Impact of the 5th cash rate cycle on Australian office sector

Over the past 30 years, the Australian economy has experienced four major interest rate tightening cycles, having varying impacts on office yields and sales transaction volumes. We are going through a fifth monetary policy tightening cycle which has seen the RBA cash rate move from 0.1% in Q4 2020 to 4.35% in Q1 2024 (Figure 1).

Figure 1: Interest rate hike cycles and Australian midpoint office yield movements

Note: JLL Research track sales transaction from 2007 to present
Source: Reuters, ASX Future Cash Rate as at 8/03/2024*, JLL Research

In periods of economic recovery, such as after the early 1990s, interest rates were raised (Q2 1994 to Q4 1994) to help curb rising inflation. However, the office market also recovered post-recession, which helped stimulate investment activity and resulted in yield compression. Similarly, from Q2 2002 to Q1 2008, the official cash rate rose from 4.25% to 7.25%, and the Australian CBD office midpoint yields compressed from 7.78% in Q1 2002 to 6.23% in Q1 2008. This period was underpinned by strong economic growth and solid office demand, driving office investment activity across the market (Figure 1).

The recent tightening cycle – commencing in May 2022 – follows from ultra-low interest rates, stemming from unconventional monetary policy to increase liquidity and flow of capital during COVID. It can be argued that the sharpest increase in rates since inflation targeting, implemented by the RBA in the early 1990s, is a reversion to the policy mean. The elevated cost of debt and structural concerns about the impact on long-term office demand because of hybrid work have resulted in investors re-pricing assets. This trend has seen the Australian office midpoint yield soften from a cyclical low of 5.06% in Q2 2022 to 6.25% in Q4 2023 (Figure 2).

Figure 2: Historical sales transaction over interest rate environment (2007 – 2025)

Source: Reuters, JLL Research

Australian CBD office investment volumes totalled AUD 4.42 billion over 2023, the lowest level of investment activity since 2009. The low transaction volume is primarily attributed to the rise in the risk-free rate (treasury bond) and liquidity crunch due to the higher cost of debt. To mitigate the risks, A-REITs have taken proactive measures to refinance their office portfolios and engage in strategic capital recycling or sales processes. This approach will allow A-REITs to generate capital to bolster positions amidst declining asset values. This is evident in the most recent reporting season (December 2023), where the majority of A-REITs have taken conservative gearing positions due to the office sale process.

Looking ahead, the ASX futures market has priced in one potential rate cut by the end of 2024 (3.96% as of 18th March 2024). Additionally, green shoots appear to be emerging, as investors have greater clarity on interest rates and therefore have more clarity on pricing office stock. This is evident as majority of the A-REITs have lowered the interest rate hedge compared to 2023 level, indicating confidence in the Australian economic outlook. We expect that well located assets with strong covenants are top of the list for larger domestic and offshore groups which has seen several high-profile assets come to market in the Sydney CBD and Brisbane CBD will provide insight to pricing levels over 2024.