The Australian Financial Review had a terrific story on its front page this week about falling office values. The story Crunch Time for Office Values noted falls ranging from 10-17% for recent sales of prime Sydney and Melbourne office towers.
Headlining the fall was Dexus’s finalisation of the sale of an A-grade office in the Sydney CBD at a 17% discount to its book value in December. The magnitude of the fall prompted fears of further large asset write-downs across the property sector.
A wave of downgrades seems likely as large, listed office managers finalise valuations for their office towers at 30 June. Expect more gloomy headlines about the state of commercial property as interest rates rise and recession fears grow.
It was hard to disagree with much in the AFR report. But the key question is how much of this deteriorating outlook is already reflected in falling A-REIT valuations.
For over a year, several fund managers I know have expected a downturn in office valuations as interest rates rise and the work-from-home boom pressures vacancy rates. They avoided buying A-REITs, believing their Net Tangible Assets (NTA) had to fall.
Also true is the market consensus underestimated the extent of interest rate rises in this cycle. More economists have recently lifted their forecast for the terminal (peak) cash rate (some seeing it going as high as 4.85%) as inflation remains elevated.
So, it’s possible that fund managers who were bearish on commercial property were not bearish enough. So, too, property owners (particularly those who are unlisted) that have not sufficiently lowered the NTA of their properties and now must play catch up.
Again, it gets back to price. Several large A-REITs are trading sharply below the consensus price target from brokers. The consensus targets will surely fall as offices values fall, but analysts have already factored in a deteriorating outlook.
That’s not to say A-REITs won’t continue to underperform. Or that contrarians should snap them up today. My sense is to watch and wait for better value as A-REITs release all the bad news after June 30 values are finalised – and even more gloom abounds.
I still believe Australia will narrowly avoid a recession or at worst have a mild technical recession (two quarters of negative GDP growth). With record migration and a still low unemployment rate, I can’t see the type of savage downturn than sparks a commercial-property meltdown that investors who were around in the early 1990s will remember.
I also think this work-from-home trend – a new workplace right in the eyes of some employees – has gone too far. I suspect many more workers will return to CBD offices this year, either permanently or for more of their working week. Some big-four banks have recently asked staff to spend more time in the office. Anecdotally, I hear about friends working less from home and more in the office. Some initially objected to requests to return the office, but soon caved in.
This trend will quicken for four reasons. First, Australia’s productivity growth is woeful. Second, companies know they lose something when staff work remotely. Again, not all organisations, but enough to require staff to return to the office en-masse.
Third, the bargaining power of workers will ease as higher interest rates bite, unemployment rises and corporate profits slow. Saying yes to remote work was easier when companies were desperate for staff, and it was an employee’s market. That won’t be the case in the next 12 months as Australia’s economy teeters on recession.
The fourth reason is employees. My hunch is the novelty of working from home will wear off, at least for some. Years of home-based work is hard work. More employees will realise the best thing for themselves – and their career – is a return to the office.
Travel data in New South Wales and other states now shows more people returning to the CBD each day. It’s still below pre-COVID-19 rates but climbing higher.
The S&P/ASX 200 A-REIT Index has now underperformed the market over three, five, seven and 10 years. But experienced contrarians know the best time to buy is usually when bad news peaks and the market overreacts. That could be the case in the next few months for A-REITs.
Fast forward 12 months and we could be talking about interest-rate cuts, a mild technical recession (or none at all) and many more people returning to the office.
If that happens, today’s valuations for Dexus, GPT, Mirvac, Charter Hall Group and others with prime CBD office exposure could look interesting in hindsight.
This opportunity suits long-term investors: a recovery will take time. But prospective investors are arguably paying bottom-quarter valuations for a sector badly out of favour.
Here are two office A-REITs to consider over the next few months:
- Dexus (ASX: DXS)
The office sector accounts for 72% of Dexus’s $17.8 billion property portfolio. Industrial comprises 24%. Under 1% is in the challenged retail-property sector. Prime offices in Sydney dominate the Dexus portfolio (about 95% of its property is classified as prime or A-grade). These high-quality properties typically hold up better during economic slowdowns.
Dexus’s average occupancy rate has consistently outperformed its market since 1999. If anything, the gap widened during COVID-19 as the well-run Dexus continued to grow its distribution per security from FY20 to FY22.
In its latest investor presentation, Dexus said it expects a period of high vacancies for the office market will persist near term. Dexus’s occupancy rate is currently more than 95%, its collection rate is 99.3% and its Weight Average Lease Expiry (WALE) is 4.5 years. That suggests Dexus is well-positioned to ride out an economic slowdown.
Moreover, Dexus said yield spreads (prime Sydney CBD offices to the 10-year bond yield) were back to their 20-year average. Also, the spread between prime and second office grades was close to historical lows. On various metrics, the valuation outlook for prime CBD offices should appeal to long-term contrarian investors.
Morningstar’s fair value of $10.80 for Dexus suggests it is undervalued at the current $7.94. Like me, Morningstar is betting on a recovery in CBD office demand as more workers return to the office this year and next.
Either way, Dexus looks interesting, having fallen from a 52-week high of $10.01 recently reaffirmed its distribution guidance for FY 23.
Chart 1: Dexus
- GPT Group (ASX: GPT)
Australia’s oldest A-REIT has a $16.1 billion portfolio, of which $6 billion is invested in office property. Another $5.6 billion is in property and $4.5 billion is in industrial property. GPT also has $19.1 billion in funds under management.
GPT’s retail property portfolio has performed strongly. Occupancy was 99.4% and total centre sales growth at 16.5% for the March 2023 quarter. But with interest rates rising so quickly, the outlook for retail property is souring.
At its Annual General Meeting address in May, GPT said the outlook for the office market remains challenging. GPT had 88% occupancy at end-March 2023. It is targeting 90% occupancy in its property portfolio by year’s end, so sees modest gains ahead.
GPT’s office portfolio is mostly premium or A-grade in Sydney or Melbourne CBDs. Like Dexus, GPT should benefit from more consistent demand for this office space compared to lower-grade properties.
Of the two A-REITs, I prefer Dexus, principally because it has higher relative exposure to office property (as a percentage of its portfolio) and less to retail, compared to GPT.
Retail property faces greater challenges from an economy moving towards recession and the longer-term trend of growth in e-commerce over in-store retail sales.
Morningstar’s valuation of $5.40 for GPT implies it is undervalued at the current $4.00 price. Like many A-REITs, GPT is well off its 52-week high.
Chart 2: GPT Group
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 13 June 2023.
