Real estate (operational and core)
(Total) return of the office
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Matthew Lane
Managing Director
Published 24 October 2022
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We are living through a remarkable period of economic upheaval. Equity markets remain firmly entrenched in bear market territory, and real chaos is unfolding in the traditionally secure and steady global bond market.

As we move through the final quarter of a turbulent 2022, the performance of the Australian office market remains resilient. Latest results show tenant demand is holding up and occupancy levels are creeping higher.1

The office sector continues to deliver solid risk-adjusted returns and prime investment yields have held relatively firm, even in those markets struggling with higher overall vacancies.2

As the dust continues to swirl around the long-term outlook for office occupier and investment demand, understanding and actively managing income risk and growth will be fundamental in driving future performance.

Income the key to office return

Total return for Australia’s office sector over the year to June 2022 was a robust 8.5%.3 Over the longer-term annual total return has averaged 10.7%.4

Significant discounting in the public A-REIT market and rising bond yields have raised questions around the outlook for value in the private (direct) office market. Despite churning uncertainty, the solid performance reinforces the office market’s resilience in periods of macro-economic upheaval.

Income forms the largest component of long-term investment performance for real estate. Driven by macro conditions including the flow of capital into the asset class and market expectations around future returns, the volatility in office market performance comes predominantly from the capital side.

Income return, however, can be more actively managed and enhanced by those with local market expertise and experience. Critical in generating income growth will be managing occupier preferences from both existing and prospective tenants.

Actively re-shaping strategy to adapt and optimise the modern CBD workplace will play a critical role in managing future cashflow risk and performance.

Reimagining the workplace

In just under three years after the forced closure of the world’s office towers due to COVID-19, the commercial office sector is proving resilient. Lease covenants have been honoured and new tenancy commitments are being made.

While some tenants are expanding, others have under-utilised space. The net effect of these micro-movements across the national office landscape has resulted in a robust quarter of a million square metres of demand over the year to September 2022.5

The CBD workplace is being re-assessed and adapted and asset owners are working to creatively re-imagine office environments.

The disruption of the pandemic and spotlight on employee wellbeing has amplified a shift in demand to prime space. High quality assets with the latest in amenities and sustainability features, good access to transportation minimising commute time as well as multi-functional and flexible space options to accommodate all types of tenants and working models are sought in preference to older stock.

Improving operational efficiencies including refining indoor air-quality, ventilation, cleaning systems and end-of-trip facilities to encourage alternate modes of transport and exercise are a focus for landlords. Building owners are also engaging more closely with flexible space operators using management agreements to share risk and to offer an alternate style of space within a traditional building stack.

Not all offices are created equal

The increasing requirement for prime office space is leading to structural vacancies emerging in some markets, keeping overall vacancies across the nation in double digits.6 As such, office market returns through the next cycle are likely to become increasingly disparate by sector and quality of asset.

As interest rates rise the implied market risk premium between investment yields and the risk-free rate is narrower than historical benchmarks. This may result in some re-pricing as assets come to market. It may also provide opportunities for experienced investors confident they can capitalise on counter-cyclical opportunities.

Real opportunities for experienced investors

Supported by strong long-term economic and population growth drivers and low correlation to other major asset classes, the outlook for total returns for the prime CBD office sector remains attractive on a relative risk-adjusted basis.

In the current market, opportunistic and tactical investors can secure prime assets below replacement cost with built-in pricing power to safeguard income returns against high inflation.

As the world transitions to a higher inflation/lower growth environment and new interest rate regime, the chaos in the bond market reminds investors of the role the commercial office sector has the potential to play as a ballast for reliable income yield.

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1. National Office Summary, JLL Research, Q3 2022, Office Occupancy Survey, Property Council of Australia, September 2022. The occupancy rate increased or remained steady in the September 2022 survey across the six major Australian CBD office markets.

2. National Office Summary, JLL Research, Q3 2022

3. The Property Council of Australia/MSCI Australia All Property Digest (AUD) All Assets, Office, MSCI, June 2022, Long-term figure quoted is the annual average 10-year total return to June 2022

4. As above

5. National Office Summary, JLL Research, Q3 2022

6. The Weekly Real Estate View, 18 October 2022, JLL Research. Canberra CBD vacancy rate is 7.3%

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