Billions of dollars are up in smoke in the office heartlands of Australia's biggest cities after workers fled to escape the spread of the deadly COVID-19 virus, leaving investors wondering if the sector can ever regain its reputation as a defensive yield play.
At the start of the year, office property looked like a great place to invest. Top office real estate investment trusts (REITs) enjoyed strong demand for prime office space, higher income and a robust pace of capital growth.
Millions of square metres of prime office space attracted near-record rents as vacancies hovered near record lows in Sydney and Melbourne.
Dexus, GPT and Charter Hall were just some in a sector where deals had just hit a new high of $22 billion, as offshore buyers drove mega-deals in Melbourne and Sydney, while Perth and Brisbane were rebounding from a long downturn.
But when workers were forced home at the end of February as the pandemic hit like a wrecking ball, the market reaction was both swift and savage. REIT market capitalisations were cut in half as investors panicked about the end of the glory days of the central business district.
The ASX A-REIT index dropped 49 per cent from its peak on February 20 to its trough on March 23. It has managed to claw back about half that drop in the weeks since.
The index includes both retail and office property, and the office REITs are struggling to recoup their losses as they battle the perception that office life has changed for good. Abacus Property Group and GPT Group are up about 30 per cent off the March low, lagging the overall advance for the sector.
YIELDS STILL ATTRACTIVE
Believers in office REITs point to yields. Despite this year's battering, expected yields from leading REITs range from 5 per cent to 8.5 per cent, which compares very favourably to the 10-year government bond yield of 0.87 per cent and the Reserve Bank of Australia cash rate of just 0.25 per cent.
“That still makes it a very attractive yield compared to other asset classes, such as cash, term deposits and fixed income,” says Damian Diamantopoulos, portfolio manager REITs and head of property research at Australian Unity.
“But the billion-dollar question the market is grappling with is whether distributions are to be believed, going forward, and whether the risk is already priced into listed stocks,” says Diamantopoulos, before adding: "I think it is."
Behind that question is a debate about whether these factors have changed forever: the volume and value of transactions, investment – and disinvestment – activity, demand for office accommodation and its impact on occupancy, development pipelines and pricing.
Listed funds with a high exposure to office property include Charter Hall Long Wale, Dexus Property Group, Abacus Property and GPT Group. Managers offering specialist funds include Australian Unity and Centuria Capital Group.
Listed property conglomerate Mirvac, known for its residential expertise, manages more office space than some of the specialist trusts.
The GREAT WFH Experiment
The COVID-19 shutdown and forced experiment that's led to millions of employees working from home are causing managers and investors to scratch their heads about the future role of offices, how to value them and measure productivity, rents and income for landlords.
Some technology companies, such as Twitter and Facebook, which have sophisticated digital networks, have told staff they don’t have to return to the office and can “work from home forever”.
That won’t work for every company. Before the pandemic, other technology companies such as IBM and Dell, which had championed remote working, started bringing their employees back to the office because they consider collaborative relationships are better than going solo.
“There is a lot of talk about the future of office accommodation. All tenants are reassessing their options,” says Daren McDonald, a partner at ShineWing Australia, an accounting and property consulting company.
“Many organisations are claiming that remote working and working from home has been successful and are assessing their future needs,” McDonald says. New distancing rules will also reverse the recent trend to greater worker density, hot-desking, open plan offices and shared spaces, he says.
Selina Short, managing partner for EY Oceania real estate and construction practice, says proposed social distancing rules mean 70 per cent of staff will not be immediately returning to an EY office, which could eventually mean finding more space while rethinking existing office configurations.
Short also says there has been a double-digit improvement in productivity since the shutdown, partly because EY is a management consultancy and clients needed more advice about what to do.
She says while employees with jobs that require a computer and internet connection have been successfully working from home for decades, more tolerant management attitudes are accelerating the trend, particularly with working mothers.
Steve James, chief executive of Teachers Mutual Bank, which has 200,000 members and assets of more than $7 billion, also says productivity increased during the pandemic.
“We are absolutely considering the future mix of office and home work,” says James, who has 610 employees, 570 full-time. About 90 per cent have worked from home during the pandemic.
The GREAT WFH Experiment
But Dugald Higgins, the head of real assets and listed strategies at Zenith Investment Partners, an investment consultancy, says: “We like the ability to work from home as a one-off, say for two or three months. But it will be interesting to see whether people feel the same way in 12 months' time. Working from home is not optimal for everyone.”
Long-term office investors have routinely experienced big hits. Massive oversupply triggered a property crash in the late 1990s, while 10 years later, a credit crunch in the wake of the global financial crisis caused dividends and yields to plummet.
“The office property market is very cyclical, even if the period between downturns of around 10 years is very long compared to other sectors,” says Shane Oliver, head of investment strategy and economics and chief economist, AMP Capital.
Global investment bank Goldman Sachs warns there are unique features to this downturn, unlike crises triggered by financial collapse and oversupply.
“There is a wide variation in the industry exposures to the virus, with physical constraints on spending, occupational health risks, and geographical variation in the outbreak affecting industries differently,” it says.
Australian Unity's Diamantopoulos notes the shutdown and associated hit to economic activity is resulting in office tenants – mainly with turnovers of less than $50 million – applying for rent relief from landlords.
“The impact to landlord incomes will come to light over coming months,” he says. “Importantly, listed office landlords remain in strong capital positions, with well-diversified tenant bases, able to manage through this transitionary phenomenon, with the risk more than priced in for many stocks.”
AMP’s Oliver adds: “Lower demand for office space in the short term associated with higher unemployment at a time of increasing supply in Sydney and Melbourne over the next few years will weigh on rents, and so rents could have 15 per cent or so downside weighing on underlying capital values in the short term."
The fall could be a bit less in other cities and the return of some workers to offices will help head off an even worse scenario but, given more stringent health and safety requirements post-pandemic, the return will be a slow process.
“And the medium-term outlook is affected by two cross-currents flowing from the coronavirus shock, with more likely to be working from home resulting in less space demand, but the need to allow for more space per person in offices for health reasons resulting in more space demand,” says Oliver.
“It is a really difficult one to unpick,” adds Zenith’s Higgins. “Everyone is grappling with what a return to work looks like. That’s put everyone’s earning forecasts out the window.”
RETURN TO WORK
About two-thirds of employers allowed employees to work from home before the crisis, so the issue is largely scale and configuration. Scenarios being considered by top analysts, fund managers and property managers include:
- Configuration of offices, role of head offices, leasing arrangements and the need for back-up locations for critical business.
- Office space to ensure some level of comfortable density that limits transmission of disease, which could lead to greater flexibility and possibly more office sites.
- Remote offices away from the head office where employees can drop in between seeing clients, or to meet clients.
- Qantas Club-style offices based in convenient locations where employees can drop in. Corporate tenants are also likely to require greater flexibility in leasing arrangements to accommodate more employees for special projects.
- Offices in locations with increased parking to allow employees to drive to work because of crowd constraints on public transport leading to increased decentralisation and the greater appeal of fringe and metropolitan office locations.
- A big increase in the growth of flexible accommodation spaces, such as Regus and WeWork, which provide shared workspaces.
- Wider corridors with one-way foot traffic, better air filtration, touchless elevator controls and video conferencing, even with the office, to minimise the use of meeting rooms.
“Everyone is still feeling their way,” says Higgins, who suspects distributions could yet fall anything from 20 to 50 per cent for some REITS. “The path out is uncertain."
Investors, fund managers and analysts have been in "flight to quality” mode, which means favouring REITS with managers experienced in change, good balance sheets, sustainable yields and low asset risk.
That increases the attractiveness of diversified blue chip trusts whose underlying assets have long leases, such as Charter Hall Long WALE with average leases of more than 14 years, or AMP Capital.
Grant McKenzie, a senior portfolio manager with Freehold Investment Management, who manages about $500 million in office investments, says there is “good value” in the sector, particularly compared to beleaguered sectors, such as shopping centres and retail.
“The virus has been overly priced in,” McKenzie says. “Dexus Group is the standout because of its high-quality portfolio, conservative balance sheet and quality tenant covenants.”
AMP's Oliver says it is hard to know which of the “cross currents” – more people working from home leading to less space demand or the need to allow more space per person – will dominate.
“But the good news is that REIT values have already moved to reflect this with the sector as a whole losing almost half its value into its March low and, despite a recovery, is still down around 25 per cent in value,” Oliver says.
“As a result the market has more than allowed for a lower profile for rents. As such, based on current valuations, investors can expect distribution yields of around 5 per cent over the medium term,” he says.
Source: Originally published by Duncan Hughes in the Australian Financial Review on May 30, 2020.