The Big Split: Quality will out for the best commercial assets

Just as in the big shake outs in the early 1990s recession and the GFC liquidity crisis there will be winners and losers as the property landscape shifts.

Retail surpassed expectations, although it has navigated a challenging period. Picture: Julian Andrews.

It is clear from the recent A-REIT reporting season that various non-residential sectors have been affected by the upward trajectory of interest rates.

Consequently, there has been a rise in asset capitalisation rates, leading to a downward influence on property values. Given the steep discounts to net tangible assets that most A-REITs are currently trading on, the listed market is implying that direct property values could or should (if you believe the listed market) decline by approximately 30 per cent.

This implied discrepancy in prices between the two markets is one of the most substantial variances seen in the past three decades. Although the pricing of direct assets, which rely on backward looking comparable transactions, may require further adjustment, it appears that the listed A-REIT market has gone beyond what could be considered as a reasonable recalibration.

In the short term, the listed market often displays a tendency to exaggerate its ascent and descent. So pricing discrepancies at various points in the cycle are not unexpected.

However, it’s reasonable to expect that the two markets – listed A-REITs and direct non-residential property – will ultimately yield comparable returns. This is because the core cash flows in both segments emanate from the underlying properties.

Indeed, during the 10-year period ending June 30, 2023, the A-REIT sector, represented by the S&P/ASX300 A-REIT Accumulation Index, delivered an annualised total return of 8 per cent. In parallel, unlisted wholesale property funds, as measured by the MSCI Mercer Core Wholesale Property Fund Index, generated an annualised total return of 7.7 per cent.

Back to the short-term. So what is really going on in the direct markets at present? There has been a significant variation in investment performance across the three key sectors over the past year. According to the PCA/MSCI Australian Direct Property Index, in the year to June 30, office properties experienced a negative total return of 2.2 per cent, while retail properties returned 2.8 per cent, and industrial properties delivered a robust return of 6.9 per cent.

Industrial property, which has stood out as a top performer in recent years, continues to thrive due to the supply chain revolution, growing online retailing, limited supply, and record low vacancy rates.

Retail surpassed expectations, although it has navigated a challenging period. This is no more evident than the negative total return of 9.5 per cent it posted at the height of the pandemic. At that time, online retailing had gained significant traction, traditional department stores had lost favour, and obituaries were written about the demise of shopping centres.

However, there has been a surprising resurgence in the appeal of shopping centres. Scentre, the owner of Westfield centres in Australia, revealed last month that they had recorded a substantial increase in customer visits to 314 million, marking a 9.8 per cent rise compared to the same period in 2022.

Moreover, they achieved record annual sales of $27.8bn by June 30, reflecting a remarkable 21.6 per cent surge from the same period in 2022.

The office sector is facing its unique set of challenges, stemming from cyclical forces and structural shifts such as work-from-home and AI advancements. These factors are contributing to softer demand and an increase in vacancy rates. While it might take time to gauge the full repercussions, predictions about the demise of the office sector seem premature. It’s reminiscent of concerns raised about the retail sector in the pandemic, which as we noted earlier, have not fully materialised.

Certainly, the office sector will need to adapt to the evolving needs and preferences of tenants and focus on flexibility, design, amenity, technology, and tenant experience. But just as in the previous two periods when office property values faced challenges – the early 1990s recession and the oversupply of space and the GFC liquidity crisis – there will be winners and losers in this landscape.

During the early 1990s recession and subsequent property market crash, office property values plummeted. Premium CBD office values, as measured by the PCA/MSCI Australian Direct Property Index, declined by 37 per cent, Grade A by 42 per cent, and Grade B by 54 per cent from peak to trough.

The GFC also witnessed a similar trend, albeit with less severe declines. From peak to trough during the GFC, premium CBD office values dipped by 15.1 per cent, Grade A by 16.6 per cent, and Grade B by 21.9 per cent.

It was a similar story with occupancy rates. According to the Property Council’s office market survey, following the recovery from the early 1990s recession, premium CBD office buildings saw a substantial 12.6 per cent rise in occupied space in the year to July 1994. Grade A properties experienced a 9.3 per cent increase in occupied space, while Grade B properties saw a more modest 3.2 per cent rise.

In the year post the depths of the GFC, occupied space in Premium CBD office buildings grew by 4.8 per cent and 3.2 per cent in Grade A, while Grade B occupied space fell by 0.2 per cent.

So what does history tell us – quality office properties outperform both in terms of valuation and tenant demand.

And while we are still going through a repricing of CBD office property in the current cycle, the flight to quality is gaining momentum again.

There is definitely a reset underway in the spread between prime and secondary office assets, and this is likely to continue through this year and into 2024.

Premium CBD office values have fallen so far by 5.4 per cent, Grade A by 7.9 per cent and Grade B by 12.9 per cent.

The flight to quality by tenants is also well underway. Occupied space in premium buildings grew by 2.4 per cent or 71,900sq m in fiscal 2023, and 0.8 per cent or 60,274sq m in Grade A and declined by 2.1 per cent or 85,725sq m in Grade B.

Looking ahead, sector allocations between the various sectors – office, retail, industrial and now alternates (ie. life sciences, data centres, child care, student accommodation, and build to rent) – will always be important factors in investment decisions.

However, the emphasis on asset selection and value creation via active asset management will be heightened, particularly within the office and retail sectors.

The ongoing asset bifurcation underscores the importance for investors to prioritise the three Qs – quality assets, quality location, and quality tenants with strong covenants.

Adrian Harrington is a non-executive director of Summer Housing and the former chair of the National Housing Investment and Finance Corporation