Ep 5: Australian office market haves and have-nots

Rebecca Kent

Welcome to another episode of the perspectives podcast. We’re back with Andrew Ballantyne, JLL’s head of research for Australia and New Zealand to reveal the most compelling trends from JLL’s latest round of research. Including: the haves and the have-nots of the office sector – that’s a gap getting bigger; What investors are learning about the price of their assets; And why cost of living pressures may not be as widespread as headlines suggest. I’m Rebecca Kent, your host. Enjoy.

Rebecca Kent

Hi, Andrew. How are you going?

Andrew Ballantyne

Hey, Rebecca.

Rebecca Kent

We’re halfway through the year. As usual, JLL’s real estate analysts have been crunching the numbers, and so we’ve got the results for the second quarter of 2023. But the midpoint of the year is always an interesting milestone, and a good reason to reflect on whether the performance of real estate sectors has panned out the way we expected 6 months ago. So what aspects of the market have got people talking at this point?

Andrew Ballantyne

I think at the moment, Rebecca, office is the sector which is capturing a lot of the headlines. We've been on a journey through the COVID period, in terms of how office space is used. At the same time we've got unemployment rates close to record lows, or in the case of New South Wales, at an all-time low at the moment. So we've got a whole range of factors that are currently influencing the sector.

If you look at our numbers over the financial year for CBD office markets, we recorded 141,000 square metres of positive net absorption. Even within that positive net absorption, we have counted a number of the subleases that came to the market through the second quarter in Sydney.

In terms of how I'm summarising these numbers, it feels like it's very much the ‘haves’ and ‘have-nots’ of the office sector. The haves have those prime grade assets, those assets, which don't necessarily have to be new, they can be older prime grade assets which have continued to see capex allocated to them, and there’s been continued investment in experience and tenant amenity.

But if you take that broader prime market, it recorded 182,000 sqm of net absorption.
If you look at secondary assets, it was minus 41,000 sqm. So there’s a very significant divergence between those two grades, and certainly showing, as I've just said, the haves of prime versus the have-nots of secondary.

Rebecca Kent

That’s so interesting. We’ve been talking about that as an emerging trend even pre-COVID pandemic, and so it’s interesting to be able to qualify it now with pretty compelling data.

Andrew Ballantyne

It is exceptionally pronounced in both Sydney and Melbourne. Sydney and Melbourne have both had positive absorption for prime, and very negative results for secondary. Secondary grade assets have been a little more resilient in the other geographies, where it hasn't been the same negative result, but clearly not as strong as what we've seen for prime grade assets.

But if you look at some of those other geographies - and take Perth as an illustration, over the last 12 months, Perth recorded 66,500 sqm of absorption. That's more than three times higher the 20-year average for Perth. So even though we talk about some of the challenges that we're seeing around how we're using space, the fact that economies are slowing more broadly, that is a phenomenal result for the Perth CBD market. When you look at Perth, generally the first thing you think of is resources. And clearly, they've been a positive contributor, but we're also seeing activity from the public sector, and professional services firms.

The other market that really jumped out from a numbers perspective is the Brisbane CBD. Over the last financial year that we've just completed, it was 60,000 sqm of net absorption, which is just over double Brisbane’s long-term average. While the Queensland government has certainly been active with a number of leasing requirements, we're seeing a lot of infrastructure-related requirements coming to market that are having a very positive impact on overall inquiry levels. And if you actually look at Brisbane, we're now starting to see some pretty firm rental growth come through.

The other market which flies under the radar a little bit that’s been interesting to watch has been the Adelaide CBD. It had 13,000 sqm of absorption over the last financial year. And one of the things that is interesting about Adelaide is it’s exposed to growth sectors of the economy: It’s exposed to education, it’s exposed to technology, it’s exposed to health, and also the Defence sector. So, when you generally think over the next five to 10 years, what sectors will really drive Australia, you actually see those sectors are very highly represented in South Australia and in the Adelaide CBD specifically.

Rebecca Kent

It’s interesting to note those solid industry drivers there. How do you explain the difference between prime and secondary uptake of offices in Sydney and Melbourne compared to, Perth, Brisbane and Adelaide?

Andrew Ballantyne

There are a couple of reasons you can look at. Outside of Sydney and Melbourne, the proportion of smaller organisations is larger. And quite a lot of those organisations don't yet have their own ESG statements. So they don't have statements around what they're ultimately looking to achieve from an net zero perspective. So they're less driven by some of those factors. What we will caution, though, is that those large occupiers that do have targets around scope one, scope two, and scope three, to me they're very much focused on scope one and two. They will start to think about scope three, given that 2040 is a big year for those organisations in terms of being net zero on scope three.

Scope three includes your suppliers, and a lot of those smaller organisations are suppliers to those larger groups. So they will start to see the influence on them through the procurement strategies of those larger organisations. And they will be getting asked the question more and more, and that will ultimately drive and shape their behavior. Because when you think about ESG, and you think about the influences, there are a whole range of stakeholders that are actually influencing this discussion: There's the general population – you and I, and what our views are. There are also, as we've touched on, suppliers and also customers. There are views on financiers before we even start to think about public bodies and other regulatory agencies.

Rebecca Kent

Ah, Okay. So it’s only a matter of time for those smaller organisations. And owners of those secondary grade assets, then had better get a wriggle on to deliver on tenants’ sustainability demands, right?

Andrew Ballantyne

I'm increasingly believing that the grade of real estate is losing a little bit of its relevance. And I think it's really around the actual credentials of the asset. And I know you might be looking at me going, ‘Surely, that's always been what it is’. But there are certainly secondary grade assets, which can either be repositioned, or actually do have reasonable sustainability credentials, but are classified as secondary for other reasons. And there are certainly lower quality grade buildings which don't have the same level of sustainability credentials. So I don't think we're going to quite necessarily see a blurring of the line between grade. But I think the assessment of an overall building is going to be a lot more complex than just looking at what its grade is and what that grade normally reflects.

Rebecca Kent

Right! So it sounds like we'll be looking at Green Star ratings, NABERS ratings, and WELL ratings even more so than we already are. So, we’ve covered leasing, I just want to shift over now to investment, so capital markets. It’s a challenging, but very interesting space at the moment.

Andrew Ballantyne

We're clearly in the office sector and other sectors, on a price discovery journey.

If you look at our transaction volumes through the first half of this year, they're sitting at around AU$7 billion. To put that in context, last year across the calendar year – and this is not just office, this is retail and logistics as well – we traded AU$30 billion. In the year before, we traded AU$48 billion.

So just looking at those numbers alone clearly shows that we are in a period of very low liquidity for commercial real estate. And ultimately what we're doing as we go through this price discovery journey is cost of capital has moved higher. I think we know that, we've certainly seen interest rates and borrowing costs move up.

And part of the challenge that we're seeing a lot of investors facing in terms of when they price assets is, we don't just look at the spot bond yield today, which is currently trading at around 4%. Real estate is a longer-term investment, so we tend to look at a terminal risk-free rate. And if you look at what most economists are saying, their terminal risk-free rate still sits somewhere between 2.9% and 3.1%. Then you add on a risk premium for real estate event of anywhere between 300 to 350 basis points, and that tells you what your unlevered return expectation should be for the best quality assets.

Now, while we're fairly comfortable around risk premium, the risk-free rate or the 10-year government bond yield, when it's currently sitting at 4%, you have to be very brave to say, ‘I think it's coming back to 2.95% to 3.1%.’

There's a phrase I learned very early in my career, which is, ‘No one pays a premium for uncertainty’. And what we're seeing at the moment is a level of uncertainty around what risk free-rate we should be using. Because if you do believe that 4% is the terminal figure, and you add on your real estate risk premium, then clearly that has a significant impact on what return expectations would be.
So, at the moment, we are seeing some groups that do believe they're able to access assets that they may not normally be able to access. And you have certainly seen the trades that have gone through have gone through at a discount to their previous valuation. But we're still dealing with a very low number of trades at the moment. And we've still not seen the trades of what we would consider the best quality buildings in our market. And that's really across the sectors.

Rebecca Kent

So are we talking about investors playing in a higher price bracket than they normally would?

Andrew Ballantyne

It's not necessarily around a shift in price, but the quality of asset that they believe they can achieve. And also, there being less competition for that asset than what you would normally see.

Rebecca Kent

And just explain price discovery. How long will this discovery journey take? How long does it typically take?

Andrew Ballantyne

If you look back at – and this is very, very different to the financial crisis, but it was a two-year period – if you look back to the early 90s, it was even longer. So we're already more than 12 months into this overall journey. As I said, we're now starting to see some assets trade, and they've been very publicly announced and a number of those are in due diligence, and they will start to become the evidence through the back half of the year. So my expectations is we will start to see an improvement in liquidity over the second half of the year. But we're coming off very, very low levels. And then we should start to see a recovery in transaction volumes in 2024.

Rebecca Kent

So this slowdown in deals, apart from being very frustrating for agents, is even more so for property owners who would like to shift their assets, but aren’t getting the price they’d quite like

Andrew Ballantyne

There's fairly limited distress in the market. So there are not too many groups that have to shift property. And if you have a view on the value of your asset, and a potential purchaser has a different view, you ultimately get a disconnect between vendor and purchaser price expectations. And that disconnect is part of the price discovery journey that we're currently on at the moment.

Rebecca Kent

Alright. But it does sound like there’ll be more clarity as we move through the year. Ok, shall we move on over to retail? Tell us what you’re seeing in our shopping centres.

Andrew Ballantyne

Retail has been an interesting one to watch for a period of time. What we've started to see in our data is the retail vacancy rates for certain categories are trending down. If you look at the CBD vacancy, that obviously peaked during the COVID period. It's not exactly a heroic reduction in vacancy, but at the end of last year it was 13.5%. Today, it's down to 13%. So we're taking small steps in the right direction.

If you look at neighbourhood shopping centers, those that are anchored by supermarkets and specialty retailers, the national vacancy rate there fell from 6.7% to 5.4%. So it's been interesting starting to see that reduction in retail vacancy across different categories. Retail clearly has been a sector that was impacted by online retail over the last few years.

The way I tend to look at online retail is to me it's a form of floor space. So if you were consuming goods 100% within a physical store, and suddenly you're now buying up to 20% of those online, that's a substitute effect. So ultimately, that means that the retail sector in terms of the physical floor space was over-supplied. The market has reacted to that over a number of years where we've seen less development activity, fewer centres built. And it feels like we've now started to reach a point where the market has found its equilibrium. And ultimately, we've absorbed that excess capacity, which is essentially the online component. And now we've absorbed that capacity is back to more normalised market fundamentals.

One of the big growth drivers in terms of consumption and retail spending, is related to population growth. And we've seen population growth rebound significantly. If you look at the forecast for Australia, if we're not the strongest, we're certainly in the top two or three in terms of population growth for a mature economy over the next decade. So that's clearly the positive or the tailwind that we see for spending.

We're not naïve enough to say that there aren’t cost of living pressures. Clearly, I don't think there would be one person in the material world that would say they haven't faced some form of cost-of-living pressure at the moment. But we're obviously at the same time seeing wages growth – not quite at the levels of inflation, but inflation is coming back down.

Also, I think, when we look at some of those cost-of-living pressures, there's a lot of fixation on what's happening with mortgage rates. And clearly, that's a very relevant part of the discussion. But it's often forgotten, when you look across Australia, 30% of homes are actually owned outright. That's owned without a mortgage. So that's a cohort of the market that is clearly not feeling any mortgage pressure. We do have 33% of houses that are actually owned with a mortgage. And typically those people that feel mortgage pressure or stress quickly, are those that are on floating rates and have typically purchased in the last few years. So yes, there would be an impact there. And yes, that clearly will have an impact on discretionary spending.

Then you've got the other part of the market, which is essentially those that rent. And that's quite interesting as well, because clearly, there would be a proportion of those and quite a large proportion that own with a mortgage. But at the same time, you've got rentals going up, which are partly offsetting that increase in costs. The flipside is the renter, that's then starting to feel some rental stress that's coming through there at the moment.

But I think what I'm trying to articulate, Rebecca, is it’s a much more complex story than saying,
‘Rising interest rates hit Australian household sector hard’. It certainly does hit parts of the market hard, but there are parts of the market that are obviously less exposed. And for those 30% of homeowners that own outright, they're probably feeling quite happy that term deposits are going up at the same time.

Rebecca Kent

So, I guess it’s too simplistic to say that everyone is going to be experiencing financial distress due to increasing mortgage rates and the retail is going to hit the skids?

Andrew Ballantyne

There will always be a level of consumer spending. Clearly there will be pockets of distress, where you have areas where you have a very high proportion of people who have a mortgage and have bought recently. Ultimately, retail spending is cyclical, it always has been cyclical. So yes, there will be some pressures on discretionary spending moving forward. But you come back to the labour market that we discussed right at the start of this discussion, we're pretty much close to full employment. That is a phenomenal statistic for the Australian economy.

Rebecca Kent

Sure is. So just moving on, we’re over the halfway point of 2023. What’s different to what we expected at the start of the year?

Andrew Ballantyne

I don't think to be honest, too much has surprised me. I think the one shift that we're starting to make in our forecasts at the moment, well one shift that we've already made in our forecasts, is we're starting to reduce supply expectations, in particular in the office sector.

If you look at say, Sydney CBD as an illustration, 12 to 18 months ago, we had a significant development pipeline for 2025/2026. If you look at what we're seeing now, it’s virtually nothing over those two years. And ultimately, the reason we've made the shift there, is that we've, as we've touched, in the capital markets, the fact that yields have moved out for the better quality assets and that has a significant impact on economic rents for new development. We’re seeing economic rents jump quite significantly, that would be above where market rents would be at the moment. So ultimately, in that type of environment, you typically see less new development activity. So we've made some pretty significant shifts in our Sydney CBD supply forecasts for 2025 and 2026.

Rebecca Kent

So that’s offices. And in retail, as you mentioned earlier, the small decrease in vacancy in CBDs is a step in the right direction.

Andrew Ballantyne

The big challenge that CBD retailers are facing is that their trading patterns have become even more uneven than what they were pre-COVID. So pre-COVID, they certainly had days of the week that were very big. Now they can be exceptionally quiet on a Monday, as an illustration. They can be exceptionally quiet on other days as well. And often the days where you're seeing it being busy are Thursday, Saturday, and Friday can be a little mixed. But often they can be facing higher labour costs on those days, because of the hours that those people are working and the times of the week that they're working as well. So it's a very challenging environment for a retailer being based in the CBD given that level of fragmentation. And given obviously, the demand for their product or service is a lot more fragmented than what it was pre-COVID.

Rebecca Kent

So interesting. Much like offices, we're all still trying to work out patterns of people working in offices. So it’s a constant calibration, I guess.. So, mid-year is also a great time to consider what the next six months hold. What should we be looking out for?

Andrew Ballantyne

I think what’s going to be interesting over a longer period of time, is we have seen announcements from the Commonwealth of Australia and some of the banks around what flexible working could look like for them moving forward. So ultimately, it will say to me that their space requirements are going to be smaller than what they were pre-COVID. Or there's going to be a period of time while their headcount growth comes through to offset that flexibility. But what we have seen in our numbers is very strong growth in small businesses.

Typically, small business growth does slow as the economy slows. But what I do expect to see is that we will see more small business formation over a longer period of time, and ultimately, smaller organisations will become a larger part of the overall occupied market. So it'll be interesting to see the types of strategies that we develop to attract and retain those types of businesses within our office accommodation.

Rebecca Kent

That diversity can only be a good thing for the economy.

Andrew Ballantyne

Small businesses are the lifeblood of any economy. So when you're seeing small business growth, that is a positive more broadly, regardless of what sector we're actually talking about.

Rebecca Kent

Excellent. All right, Andrew Ballantyne. Until next time, thank you very much.

Andrew Ballantyne

Thank you.