Australian office market performance insights MARKET MONITOR OF F I CE 2022
CONT ENTS Office market recovery begins 3 Demographic trends 4 Sector trends 7 • S ofter economic conditions will present challenges 7 • T enant space requirements in a WFH world 8 Supply & vacancy 9 Rents & incentives 12 Investment market 13 Legislative & infrastructure update 14 LJ Hooker Commercial offices 15
Office Market Monitor | 2022 3 Over the past two years office occupancy rates, across the globe, have been severely impacted from the ‘stickiness’ of recent work from home trends. Forced lockdowns and government restrictions initially presented a huge challenge for business owners and office landlords alike, however, it was widely seen to be temporary (and necessary) as we dealt with the pandemic. The biggest change for office markets this year has been on the capital and investment side, and that is primarily due to the rapidly tightening monetary policy environment both locally and around the globe. During the pandemic, while interest rates remained at record lows, transaction volumes were relatively healthy and capitalisation rates stayed low, despite occupancy challenges. Investors and owners are now faced with a tricky combination of rising capitalisation rates and high vacancy rates (particularly in CBDs). Demand conditions are also uncertain, as businesses struggle to understand their future space requirements. Office market recovery begins Mathew Tiller Head of Research, LJ Hooker Group On top of this, the Australian economy looks set to slow considerably in 2023, as higher interest rates, due to soaring inflation, impacts consumer spending and business investment. All of these factors will combine to create a ‘fragmented’ commercial real estate market in 2023. This means that office markets across the country won’t rise and fall as one. We are already seeing a divergence in the performance of prime and secondary buildings and moving forward ESG credentials of buildings will play a huge role, as energy costs bite and tenants look to move to buildings that can operate at the highest possible efficiency.
Office Market Monitor | 2022 4 Demographic trends In addition to economic conditions, demographic changes always have a significant impact on demand for office space. Right now, it is more important than ever to understand the population changes happening across Australia, as we move out of one of the greatest periods of demographic and social disruption. Population growth The good news for the office market is that overseas migration has recovered dramatically since borders reopened earlier in 2022. In fact, the March 2022 quarter saw the largest ever number (on net terms) of overseas migrants enter the country, at 96,107 people. The March quarter historically records the highest number of migrant entries each year, due to the academic year starting, and the previous largest number of migrants was the March 2008 quarter, when 93,462 migrants entered the country. While Australia has always been a migrant country, the patterns of migration have changed dramatically during the last 10 years, and this has had real impacts on demand for office space. Prior to the GFC (2008), overseas migrants settled evenly around the country, relative to the size of each state with 56% settling in NSW and Victoria. However, post-GFC, settlement patterns changed dramatically. Between March 2012 and March 2020, when Covid impacts started, 68% of all overseas migrants settled in NSW or Victoria. The dramatic increase in overseas migrants to our two largest states caused a dramatic shift in office demand, and in turn where developers sought to build new supply. Between 2006 and 2010, new supply was concentrated in the CBDs outside of NSW and VIC. Since that time, 3.16 million square metres of new supply has been built in Sydney and Melbourne CBDs, and only 2.27 million square metres in all other capitals combined. Overseas migrants generate office demand as they both fill and create the need for more white-collar jobs, particularly in the services industries (legal, finance, health, IT). Demographic overview and outlook In addition to economic conditions, demographic changes always have a great impact o demand for Australi ’s office markets. Right now, it is more important than ever to understand the demographic changes happening in Australia, as we move out of the greatest demographic and social upheaval we have seen in generations. Population growth The good news for the office market is that overseas migration has recovere dramatically since borders reope ed earlier in 2022. In fact, the March 2022 quarter saw the l rgest v r number (on net erms) of overseas migrants e ter the countr , t 96,107. The March quarter historically records the highest number of migrant entries each year, due to the acad mic year starting, and the previous largest number of mig ant w s the March 2008 quarter, when 93,462 migrants entered the country. Source: ABS While Australia has always been a migrant country, the patterns of migration have changed dramatically during the last 10 years, and this has had real impacts on demand for office space. Prior to the GFC (2008), overseas migrants settled evenly around the country, relative to the size of each state -60,000 -40,000 -20,000 0 20,000 40,000 60,000 80,000 100,000 120,000 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 Annual Net Overseas Migration by State NSW VIC QLD SA WA TAS NT ACT GFC Impact 2009 - 11 Covid Impact 2020 - 21 Source: Australian Bureau of Statistics NSW VIC QLD SA WA TAS NT ACT Annual Net Overseas Migration by State Covid Impact 2020-21 GFC Impact 2009-11
Office Market Monitor | 2022 5 Source: PCA, Clio Research While net interstate migration does play a role in influencing office demand, the impact is smaller as Australian migrants don’t generate as much need for new services. For this reason, the big surge in interstate migrants to Queensland doesn’t have the same impact on the Brisbane office market as overseas migrants have on Sydney and Melbourne. Source: ABS What is clear from historic patterns is that economic downturns do impact demographics. It is likely that 2023 will be one in which many countries will experience recessions, and Australia’s growth rate is almost certain to decline as interest rates bite. Investors and owners should be aware that that may result in fewer migrant moves for some years, as happened after the GFC. 0 50,000 100,000 150,000 200,000 250,000 300,000 350,000 400,000 450,000 500,000 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Jan-18 Jul-18 Jan-19 Jul-19 Jan-20 Jul-20 Jan-21 Jul-21 Jan-22 Jul-22 Gross New CBD Office Supply Syd & Mel All other CBDs -20000 -15000 -10000 -5000 0 5000 10000 15000 20000 Mar-2006 Mar-2007 Mar-2008 Mar-2009 Mar-2010 Mar-2011 Mar-2012 Mar-2013 Mar-2014 Mar-2015 Mar-2016 Mar-2017 Mar-2018 Mar-2019 Mar-2020 Mar-2021 Mar-2022 Net Interstate Migration by State (qtrly) NSW VIC QLD SA WA TAS NT ACT Source: Property Council of Australia Gross New C Office Supply Syd & Mel All other CBDs While net interstate migration does play a role in influencing office demand, the impact is smaller as Australian migrants don’t generate as much need for new services. For this reason, the big surge in interstate migrants to Queensland doesn’t have the same impact on the Brisbane office market as overseas migrants have on Sydney and Melbourne. Source: PCA, Clio Research Whil ne interstat migration does play a role in influencing office demand, the impact is smaller as Australian migrants don’t generat as much need for new services. For this reason, the big surge in interstate migrants to Quee sland doesn’t have the same impact on the Brisbane office market as overseas migrants have on Sydney and Melbourne. Sourc : ABS What is clear fr m historic patterns is that economic downturns do impact demographics. It is likely that 2023 will be one in which many countries will experience recessions, and Australia’s growth rate is almost certain to decline as interest rates bite. Investors and owners should be aware that that may result in fewer migrant moves for some years, as happened after the GFC. 0 50,000 100,000 150,000 200,000 250,000 300,000 350,000 400,000 450,000 500,000 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Jan-18 Jul-18 Jan-19 Jul-19 Jan-20 Jul-20 Jan-21 Jul-21 Jan-22 Jul-22 Gross New CBD Office Supply Syd & Mel All other CBDs -20000 -15000 -10000 -5000 0 5000 10000 15000 20 0 Mar-2006 Mar-2007 Mar-2008 Mar-2009 Mar-2010 Mar-2011 Mar-2012 Mar-2013 Mar-2014 Mar-2015 Mar-2016 Mar-2017 Mar-2018 Mar-2019 Mar-2020 Mar-2021 Mar-2022 Net Interstate Migration by State (qtrly) NSW VIC QLD SA WA TAS NT ACT Source: Australian Bureau of Statistics Net Interstate Migration by State (Qtrly) NSW VIC QLD SA WA TAS NT ACT What is clear from historic patterns is that economic downturns do impact demographics. It is likely that 2023 will be one in which many countries will experience recessions, and Australia’s growth rate is almost certain to decline as interest rates bite. I vestors and owners should be aware that that may result in fewer migrant moves for some years, as happened fter th GFC.
Office Market Monitor | 2022 6 The opening of international borders will have a positive impact on office demand.” “
Office Market Monitor | 2022 7 Sector trends The Australian economy, in 2023, is going to present many challenges for Australian businesses and families. In 2020 and 2021 the economy was seriously threatened by Covid, however, the RBA and Federal Government stepped in and ensured the country was awash with cash. The same thing happened around the world. In 2023 the challenge is inflation, unfortunately a much more difficult problem to contain and one where the solution is tough on everyone and slow to work. Cheap money has now evaporated around the globe, and any industry needing large amounts of capital for growth, or where customers are reliant on credit, should expect softer conditions. This includes the construction, technology, real estate, finance, arts/entertainment and some parts of the retail sector (particularly large format retail where a significant portion of demand is derived from the new housing sector). 1. Softer economic conditions will present challenges Of those industries, real estate, finance and technology mostly occupy office space, and are likely to reduce their demand requirements over the next two years. Big office occupiers like government, accounting and legal firms tend to see smaller changes to their workload during economic downturns – and therefore their demand for office space - as they mostly provide services to businesses and the community that can’t be foregone. Unfortunately, when inflation is high, it is small and medium sized businesses that find it harder to cope. This is because they have less purchasing power, so usually have to accept higher prices than bigger organisations, have a smaller customer base through which to spread higher costs amongst, and (usually) smaller cash reserves. While big businesses may be able to absorb some higher price inputs for a while, smaller businesses have far less capacity to do this. This means that any market that is dominated by smaller businesses will be riskier over the next few years.
Office Market Monitor | 2022 8 Prior to the pandemic, the property industry – owner and occupier alike – used a ‘Floor Space Ratio (FSR) calculation’ to determine how much space a tenant required to lease. Over the years, as fitouts became more efficient and ‘hot desking’ became more commonly used, the average FSR reduced from roughly 20 square metres per employee, at the turn of the century, to around 14 square metres per person just prior to the pandemic. An FSR however, worked on the assumption that employees, mostly worked from the office. In a world where many employees are working two or three days from home, calculating how much space is required has become exceptionally difficult for all occupiers – be they small or large. Agents around the country are reporting that while demand for office space is holding up reasonably well, negotiating leases is noticeably slower and more difficult, as occupiers hesitate over how much space they need. And it is easy to understand the hesitation. When employees do come into the office, nearly all expect a desk to work at. A pattern has also emerged of Tuesday, Wednesday and Thursday being the most popular days that employees go into work, and Mondays and Fridays are noticeably quieter. This leaves decision makers in a quandary - take enough space to accommodate all their employees on the busy days and they risk wasting money on empty office space on Monday and Friday. Take too little space, however, and they risk turning employees off coming into the office if they think they won’t be able to get a desk. Ultimately, most occupiers will choose the option that best supports revenue generation and that future proofs their business. People costs are almost always far higher than rental costs, so keeping employees happy and engaged through the right property decision can save money via less people turnover. On the flip side, there will be some occupiers that are eyeing off more difficult trading conditions in 2023 and potentially also 2024 and will be reluctant to spend more money than they must on office space, although these occupiers are likely to be the minority. Owners of space need to be patient during negotiations and support the process as much as possible by providing flexibility solutions or options. 2. Tenant space requirements in a WFH world
Office Market Monitor | 2022 9 Over the first six months of 2022, almost 320,000 square metres of supply was added to the market, around 83% of which was new supply, and 75% of which was in CBDs. In the CBDs, the major new buildings to complete were Quay Quarter Tower (87,000sqm) in Sydney and 80 Ann Street (44,000sqm) in Brisbane. The major contributor to non-CBD supply was Parramatta Square Stage 8 (53,000sqm). Over 150,000 square metres of new supply is due to complete in non-CBD markets in the second half of 2022, with this supply spread across many buildings around the country. However, construction delays may cause building overruns and we expect some of these completions to happen in early 2023. Completions in CBDs for the second half of 2022 could total around 165,000square metres. Cbus Property’s 83 Pirie Street (30,000sqm) is due for completion in Adelaide, as well as Salesforce Tower (55,000sqm) in Sydney, 72 Northbourne Avenue (33,000sqm) in Canberra, and Wesley Place Stage 2 (22,000sqm) in Melbourne. Beyond 2022, there is only 220,000 square metres of CBD office supply under construction, 57% of which is in Melbourne. There is almost 1 million square metres of projects that have planning approval or are undergoing site works, but almost all these projects will require a substantial tenant pre-commitment before developers commence construction. This is why building completions over 2024 to 2026 will be very low, as those developments need pre-commitment now, and this is very hard to come by. Interestingly, the focus of developers for longer term projects is shifting considerably to Sydney Metro and Brisbane CBD markets. This is where the bulk (55%) of projects due to complete in 2024 and beyond will be located. This is in response to both the demographic trends of strong internal migration to Queensland, and also as more people prefer to avoid the time it takes to commute to the big CBDs of Sydney and Melbourne. Supply and vacancy Source: Property Council of Australia Note: The percentage (%) figures in the table represent the percentage of total new supply to be completed during that period. Forecast New Office Completions* by Market, 2022 to 2024+ 2022 2023 2024+ Sydney CBD 28% 7% 20% Sydney Metro 16% 19% 31% Melbourne CBD 4% 18% 8% Melbourne Metro 8% 2% 4% Brisbane/Gold Coast 19% 8% 24% Adelaide 6% 13% 2% Perth 3% 22% 4% Canberra 16% 11% 8% The new office supply pipeline is noticeably constrained, post 2024, as pre-commitment activity was soft throughout Covid and into 2022. This outlook is not unexpected after many years of strong supply, particularly in Melbourne, and a demand ‘shock’ in the form of Covid.
Office Market Monitor | 2022 10 Overall, we know that the risk of commencing construction of a new office building today is much higher than it was pre-Covid. This is because of higher interest rates, uncertain tenant requirements, and higher vacancy across the board. Nevertheless, many tenants are choosing to upgrade to new or prime grade space, and this should sustain some demand for new developments going forward. Vacancy Rates have increased in all markets throughout the pandemic. However, Prime Grade CBD space is proving the most resilient, as many tenants are choosing to upgrade to better space as more has become available, and to provide their staff with the best possible office conditions. Interestingly, non-CBD vacancy rates have increased by the biggest margin. This is a response to both increased supply in some markets (such as Parramatta & North Sydney) and tenants choosing to not renew leases as staff are working from home. In some cases, businesses are choosing to keep their central CBD space, and relinquish satellite/suburban offices that the home office has essentially replaced. Office Vacancy Rates Vacancy Rates have increased in all markets throughout the pandemic. H wever, Prime Grade CBD space is proving the most resilient, as many tenants are choosing to upgrade to better space as more has become available, and to provide their staff with the best possible office conditions. Interestingly, non-CBD vacancy rates have increased by the biggest margin. This is a response to both increased supply in some markets (such as Parramatta & North Sydney) and tenants choosing to not renew leases as staff are working from home. In some cases, businesses are choosing to keep their central CBD space, and relinquish satellite/suburban offices that the home office has essentially replaced. source: PCA OMR July 2022 Rent and incentive update Despite challenging demand conditions and high vacancy, face rents continue to rise in all markets, albeit it marginally. Many landlords prefer to offer higher incentives rather than reduce the face rent, as rents are reviewed each year to either CPI or another agreed amount, and this ensures that rents keep up with inflation. 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0% Jul-12 Dec-12 May-13 Oct-13 Mar-14 Aug-14 Jan-15 Jun-15 Nov-15 Apr-16 Sep-16 Feb-17 Jul-17 Dec-17 May-18 Oct-18 Mar-19 Aug-19 Jan-20 Jun-20 Nov-20 Apr-21 Sep-21 Feb-22 Jul-22 Office Vacancy R s CBD Prime CBD Secondary Non-CBD Prime Non-CBD Secondary CBD Prime CBD Secondary Non-CBD Prime Non-CBD Secondary Source : Property Council of Australia
Office Market Monitor | 2022 1 1 Many tenants are choosing to upgrade to higher quality office space as more has become available.” “
Office Market Monitor | 2022 12 Despite challenging demand conditions and higher vacancy rates, face rents continue to rise in all markets, albeit it marginally. Many landlords prefer to offer higher incentives rather than reduce the face rent, as rents are reviewed each year to either CPI or another agreed amount, and this ensures that rents keep up with inflation. Conversely, many tenants prefer the incentive upfront in order to finance their fitout. There are markets, however, that are performing better than others. Despite having higher vacancy than Sydney, Melbourne or Canberra, Brisbane face rents are increasing at the fastest rates, and incentives are reducing – albeit from a high base. Office net absorption in the first half of 2022 was 44,690square metres, according to the Property Council of Australia (PCA) and this was the highest level since 2016. Take up in prime grade space dominated, and flight to quality by tenants is what is driving the increase in rents and decrease in incentives. In Sydney, Melbourne and Canberra, face rents are rising very incrementally, and incentives are staying steady, as take up comes up some very strong years prior to the pandemic. Perth and Adelaide have also recorded minor increases in face rents, and minor decreases in incentives, helped along by the fact that day to day office occupancy in these markets were the least impacted by both lockdowns and bad weather. Looking forward, it is likely that incentives will stay elevated as the new supply that is due to complete in the remainder of 2022 and 2023 is worked through. It is not until the supply pipeline starts to look very thin in the next year that incentives really start to reduce. This will likely be 2024 and should also correspond with a recovery in economic conditions both globally and domestically. Rents and incentives Australian Office Market Indicator Expectations – 12 months Source : LJ Hooker Commercial FACE RENTS INCENTIVES Sydney Melbourne Brisbane Adelaide Perth Canberra Stable Slight increase Slight decrease
Office Market Monitor | 2022 13 The office market in Australia is heavily exposed to monetary policy decisions of the RBA, as yields (or capitalisation rates) tend to move in line with the 10-year government bond rate. Yields on 10-year government bonds have risen from 0.89% in March 2020 (roughly the start of lockdowns) to 3.92% as of October 2022. The last time yields were this high was around April 2014. In addition to a serious increase in the 10-year bond rate, the inherent risk in office property has increased as tenant demand is now much harder to understand. This in turn has increased the risk premium that many investors will need above and beyond the 10-year bond rate. That being said, many large institutional investors are still very confident in office property long term, particularly prime grade CBD space. While there have been wild swings in industry expectations of value throughout Covid (remember in early 2020 we were more or less guessing on the length and severity of impact of the pandemic on commercial property markets), patterns of expectations of capital value have now settled. Due to the difficulty in getting people back into the office, the capital value expectations of office property are the lowest amongst the three major asset types. It is likely we won’t see a recovery in this sentiment until the monetary policy tightening cycle starts to ease or is stopped, and more office workers head into the office with more regularity, thereby giving the industry more comfort around future demand conditions. Investment market Property Industry Expectations on Capital Value Source : ANZ/Property Council Survey 20 0 -20 -40 -60 -80 -100 Industrial Retail Office Dec-19 Mar-20 Jun-20 Sep-20 Dec-20 Mar-21 Jun-21 Sep-21 Dec-21 Mar-22 Jun-22 Sep-22
Office Market Monitor | 2022 14 The recent Federal 2022-23 Budget update (October 2022) came with some fairly sobering updates on inflation and the economic outlook for 2023. The forecast inflation peak has been revised up, and the Treasurer was quite blunt in his assessment that 2023 was going to result in much slower economic growth in Australia, and indeed around the world. In many ways, this is required to get inflation under control, and the Federal Government must contribute to the fight against inflation by reducing spending. Therefore, spending on infrastructure going forward is likely to be far less liberal than what it has been over the last 10 years. This is also as a result of the rising costs of all of these projects. Cost increases for federally funded projects usually are expressed in terms of billions of dollars, so have massive impacts on both construction costs locally and government spending. The impact for the commercial property market will be seen in 2024 and beyond. With infrastructure projects reducing in size and quantity, the likely beneficiary will be CBD markets, where infrastructure is already quite good and centralised. In addition, Sydney and Melbourne CBDs will benefit from their respective metro projects reaching completion, with these already underway and funding locked-in. Legislative and infrastructure update Selected Economic Forecasts - October Federal Budget 2022/23 OUTCOMES FORECASTS 2021-22 2022-23 2023-24 Real GDP 3.9 3.25 1.5 Household Consumption 4.1 6.5 1.25 Dwelling Investment 2.8 -2 -1 Consumer Price Index 6.1 5.75 3.5 Wage Price Index 2.6 3.75 3.75 Unemployment Rate 3.8 3.75 4.5 Net Overseas Migration 150,000 235,000 235,000 % change p.a. except Net Overseas Migration Source: Australian Federal Government budget papers 2022/23
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