The Valuers' View - Office Property

March, 2021

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The Valuers’ View

To assist lenders, investors and owners, the Valuers at m3property have contributed their opinions on the current performance of the property markets and where they expect those markets to head over the short to medium-term.

The survey examines nine property sectors, looking at the key measures of market yields, internal rates of return (IRRs), rents incentives and value. Occupancy rates and average daily room rates were added to the survey for the hotel sector. Indicators including zeros indicate stability was also selected by respondents.

The key themes that will drive the real estate markets in 2021 will be:

  • Economic recovery as restrictions ease and confidence returns

  • Low population growth, but likely to rise as the vaccine rollout continues and borders re-open

  • Record low interest rates

  • Continued focus on Environmental, Social and Governance (ESG) factors when investing and managing portfolios

  • Growth in inflation resulting in rent growth for landlords, where rent increases are linked to inflation

  • The gap between prime and secondary yields is likely to widen

  • Government spending to remain high, despite stimulus starting to reduce

  • ‘Flight to quality’, flexible terms and convenience expected to continue to drive tenant demand

  • Rebound in investor demand due to cashed-up investors, low cost of debt and global interest in strengthening countries with stable property returns

  • Continued investor focus on defensive assets, particularly in sectors with government backing and for properties with long WALEs and minimal need for capital expenditure

  • Despite strengthening residential markets, the official cash rate is likely to remain on hold in the short  to medium term due to continuing economic uncertainty, low wages growth and labour markets not being at full capacity. The appearance of an asset price bubble is more likely to be remedied with macro-prudential constraints on lending rather than rising interest rates, which could derail the economic recovery if used too early.

  • If the post-COVID-19 economic recovery does surprise on the upside resulting in asset price bubbles, full employment and rising wages, this would drive up inflation, bond yields and the cash rate. This scenario would represent a risk to the property markets as it could flow through to the cost of capital and yields. That said, the RBA is likely to continue to implement yield curve control to keep bond yields in line with the economic recovery and a strengthening economy would provide stronger cash flows and vacancy would reduce.

Authors

Andrew Duguid

Managing Director

View Profile > NSW

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Office Property

Office occupier demand slowed significantly over 2020 and is expected to remain weak over 2021.

Investor and tenant ‘flight to quality’ is expected.

Yield tightening is expected for prime assets over 2021. With yields for secondary assets likely to soften, the yield spread is expected to widen.

Office Results

 

 

Yields

  • As predicted in the last Valuers’ View survey, the yield spread between prime and secondary assets has widened as risk was re-priced. Further widening is expected over 2021.
  • Yields on assets with secure cash flows and long weighted average lease expiries (WALEs) are likely to hold in the short-term and may tighten as confidence improves.
  • Secondary office buildings are showing an increased risk profile given the combination of tenants’ “flight to quality”, rising levels of backfill space in many markets, plus lower grade tenants’ limited ability to meet their rental obligations. The latter may be exacerbated when JobKeeper and the ‘Code of Conduct’ are wound up on March 28, 2021. Secondary stock with strong tenancy profiles, however, are likely to see yields stabilise.

IRRs

  • Prime and secondary IRRs have tightened over 2020 as a result of the lower cost of capital, property prices largely holding and the rental growth rates and incentives having softened.

Rents and Incentives

  • Rent risks are on the downside with some Valuers predicting a slight reduction in face rents over 2021. Secondary buildings have already witnessed a face rent decline in some markets while prime rents have generally been stable.
  • Overall, the Valuers expect incentives to be adjusted more than face rents resulting in a continuation of effective rent decline in 2021.
  • Incentives are rising across most markets as owners attempt to hold face rents steady.
  • In some markets, secondary incentives have been relatively low. They are therefore expected to increase further than prime over 2021.
  • With office markets, factors that could come into play include:
    • return to work changes to office layouts to accommodate staff safely and more flexibly;
    • vacancy levels due to the loss of some businesses and increasing sublease space;
    • likely backfill space created by pre-COVID-19 projects reaching completion; and
    • impact of delayed developments in a time of decreasing demand.
  • Higher vacancy levels and longer downtimes will result in incentives increasing.

Values

  • Prime assets with strong income security are likely to maintain their value or show some growth over 2021.
  • Secondary values are expected to decrease moderately. Assets with poor tenant profiles and in secondary locations are likely to experience larger declines in value.