Why towers and property trusts aren’t good investments

JLL’s March quarter report says the vacancy rate in Melbourne is 15.6 per cent.

For over a decade, I have explained to investors that commercial offices must be an unattractive long-term investment proposition.

Why? Simple. When we invest, we should maximise exposure to appreciating assets and minimise exposure to depreciating assets.

It’s one of the reasons I don’t like airlines. They buy planes. And planes depreciate. Eventually, the need to replace ageing aircraft – depreciated on a historical cost basis and therefore understating the true cost of replacing them and artificially boosting accounting profits – will catch up with the airline.

Similarly, when investors buy an office tower, they buy land and a building. My observation is that the bit that’s appreciating is a small stamp-sized parcel of land. The bit that’s depreciating is, proportionately larger, a tall office tower.

Over time the tall office building ages, and it falls from A-grade to B-grade and then C. Newer, shinier buildings with the latest gadgets, functionality and amenities inevitably rise somewhere nearby, and tenants always want the shiny new thing to offer the next generation of employees the best environment in which to be productive. Consequently, tenants vacate the aged office tower and move to the latest A-grade building.

The economics are average at best and horrible at worst.

Melbourne’s renovated 637 Flinders St was vacant as of April. Picture: Emily Godfrey

Consider 637 Flinders St in Melbourne. Formerly the site of the Victoria Police, a speculative $80m refurbishment by its Singaporean owners, commencing in 2021, modernised the office tower. Yet, despite all the latest flash gizmos and a convenient location, it was empty as of April this year.

By contrast, I’ve always liked industrial property and invested in it. Why? Lots of land that appreciates, and a simple and cheap (depreciating) shed on top. Even though the shed depreciates, it’s a smaller proportion of the economics because it was so cheap to install. The appreciation of the land is a far greater proportion of the return.

And guess what? Investors can receive a decent income yield while waiting for the land to grow in value – which it will, sooner or later. Finally, precious little of that income earned is required to be reinvested for upkeep, unlike for the office tower owner.

Recent news of deepening vacancies in Sydney and Melbourne office towers is being painted as a function of the post-Covid trend to working from home. And there’s some truth to that, but the news also highlights the poor economics of owning office towers long term.

Across Australia, office towers are tenanted at fractions of their pre-Covid levels. Buildings are empty or tenants occupy just a segment of the lettable area.

Consider Grosvenor Place in Sydney – a building with prized harbour views and the building I worked in early in my career.

According to some reports, Grosvenor Place is effectively half empty. And it is just one of at least 24 major Sydney and Melbourne office buildings with significant vacancies or with tenants about to move out or downsize as flexible working arrangements become entrenched, leaving CBDs like Melbourne’s empty and experiencing consequent rising crime.

According to Macquarie Group, CBD vacancies in Sydney and Melbourne are at levels unseen since the recession of the early 1990s. The same is also true in Perth and Adelaide.

And according to JLL’s March quarter report, vacancy rates in Sydney and Melbourne are nearly 14 per cent and 15.6 per cent, respectively. That’s one in every 6½ office towers empty.

Perhaps Covid-19 and the subsequent work-from-home trend are now finally lifting the veil off the eyes of commercial office investors, forcing them to admit to the economics of long-

term ownership that is inescapable.

The Grosvenor Place building in Sydney's CBD.

Given the poor economics now explained, it should be unsurprising the share prices of Australia’s biggest listed CBD property investors have collapsed.

REITs with material exposure to the poor economics of office tower ownership have suffered since the pandemic began. Dexus is down 42 per cent, while GPT is 34 per cent lower since July 2019, Charter Hall has almost halved since December 2021, and Centuria has declined 54 per cent since September 2021.

And lest you think this is a local phenomenon, consider New York’s Empire State Realty Trust’s share price, which is 61 per cent lower than its August 2016 high.

Separately, we have had a string of changes at unlisted office trusts in the local market with news that there are now “limited redemptions” being imposed at Charter Hall and suspensions at Centuria Capital.

By contrast, industrial storage unit owner National Storage REIT’s share price is 32 per cent higher than its July 2019 price.

Roger Montgomery is founder and chief investment officer at Montgomery Investment Management