Trends in Australian commercial property market

Intro:
Welcome to CPA Australia's COVIDChat. A weekly podcast to answer your questions about the latest news and developments impacting business.

Gavan Ord:
Hello, I'm Gavan Ord, Senior Manager, Business Policy at CPA Australia. It's Monday the 8th of November, and you are listening to COVIDChat, bringing you this week's need to know information for businesses and accounting professionals. Today we're going to talk about how COVID-19 has impacted the Australian commercial property market. For this discussion we're joined by William Young CPA, who is Fund Manager - Mortgages for real estate investment with Australian Unity and a member of our CPA Australia's Victorian SME Committee. Many have surmised that lockdowns and the increasing number of people working from home will trigger companies to reduce the floor space they rent. William, could you share what trends you are seeing in the commercial property market? Is there a rush of businesses seeking to reduce their floor space? Or is it the opposite, and why is that?

William Young:
Yeah. Good morning, Gav, how you going? What we are seeing, look, first of all every office market is different, right? So we've got to, look at it from a general perspective today, but what we have seen is that the office demand has dropped but also office supply has dropped as well. So what we are seeing is even though there's office supply coming on in a lot of the major cities, including Sydney, Melbourne and Brisbane, a lot of the offices have already been pre-leased. And so moving forward there's been a reduction in approved projects, so what that means is there's a reduction in supply.

William Young:
What we are also seeing in terms of the office market trend is that there is a little bit of a gravitation towards moving to city fringe areas and that's a kind of mechanics of working from home, more flexible working arrangements, people don't need to be in the city as much as they used to be.

William Young:
Now in relation to reduction of floor space, at the beginning of COVID we did see a lot of people seeking to reduce their floor space, whether it be by subleasing or trying to give back some space, but this is now kind of stabilised and we're not now seeing a rush of businesses looking to reduce their floor space. What we've also seen is that actually part of it's in reverse because a lot of businesses are now looking at more square metre rate per staff, better social distancing, they're actually now needing a little bit more space. And what we are also seeing is that there are a lot of tenants looking to take entire floors because they want to be more COVID safe, and they are looking for opportunities where they don't need to share a floor with other people, and smaller office buildings so there are less people in the lifts.

Gavan Ord:
That's really interesting William and it goes against what people have been saying. So with businesses holding on to their floor space, that leads to the obvious question on commercial rents. What are you seeing on the commercial rent front?

William Young:
Yeah, so, in office sector, we typically categorise offices into different grades. So from Premium Grade A, A, B, C and D. In the Premium A and B grade office space, we haven't seen much of a drop in the face rents or what we also term as quota rents, but what we have seen is some increases in incentives provided by landlords to attract tenants, and some of the increases of these incentives could be up to around 15%. What this means is that the effective rents to the landlords have dropped a little bit to attract people to their office space.

William Young:
Now, this kind of phenomenon is factored in by things that... there are actually less leasing activities at the moment, because there are lot of companies that are holding on on major leasing decisions. And of course, as I mentioned before, because the supply is not in abundance, the rents in itself are kind of holding up for now. What remains to be seen is what's going to move forward, right? How things are in all depends on business confidence and how many people are going to take up more space going forward. But at this stage the rents are still seen to be holding up.

Gavan Ord:
So with, with rents holding up the next logical question is what are you seeing happening to commercial property prices and value, and what is activity like in the buying and selling of commercial property at the moment?

William Young:
Yeah, for this one it's interesting because it kind of goes against kind of COVID and a lot of the stress early on. We are still seeing very very strong pricing and very strong demand in buying of commercial office. We've seen the yields continue to be low and actually has been reducing, making prices actually higher. It's been very very active in the commercial office sales arena with a lot of very active buyers in the market, and it is driven a lot by a number of things. One is low interest rates making borrowing a lot cheaper. There is an abundance of liquidity in the market and a lot of people have a lot of money. And we are also still seeing very strong interest from both domestic investors, as well as offshore investors. So for some of the recent sales we've seen in Sydney and Melbourne, for example, there've been at least 15 to 20 bidders on purchasing of office building in both the city and also the city fringe. So all in all the market itself is still very strong.

Gavan Ord:
That's a fascinating summary of the current state of play at the commercial property market in Australia. What do you see happening longer term in the sector?

William Young:
Yeah, well that's a very interesting question and it's one that's a little bit premature to answer from my point of view, because I think that it is really dependent on how the economy will weather COVID. And I think that to some extent it's still a little bit early to understand the full impact of COVID especially for States like Victoria where we've only come out of the most recent lockdowns. So it will still take some time for all this impact to flow through but what we can see is that today, is that business confidence is still very solid and employment figures have fared better than expected but there are other things that impact, like, we don't know what's going to happen when borders reopen and how will migration be impacted by the long COVID stretch that we've had.

William Young:
So I think in that regard it's very hard to understand right now how office will perform ongoing. At the moment it seems very positive but what we do see, kind of longer term trends, is we are seeing some flight to quality at the moment, for example, people in C grade or D grade offices trying to move to A grade and B grade and or, moving from a city to CBD which, I'm sorry, from a city to the city fringe which we think will continue to happen. We're also seeing longer term people changing the way they use their office space whether it be because of more flexible working arrangements, changes to people gravitating towards more square metre per staff and also increasing amenities that some of the office users are gravitating towards. And by way of example, I had a recent discussion with a friend of mine who... his company's looking to increase office space because they're looking to create more socialising areas, more gaming rooms, more table tennis, free food, more like a Google type setup as a way of retaining staff.

William Young:
And so we are seeing this kind of move towards more innovative use of office space and we think that this trend will continue.

Gavan Ord:
So that was a summary of what's happening in Australia. Are you noticing any different property trends in other markets and do you expect these trends or at least a variation of these trends to reach Australia anytime soon?

William Young:
Yeah, we have seen in Asia some interesting changes in the use of office. So for example, in KL, there's been a trend for converting unused office space into co-living or executive office space, and there's also been a trend of converting offices into distribution centres. Now that's probably because some of the Asian market offices aren't performing so well and so there's been a need to innovate.

William Young:
Now, given that the Australian office market has been performing relatively well and there's no urgency for office conversion, we may not see some of these trends of numbers in Asia coming through to Australia very quickly. However having said that some of these trends do seem to be very interesting from a business perspective. So my sense is that potentially some of the conversion of C or D grade office space into things like distribution centre, for example in the city fringes, may be interesting because we are seeing a growth in online shopping or more of distribution requirements and having them closer to city will make it more efficient.

William Young:
The other thing I guess to understand is, we have seen in the past already a little bit of a move in terms of how people have been doing office developments. In terms of doing mixed use so there's a lot of office developments in a city, for example, now converting into partly office and partly hotel or service apartment or partly office and partly residential. So even prior to COVID the change in the trends of how people were developing office mixed use have already been in place but obviously for some of the Asian markets we're seeing a quicker conversion from office space into different uses because of a weaker office performance.

Gavan Ord:
Moving on to other types of property, what's happening in the Australian industrial property sector and why do you think that's happening?

William Young:
Yeah, the industrial sector has been very active and we are seeing a lot of transactions and a lot of popularity in this sector. And the thing is driven mainly by a few things, right? First of all, is online shopping. [inaudible 00:11:31] online shopping, it was already happening before COVID but COVID has kind of given a bit of a turbo charge, has meant that warehouse and distribution centres are in large demand, and so that's been very active. The other one that we've also seen that's become very popular is data centres because with the growth in online shopping and working from home, there has been a need for increase in servers and data storage. So data centres have also been a very hot market. So from both a user perspective and also investor perspective, we have seen... very active in this space and it's kind of flavour of the month. Now that on top of, as what I mentioned before, low interest rates, a lot of liquidity, that's helped, all of this has helped the industrial sector to be very, very popular.

Gavan Ord:
And what about the retail property sector? Obviously, everyone's talking about that. What are you seeing in that sector?

William Young:
Yeah, retail is probably one of those that's lagging a little bit in terms of market, but I think it's important to appreciate that retail as a sector was transitioning or innovating even before COVID. So there's always been a growth in online shopping, and so a lot of the retail asset owners have had to change the way they offer the experience. So it is especially important for nondiscretionary retail. So some of the trends that we've seen include repurposing of the property to a more destination driven... adding in wellness, things that you can't buy online... better dining experience. We're seeing some shopping centre adding car dealerships because normally you would go and look at the car, test drive the car before you buy it, and other things include things like putting a hotel next to the shopping centre so it becomes a bit of a holiday destination.

William Young:
So that has already been happening even before COVID, but even now with COVID it has highlighted the importance of people understanding and changing the way they offer their retail experience to users. We've also seen a lot of developers or property owners now looking at redeveloping excess land. Cause if you've got, for example, a large shopping centre with a lot of car park that is not used, then we've seen people try redeveloping those or people moving up, so going up on using the air rights to put residential on top of the shopping centre. Now what that helps to do is it creates demand. It creates foot traffic naturally to go into the shopping centres.

William Young:
So these are kind of important things in terms of thinking about the sector by thinking about what you need to do to change it to make it purposed for today's use. The other things that we've also seen I suppose is people trying to change the leasing structure and changing the way that they pay their rents to be fully a percentage of their turnover whereas before a lot of people were paying a base rent plus a percentage of their turnover because of COVID and because of people understanding the volatility of their sales they're trying to match their rental payments to that as well. So that's some of the things that we've been seeing in the retail sector.

Gavan Ord:
And finally, what trends are you seeing in how larger private real estate projects are being financed?

William Young:
Yeah, so we are seeing major shifts in the use of non-banks such as Australian Unity to fund projects and that's driven by a few things. One is higher gearing that some developers require, they understand that the time value of money is getting projects started earlier, actually might give them a better return on their equity. We're also seeing a trend where developers are now having better focus on considering their project financing early on in the piece and not waiting till the construction time to start before they think about funding. So we now get involved a lot early on in terms of how we stage a project or how we help them plan the development to make sure that it is easily financeable. And I think that's also... the other thing is the speed of action of nonbanks is quite prominent now.

Gavan Ord:
Thank you, William. That was William Young from Australian Unity. And thank you for that very interesting discussion on the Australian commercial property market. If you've got a question about any of the topics we've discussed today or on any of CPA Australia's policy and advocacy work, please email [email protected]. And if you've enjoyed what you've heard today please tune in again and tell your friends. From all of us at CPA Australia, thank you for listening.

Outro:
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