Today’s office environment sits in stark contrast to the one we knew prior to the outbreak of the COVID-19 pandemic. Australia has weathered the first seven months of the new virus better than most. Australia has seen approximately 26,000 cases with over 22,000 recovered and 770 fatalities. Of course, some states are faring better than others, and, as we have seen over recent months in Victoria, it only takes a few simple mistakes to see a significant outbreak develop.

The long term economic, social and health ramifications of the COVID-19 pandemic will echo well beyond the time period allocated to the outbreak itself, even assuming that a safe and effective vaccine is developed.  We are already seeing a forced change in thinking from many organisations around the globe as to how staff are interacting with their workplaces.

EG has, like most other businesses in Australia, been grappling with the balance of keeping team members and their families safe with the economic realities of doing business. We understand now more than ever that businesses need to continue to evolve to prosper. Like many others, we are continuing to experiment on best practice, always with a people-first approach.

So what does all of this mean for office investment in Australia? And how do purchasers evaluate risk in a market where there is no certainty through a health crisis without a determinable end? How many businesses will contract?  By how much? How many will disappear entirely? Will businesses change the way they work forever, or will they revert to pre-COVID-19 habits? When will we see stabilisation and a subsequent recovery? The answers to all of these questions will be answered over time, and many of the outcomes are tied directly to the course of the pandemic itself.

“We understand now more than ever that businesses need to continue to evolve to prosper.”

Leading indicators show leasing fundamentals are shifting in favour of tenants. Increasing sublease space, a reluctance from tenants to make long-term decisions in an environment of uncertainty, and landlords focused on shoring up cashflow and covenant strength all point towards further softening of effective cashflows and better bargaining power for tenants. This is going to translate to softening office pricing. We’re already seeing the early signs, including;

  • A growth in “select off-market” processes where vendors invite pre-qualified purchasers to bid on assets in a closed environment. These processes are generally run quietly and without formal marketing to allow the vendor a swift (and silent) exit if target pricing cannot be reached.
  • Purchasers are often inserting “COVID Clauses” into offers addressing the rental income which is currently in limbo as landlords and tenants work through rental relief framework. Effectively, in these scenarios, the vendor will “top up” any rent nominated in the tenancy schedule but not being realised via future monthly rent payments.
  • Some purchasers are requesting an escrow at settlement encompassing all income (not just income that is deemed to be “at risk”) over an agreed period, whereby the vendor guarantees an income yield over to give purchasers cashflow comfort for a defined period.
  • Secondary assets are seeing higher rates of rental delinquency and we expect to see a flight to quality as rents become more affordable and tenants seek to “trade up”. We see this movement in every cycle. This spells bad news for B and C grade offices in the medium term. 
  • Assets which would have expected to trade above book values prior to the pandemic are now seeking current book value as the target sale price. The realised value could be down by up to 15% on what the asset may have attracted ‘pre-COVID’ through an open market campaign.

All offers in the near future will inevitably reflect a softening in growth rates, retention rates, letting up periods and effective rentals. Cap rates and discount rates are remaining relatively steady at present as a result, but pricing is coming off as other levers are paired back. Cap rates may well be the next cab off the rank.

Rental income underwritten by “COVID Clauses”and escrows will not be fully reflected in transaction deal analysis because non-performance of income happens over time and into the future. This means that the reported deal metrics at settlement will likely look better than the actual deal over time. Once escrow amounts are allocated to income holes the effective sale price will be lower than reported. Hence, we expect some hidden underperformance over the medium term.

The next 12 months will see general value erosion in national office markets. However, as in all volatile markets this will provide genuine opportunities for those seeking medium to long term outcomes on assets which will rebound more quickly due to superior location and/or future potential for value creation.

EG are constantly updating and challenging our house view on Australian office, an investment class which has made up a significant percentage of our historical acquisitions in Australian Real Estate. Commercial office has delivered a significant proportion of the outperformance of our previous funds and mandates and the office sector remains a target for our open ended Australian Core Enhanced Fund, established in June 2019.

While we don’t yet have answers for the questions that are raised by the pandemic we believe the market cycle driven by this health crisis will deliver excellent opportunities for patient and prudent investors.