Macquarie analysts warn on office market recovery

The country’s real estate sector is heading for a reset in asset values as credit markets tighten – hitting the development pipeline with office landlords most at risk.

Storm clouds loom over the construction development sector. Picture: Getty Images

The country’s real estate sector is heading for a reset in asset values as credit markets tighten – hitting the development pipeline with office landlords most at risk.

That’s the conclusion of a detailed analysis by brokers at Macquarie ahead of updates from the nation’s largest listed developers and real estate investment trusts.

The findings by researchers at the investment bank are in line with the view of Colliers and JLL, two large commercial realtors, despite surging rents for core assets.

In a 200-page report, brokers at Macquarie note the REIT sector declined 20.5 per cent over the 12 months to December 31, compared to an overall market decline of just 1 per cent on a total returns basis, a major underperformance.

The majority of that weakness, however, was early in the year as bond yields rose from 1.67 per cent to 3.34 per cent, hitting the performance of fund managers and property developers.

Among Macquarie’s picks are industrial real estate trusts including Goodman Group and GPT – which has substantially expanded its exposure to the sub-sector in recent years. Offices remain the key concern for the bank, including at GPT, where more than 30 per cent of the portfolio will have a lease expiry in the next three years.

The post-pandemic recovery in the office market, the bank said, had been “far more moderate than we had anticipated”.

“With cyclical headwinds likely to strengthen as rate hikes impact unemployment … sentiment and … profitability, we have become more cautious on any recovery in office, with the potential for another year of rising vacancy in 2023,” the note to clients reads.

The post-pandemic recovery in the office market, the bank said, had been ‘far more moderate than we had anticipated’. Picture: Getty Images

“Commentary from the REITs and industry contacts have suggested that a weakening labour market may be a positive for office demand as it encourages employees to return to the office.

“We believe that any positive impact from employees returning to work is unlikely to offset cyclical headwinds which have already seen companies reduce headcounts and begin to decrease office space,” it reads, forecasting a rise in Sydney vacancies from 14 per cent in December to 15.6 per cent within a year.

There will be several additions to premium office accommodation in Sydney over the next two years with the 95,000sq m Martin Place metro development and the redevelopment of the 31,000sq m One Shelley Street tower to come into the market in 2023 and 2024. So too will the 48,000sq m Parkline Place development, although the Piccadilly Centre precinct is expected to be pulled for redevelopment in 2024.

Separately, Macquarie expects rental growth for retail landlords to restart, while the bank’s brokers described industrial real estate as the “shining light”.

“From a valuation perspective, following from significant cap rate compression in the sub-sector, we expect expansion will continue to come through given rising bond yields/funding costs,” the note reads. “Therefore, the key to offsetting this expansion will be the ability to realise strong market rent growth near-term.”

Dwight Hillier, managing director of valuation and advisory services at Colliers, said the office, retail and industrial sectors were experiencing a “crystallisation of asset repricing”. “We’re seeing the capital certainly chase opportunities in the industrial market that have shorter-term lease expiries or weighted average lease expiries so they can grab that reversion or … higher rate … available in the market now,” he said.

After a strong two years, the industrial sub-sector was set to face more difficult conditions.

While Colliers analysis shows the weighted average national industrial rent was six times the 10-year average last year – now 21.7 per cent – rental growth has been outpaced by softening yields as a result of industrial prime capital values falling 6.2 per cent nationally since the first quarter of 2022.

To preserve industrial asset values, a 7 per cent bump in rents for every 25 basis points yields softened would be required.

“The industrial market has had an amazing run … what’s happened in the industrial market to date is that it had such phenomenal rental growth, about 22 per cent over the last calendar year,” Mr Hillier said.

Separate analysis by Morgan Stanley found a decline in asset values is a key challenge for the REIT sector, and in particular those exposed to retail.

Scentre and Vicinity are trading at 20 per cent discounts to net asset values, “implying equity investors are anticipating asset value headwinds”, Morgan Stanley analysts wrote last week. “Our channel checks with direct property stakeholders suggest that the buyer pool across all asset classes has become thinner over 2022, due to rising cost of funds and a wider bid-ask spread, implying both vendors and buyers are either refusing to transact or taking significantly longer to do so.”

Scentre shares have risen 2.4 per cent in the past year.

Fergal Harris, head of capital markets at JLL, said the market had already priced in much of the rate rises over the year. “There’s a lot more comfort around interest rates as we sit here today than … before we went into the break at Christmas,” he said. “There’s a lot more forming of clarity around what prices should be.”