tunnels across Brisbane.
  • CPB Consortium – has leased 8,070 square metres of space in Milton. CPB was the winning bidder for the Cross River Rail project.
Co-working is a type of flexible workspace that allows the leasing of desks or private offices on a flexible basis.

The boundary between the CBD & Fringe is blurred

Following the trend of tenants moving from the CBD to the Fringe (circa 2013-2015) and then the reversal of this trend over the past few years, there now appears to be no clear trend in terms of which direction large tenants are
moving (although smaller firms still appear to be showing a preference for the CBD).

It is our view that parts of the Fringe market are becoming, in a way, an extension of the CBD market. This is particularly for parts of the Urban Renewal and Inner South markets which will benefit from new public transport
stations following the completion of the Cross River Rail project in 2025.

New development in the Fringe also often has the drawcard of higher-quality surrounding amenities, with new development often part of mixed-use retail, residential and entertainment precincts.

Lease renewals are increasing

After a number of years of the ‘flight to quality’ story, we are now starting to see the winds of change with an increase in the number of lease renewals, as a proportion of total leases. Renewing a lease is a prime example of corporate firms trying to cut costs in a time of weaker business confidence and conditions.

Our analysis of a sample of leases across the Inner Brisbane market shows that lease renewals increased from 13% (as a proportion of total leases) in 2017, to 18% in 2018, and circa 30% for leases struck in 2019 to date.

During the period of ‘flight to quality’, it was common for tenants to receive an incentive by way of new fit-out. For these tenants, who may now be approaching lease expiry, it is likely that their current fit-out is in an adequate
condition and still has residual value. Adding to this the down time and costs involved in moving offices, as well as the tenant’s current ability to negotiate an incentive in the form of a rental abatement that is comparable to what
is being provided on new leases, these tenants now have less inclination to move.

Tenants are reducing their footprint

Another trend that is often occurring alongside tenants choosing to renew their leases is the reduction of the tenant’s footprint. A number of factors are contributing to this trend, including:

  • Growth in Activity Based Working;
  • increased flexibility in employee working arrangements (i.e. staff working remotely);
  • Firms choosing to consolidate multiple offices; and
  • Growth in flexible working space options (which is providing organisations with the ability to expand and contract space requirements as required).

Some current examples of this trend are detailed below:

  • Arrow Energy is close to re-signing at 111 Eagle Street, however, is expected to downsize by 1,250 square metres.
  • Shell re-signed at 275 George Street, however, downsized by 1,300 square metres.
  • Cardno re-signed at 515 St Pauls Terrace in Fortitude Valley, however, downsized by 1,755 square metres.
  • Insurance Group Australia is close to re-signing at 189 Grey Street in South Brisbane, however, is expected to downsize by 1,780 square metres.
m3property Valuation: 201 Charlotte Street, Brisbane

Vacancy

The CBD, Milton, Spring Hill and Urban Renewal precincts saw a decline in vacancy over the past six months. The Inner Brisbane vacancy rate declined 131 basis points over the six months to be 12.55% as at June 2019.

Over the past 12 months, a key factor behind the decline in vacant space in the CBD and some Fringe sub-locales has been the expansion of co-working / flexible office space providers in the Brisbane market. Other key contributing factors include stock withdrawal, the expansion of the State Government workforce and space taken up by firms contracted to some of the major projects across Brisbane.

Supply

The Inner Brisbane supply pipeline has grown considerably and now includes over 25 projects at various stages of the construction and planning process. Projects under construction include:

  • 300 George Street, CBD – circa 7% committed to Transurban.
  • The Annex, CBD – no known commitments.
  • Mid Town Centre, CBD – circa 48% committed to Rio Tinto.
  • 80 Ann Street, CBD – circa 66% committed to Suncorp.
  • The Eminence, Fortitude Valley – circa 57% committed to Pellegrino and Mosaic.

Projects that are partially or fully pre-committed but yet to start construction include:

  • 470 St Pauls Terrace, Fortitude Valley (‘Jubilee Place’ Development) – circa 45% committed to Watpcac and
    IWG (Regus).
  • 11 Breakfast Creek Road, Newstead – circa 15% committed to John Holland.
  • 152 Wharf Street, Spring Hill – reported to be 100% committed to the ATO. Construction is expected to commence in the near-term with the development likely to be completed in 2021.

There are a large number of projects with approval or mooted for development over the longer term, however these projects are unlikely to proceed to construction unless they receive a significant pre-commitment. In saying this, there are some large space requirements in the market that could trigger the development of new stock. Major requirements include Sunsuper (13,000 to
15,000 square metres), Commonwealth Department of Human Services (35,000 square metres) and potentially Virgin Australia (12,000 square metres plus).

The strong investment market and significant yield compression has allowed new development to take shape, despite an extended period of subdued rental growth. It is
expected that the Urban Renewal precinct will contribute significantly to new supply over the medium-term. The economic rent for new development in this precinct is currently between $685 – $700 gross, in context of market-led incentives of circa 40%.

Inner Brisbane Vacancy Rate

Source: Property Council of Australia, m3property

Inner Brisbane Supply Pipeline
Source: Property Council of Australia, BCC PDOnline, m3property Research

Rental Market

Average gross face rents have increased modestly over the past year. Notably, the largest increase has been for B-grade tenancies in the CBD, with average rents increasing 4.55% over the year to September for this part of the market.

Source: m3property Research

Rental growth in the CBD’s B-grade market is partly a result of a number of buildings undergoing refurbishment works or improvements to end-of-trip facilities and amenities. Another factor is the high average incentive on offer, which is a drawcard for small Fringe and Suburban firms to move to the CBD.

Typical ranges for gross face rents as at the September quarter 2019 are shown below.

Source: m3property Research
m3property Valuation: Jubilee Place, Fortitude Valley Development

Investment Market

The investment market continues to perform strongly. During 2018 there was $2.8 billion of office buildings sold (sales over $5 million) in the Inner Brisbane market. During 2019 to date, there has been circa $1.45 billion of transactions.

Source: m3property Research
Note: Sales ending August 2019

Yields have continued to tighten, and it is our view that they are likely to tighten further over the coming six to 12 months. Over the short-term, property yields are expected to remain more attractive than some of the other major
asset classes (such as bonds and equities) and we expect that this will result in further investment demand for property, thus pushing yields down further.

Source: BIS Oxford Economics, m3property Research
Note: 10-year government bond rate shows end of period
Sep-19 forecast

Analysis by m3property Research shows a strong positive correlation between 10-year bonds and prime yields. The falling 10-year bond yield is generally associated with a fall in yields and this relationship typically exhibits a three to six-month lag from when the bond rate falls before the adjustment is shown in office yields.

The following chart shows the spread between the 10-year government bond rate and long-term average yields and current yields. The difference between the long-term average and current spread between yields and the bond rate currently ranges between 146 and 190 percentage points, indicating the possibility of yields declining further to be more in-line with the long-term average.

Source: BIS Oxford Economics, m3property Research

There is a strong positive relationship between 10-year bond yields and prime IRRs in the major property sectors. For prime CBD office IRRs, when a six-month lag is factored-in, the relationship is even stronger. The spread between prime property yields and 10-year bonds is currently close to its maximum differential that it has been over the past six years.

Foreign investors have driven yield compression

One trend in the investment market has been the strong presence of foreign investment groups in the CBD, yet a weaker presence in the Fringe. Since mid-2017, foreign investment groups have accounted for circa two thirds of CBD sales that have transacted at yields of sub
6%. Foreign investors are assisting in driving the yield compression, having set new benchmarks on a number of acquisitions. Examples of this are Rockworth Capital Partners’ acquisition of 100 Edward Street at a yield of 5.61% for a secondary-grade asset and M&G Real Estate’s 50% acquisition of 80 Ann Street at a yield of 5.00%.

The introduction of the new Foreign Land Tax Surcharge has the potential to deter some foreign investment in Queensland. However, we expect that Australia’s relatively stable policy and economic environment, the comparatively higher yields on offer in Australia (and Brisbane relative to Sydney and Melbourne) and the value of the Australian Dollar will still encourage foreign groups to purchase assets in Queensland, particularly once there is more certainty around the Surcharge.

Outlook

Investment Market

  • Yields are expected to tighten further during the coming 12 months as the bond rate remains at historically low levels and the spread between Brisbane and Sydney, Melbourne and offshore yields continues to encourage investment in the Brisbane office market. Following tightening over the next 6 to 12 months, we then expect yields to stabilise, however at the lower level.
  • The impact that the new Foreign Land Tax Surcharge will have on investment demand is yet to be fully determined. The initial reaction has been negative, however, with the State Government due to release its ex gratia relief guidelines over the coming weeks, this will hopefully provide more certainty
    regarding the Surcharge.
  • m3property expect that the fundamentals of Australia’s stable policy and economic environment, the relatively higher yields on offer (compared to what is available offshore) and the low value of the Australian Dollar will continue to work in the favour of foreign investor demand despite the introduction of the Surcharge.
  • Furthermore, given the new Foreign Land Tax Surcharge applies to trusts, companies or individual with at least 50% foreign ownership, we expect that
    acquisitions made via joint ventures between domestic and foreign companies will increase.
  • The increase in Land Tax rates (applicable to domestic and foreign buyers) will impact capital values over
    the short term.
  • The level of impact will depend upon the existing lease structure in place, as any increase in outgoings can potentially be recovered from the tenant. Ultimately
    this additional cost will be passed onto the tenant, impacting business confidence and further cost cutting by corporations. Moreover, It is difficult to predict how much (if at all) this additional cost will impact or disrupt rental growth going forward until existing leases expire and new deals are negotiated.

Supply

  • Supply will remain pre-commitment driven.
  • The next wave of commercial supply will, more than-ever, incorporate amenity, environmental considerations, wellness and a community offering. This trend will be driven by tenants and will encourage development in the Fringe sub-locales where there are larger land holdings available for development at a more affordable cost to developers.

Leasing Market

  • The vacancy rate is forecast to increase to circa 13.5% by the end of 2019. This increase will be the result of the completion of 300 George Street later this year. Vacancy is then forecast to trend downwards to be circa 11% to 11.5% by the end of 2021.
  • Rents are forecast to continue to nudge upwards over the short-term.
  • Incentives are entrenched in the Brisbane office market nowadays and we don’t expect this to change drastically. Whilst we expect they will trend downwards over the medium-term, we expect that they will stabilise when reaching around the 25% mark.
Inner Brisbane Market Balance
Source: Property Council of Australia, m3property Research