The commercial office market in Australia is facing a challenging landscape, with potential risks and uncertainties that investors need to be aware of. A combination of changing work habits, rising bond yields, and structural threats to office and retail space demand has implications for the value and performance of commercial properties.
The pandemic has reshaped work habits, leading to the adoption of hybrid work strategies. While office occupancy rates initially surpassed 50% as a positive sign of “returning to the office” work habits, the reality is that many companies have embraced hybrid work models that show little sign of fading. In the US, around 58% of companies now allow employees to work remotely for a portion of their week, reducing the demand for traditional office space. This trend is unlikely to entirely reverse as employees push back against a full return to the office. AMP chief economist Shane Oliver has warned that unlisted commercial property, especially office, and retail space, could face a significant loss in value.
The following chart from AMP shows yields for unlisted commercial property. With each 0.25% fall in property yields translating to a roughly 4% capital gain, and with average commercial property yields having fallen from 7.3% to 4.9% between December 2009 to December 2019, this provided a huge boost to returns, averaging roughly 4.3% p.a. and pushing values nearly 50% higher over ten years. This is now starting to go in reverse.
While office and retail spaces face considerable vulnerabilities, industrial property is better positioned due to its lesser exposure to structural threats. The decline in bond yields has benefited industrial properties, which do not face the same challenges in terms of space demand.
The impact of these risks on the commercial property market is evident in the declining values observed in recent deals. Discounts of up to 15% for significant CBD office towers signal a resetting of values. Listed real estate investment trusts (REITs) have already experienced volatility in the share market, while direct property is now starting to show signs of falling values. While Moody’s Investors Service warns of weaker interest cover and asset value declines, ASX-listed property companies are expected to have sufficient financial buffers to weather these challenges.
Investors in the commercial office market should exercise caution and adapt to the evolving landscape. Diversification across property sectors can mitigate risks, with industrial property appearing more resilient compared to office and retail spaces. Monitoring changing work habits, bond yields, and structural threats is crucial for making informed investment decisions. Additionally, considering the financial resilience of listed REITs can provide further insights into the market’s overall health.
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