Sound fundamentals of property

Office market

Over the last three years, the office market has been challenged. However, compared to other major cities globally, the vacancy rates in major Australian cities, whilst elevated — Sydney at 11 per cent and Melbourne at 14 per cent — are still lower than the global average.

“The office market is facing some key challenges,” says Damon. “From a cyclical perspective, demand might be sensitive to the economic slowdown that we’re currently experiencing, and from a structural perspective, the market is adapting to the impact of hybrid working.”

A trend in the office market that Damon identifies is the flight to quality. Occupiers are concentrating their demand for space into modern, high-quality buildings, in good locations. This trend has implications in terms of asset selection and performance. High quality buildings in desirable locations are better placed to retain their tenants and grow rental returns, whereas buildings of secondary quality will have greater difficulty in retaining tenants.

Having recently returned from a research trip to the U.K. and United States, Mary Power — Principal Consultant at JANA Investment Advisers — is able to make a number of key observations about the property market globally.

Looking at the office market in the U.S., Mary believes this sector remains challenged due to the lack of available quality stock and declining fundamentals.

“Office vacancy and tenancy are poor compared to long-term averages, even when compared to previous ‘distress’ periods,” she says. “With the current vacancy rate at 17.7 per cent, vacancy is expected to remain at elevated levels. Clarion Partners (a global real estate investment firm) forecasts net effective rental growth of -4.5 per cent in 2023, -3 per cent in 2024, and -0.1 per cent in 2025.”

While construction of new office buildings is focused on high quality, sustainable buildings, which are still in demand from tenants, Mary says investor sentiment towards office remains negative, primarily due to concerns of weakening fundamentals, pending loan maturities, and the rise in hybrid and remote work preferences, which has largely hampered a full return by employees to the office since COVID.

Mary believes the trend towards a more hybrid workforce, where staff divide their working hours between home and office, will continue to impact this sector of the property market.

Damon agrees: “The nature of the space within an office will change. There will probably be some upward pressure on the ratios of square metres per person, because instead of having little cubicles where people are working side-by-side, it’s increasingly now becoming more about collaboration, meeting and communal type spaces, which may mean businesses will require more square metres per person.

“These issues are complex. It’s not as simple as reducing your office space by 40 per cent, because staff are only in the office three days a week. There are a lot of factors to consider.”

Retail market

According to Damon, shopping centres have been the ‘quiet achievers’ post-COVID. During the pandemic period, retail sales ran at approximately double long-term averages, with discretionary retail spending growth peaking at over 30 per cent in 2022. However, with higher interest rates and cost of living pressures, the growth rate of discretionary retail spending declined significantly from early 2023.

“The good news is the vacancy rates within most shopping centres are trending down, apart from CBD retail, where many people still haven’t returned full-time to their city offices post COVID, which has impacted retail establishments,” says Damon. “Overall, large regional shopping centres are well placed to weather the slowdown in retail activity that we’re experiencing.”

Damon adds the rental income coming out of retail assets has been sustainable, despite potentially slowing retail trade conditions. Yields for retail shopping centres have also generally been higher compared to comparable properties within the office and industrial sectors. “So, from a relative value perspective, the retail sector holds some appeal.”

Industrial market

The industrial market has been the star performer in the Australian real estate market over the last few years. The last 12 months has seen this sector achieve extraordinary rental growth, increasing by 15-30 per cent across the major markets in Australia. Damon says this increase in market rents has been driven by a surge in demand for industrial space that occurred during the COVID pandemic.

“The demand for space peaked in 2021 at over 4 million square metres or approximately double long-term averages. This was driven by a surge in demand for online shopping and also by businesses looking to secure their inventories in a period of global supply chain disruption during COVID,” he says.

“However, as the economy slows, what we’re seeing now is that demand tapering off. So, our forecast for 2023 has industrial demand falling back towards long-term averages of just over 2 million square metres. As demand tapers off, so too will rental growth taper and drop back to long-term averages. However, from a supply perspective, we don’t believe there is sufficient supply entering the market to force vacancy rates back up to pre-COVID levels.”

According to Damon, Dexus remains positive about the long-term conditions for the industrial sector, which has solid fundamentals. These include: a sound demand/supply equation; benefits from tailwinds associated with Australia’s population growth; and a growing appetite for e-commerce, which will drive demand for industrial space over time.

According to Mary, key market insights coming out of the U.K. and European Union shows that logistics real estate remains a key sector for many investment managers, with strong logistics rental growth in Europe of 18.4 per cent outpacing other sectors, like residential (8.6 per cent), office (2 per cent), and retail (-12.2 per cent). 

“The industrial sector continues to benefit from a backdrop of positive fundamentals,” says Mary. “The U.K. has the highest e-commerce uptake globally, with parts of Europe showing similar levels of growth to the U.S. and with little evidence of slowing. Continued growth of e-commerce is expected to drive tenant demand.”

She adds that industrial has been the strongest performing sector in terms of rental growth, compared to other traditional (and some alternative) sectors. 

“In the U.K., leases have five yearly market rent reviews and nearly all continental European countries have CPI-linked leases, providing an inflation hedge and net operating income growth for long-leased assets,” says Mary. “We believe European logistics real estate will continue to deliver the highest returns compared to other real estate sectors.”

And what about the United States? According to Mary, the industrial market has outperformed every property type throughout the current cycle, with the growth in e-commerce leading the way.

“U.S. industrial vacancy is 3.7 per cent, while the long-term average is 7 per cent. If only 20 per cent of the stock being developed today is leased upon completion, vacancy will only increase to 6.6 per cent,” says Mary. “However, moving forward, supply is not expected to keep up with demand.”

According to Mary, if you look at the Australian index for unlisted property to the end of June 2023, it declined by -1.3 per cent. However, in the U.S. that decline was -10.7 per cent, and in the

U.K. it was -17.1 per cent. This shows quite a dispersion in negativity across the globe, with the driver being the rise and speed of interest rate hikes.

Yet, despite this dispersion in negativity, Damon believes there are opportunities in real assets for investors, particularly outside the three traditional property sectors. He says there is a definite increase in appetite by investors in the Asia/Pacific region for some alternative retail sectors, such as: residential, healthcare, and student accommodation.

“However, the challenge for investors is getting exposure to quality investments in the Australian market, where some of the sectors, such as the residential ‘built-to-rent’ sector — large-scale, purpose-built rental housing that is held in single ownership and professionally managed — are in their infancy. So, whilst there is a lot of investor demand and interest in these sectors, there is very little product currently available in some of these alternate spaces.”

A definite trend Mary is seeing from overseas is the demand by tenants for sustainable property. She says environmental, social, and governance (ESG) considerations are increasingly becoming more important to real estate investors and tenants globally.

“Market consensus is that buildings with strong ESG credentials will outperform, both in terms of occupancy rates and investor returns,” she says. “This is supported by industry research from 250 asset managers across Europe, which validate the view that green buildings command higher rental growth. Therefore, it’s not surprising that investors are actively targeting new investments with high ESG standards and restructuring their portfolios accordingly.”

Mary believes sustainability is bifurcating the market. Not every office building is well credentialed from a sustainability perspective, and so have difficulty attracting tenants. “The clear message is, buildings and assets that have strong ESG credentials will outperform across a range of categories, like occupancy and rental return, compared to those that don’t.” 

According to Damon, investors are very clear about what they look for when investing in real estate. Despite the volatile period we’ve been through, he says diversification and low correlation to other asset classes, as well as reliable income streams and a hedge against inflation, are some of the reasons why investors choose to invest in real estate.

“Globally, markets are moving at a different pace than Australia, including across different property sectors, which investors need to be aware of,” says Damon. “Investors need to consider real estate as a long-term investment. This means looking for diversification, and seeing whether you can get exposure to both public and private markets, across different sectors and also across different geographies. It is a difficult task, but there are funds available that will enable investors to do this.”

Mary agrees that when it comes to portfolio construction, diversification is important for investors. She also adds that when investing in real estate, investors need to think about their investment timeframe.

“I wouldn’t be going into unlisted property if your timeframe is relatively short, like three years,” she says. “In this asset class, you need a long-term period in which to invest, particularly in order to take advantage of attractive opportunities that emerge during periods of dislocation.”

However, when it comes to allocating property within a portfolio, Damon acknowledges that many investors remain cautious, choosing instead to see how the market plays out. He says this caution is linked to the valuation cycle. From an unlisted perspective, the higher interest rate environment feeds through to capitalisation rates, which pushes values down.

“Most investors are wanting to see a bit more of that valuation movement come through before they consider getting back into the unlisted side of property,” he says.

Damon adds that for investors who already have exposure to property and are looking at it as a long-term investment, now is not the time to be exiting the market. “That’s because we’re on the downward side of the cycle and good opportunities will inevitably present themselves to investors. A lot of the really strong performance for real estate comes out of the rebound phase that the cycle will eventually move into.”

As the market continues to adjust to a higher interest rate environment and an economic slowdown, Damon concedes there are challenges for real estate over the short-term. However, he also believes the fundamentals of the Australian market are sound. The economy is proving resilient, the Australian market is transparent and attractive to offshore capital, and there is a positive demand outlook, which is underpinned by strong population growth.

Mary agrees, adding that overall, the Australian property market has faired well, despite Australia having had 12 interest rate rises in quick succession. This has meant that capitalisation rates have had to readjust upward.

“Yet, despite this, the property sectors are generally in good shape,” she says. “So, once the readjustment takes place, and you overlay the sustainability criteria — which means that in some cases, the property universe will shrink to only those assets that can provide very good ESG credentials to tenants — I believe the sectors that are driven by rental growth should be quite attractive going forward.”