Return To Office
The commercial property sector took a beating thanks to pandemic-era lockdown laws and was given little reprieve as interest rates started climbing, but as more employees return to the office will we also see the return of returns?
Workers have been returning to the office albeit taking a more hybrid approach for some time now. But with the New South Wales government recently announcing public sector workers are expected to primarily work from an approved office location, it seems as though the commercial property sector will be one to benefit.
According to research from Colliers, occupier activity across national CBD offices has been showing resilience in the face of economic challenges, with the national CBD vacancy rate sitting at around 14% over the second half of 2023.
This is a positive sign for a sector that has struggled over the past couple of years. In 2022 global listed real estate returns were around -20%, Justin Blaess, portfolio manager at Quay Global Investors says.
REIT underperformance began in 2022 as the US Federal Reserve and other central banks raised rates to combat infation. Higher rates led to higher discount rates and higher borrowing costs which pressured listed REIT performance for the better part of two years.
“We went from easy money in a zero-interest rate policy environment to quickly switching to very restrictive policy,” Blaess says. “That hit hard. Not just for the required return you need from an investment, but also the expected return.
“Real estate is a longer-duration investment, so it got hit hard and was probably one of the worst performing sectors in 2022.
Then 2023 came around and there was no change in central bank attitudes, so 2023 was very volatile.”
Despite suffering through some drastic years, Blaess says the market has started to take pause now.
“As we started this year, central banks and the market began to walk back expectations around the magnitude and timing of expected interest rate cuts. So, we got to June 30 and our total return was nothing,” he says.
“But by the time we get to July, our returns were up 6% as central banks started to talk about cuts again, so the big theme determining returns has really been interest rate policy, and the correlation between the US bond yield.”
As Blaess points out, the real estate sector can be tumultuous because these major swings in returns were not due to interest rates actually changing, but rather whether people thought they might.
“If you actually look at the fundamentals, they haven’t been too bad. Companies are growing their rents, economies haven’t collapsed, no one has gone into a recession yet,” he says.
“So, occupancies are growing, and rents are being paid. It hasn’t been too bad. There has just been some erosion at the margin as higher interest rates have made their way through.”
And while higher interest rates can have a negative effect, the cause of those higher interest rates being inflation, can actually help property assets thrive.
Grant Berry, SG Hiscock portfolio manager, says property assets that tie rent to inflation actually benefit from the more disruptive environment.
“If you think about owning a shopping centre and your rent is tied to inflation, it’s a pretty good asset class to hold during the cycle,” Berry says.
“It’s going to depend on the investor and their tolerance for risk, but time says it is about being in the market rather than trying to time the market.”
Berry says it is likely we are at the peak of the global interest rate cycle now, and while the Australian central bank may lag the US when it comes to cutting, it doesn’t really matter so much in terms of commercial real estate.
“Short-term rates is not how we price stocks, we price stocks on inflation-linked bonds. If you go back to 2021 they were -1%; they’ve now moved up to 1.9% which is actually higher than we have seen for over a decade,” Berry says.
“You’d have to go back to 2013 to get that level and I think that is a reasonable framework to invest and puts roots in a good pricing point for future returns.”
Berry says that volatility exists in every sector, and while interest rates, inflation and various other macro factors can have an impact, he warns that investors shouldn’t focus too much on looking backwards.
“There is a tendency for people to look in the rear vision mirror and then use that as their formula for investing going forward,” he says.
“But if you look at global REITs over the last seven years, they have returned around 1.1% per annum. Are those anemic returns likely to continue? We think it’s unlikely. But we’re finding good properties that we invest in on
a yield of circa 6% per annum. At that level you’re setting yourself up pretty well for reasonable returns.”
Hidden opportunity
While some investors are playing it cool, LaSalle Global Solutions chief investment officer Matt Sgrizzi believes REITs are about to experience a new “golden era”.
“We’ve become increasingly more bullish on the potential for a REIT turnaround; in fact, we believe we are at the cusp of the next golden era in REIT investing,” he says.
“We don’t think it’s only about the potential for interest rates to come down. The lingering headlines of negative bank and financing sentiment, and the ‘death of office’ narratives are easing, and office is not today’s commercial real estate universe – traditional office is less than 10% of the REIT universe today.
“Property fundamentals remain solid with an economic backdrop that should remain supportive of demand, secular demand drivers remain at work and maybe most importantly, a tailwind of declining supply in the near to medium-term.”
Sgrizzi says that as inflation slowly edges back into the Reserve Bank of Australia’s target range of 2-3%, REITs are likely to benefit. “As inflation continues to ease, financial conditions could not only become less of a headwind but potentially turn to a tailwind as we embark on a global central bank easing cycle,” he says.
“This dynamic has historically been a strong time to invest in real estate and REITs.”
And while yes, there is a consensus that the lory days of the office are returning, there are other opportunities as well.
American Century Investments vice president and portfolio manager Steven Rodriguez says the best opportunities can be found in sectors that have favourable demand trends and pricing power.
“Currently, that leads us to an overweight in data centres and health care. We continue to see opportunities in data centres as artificial intelligence and the growth in cloud computing fuel demand for computing space,” Rodriguez says. “These strong demand trends have led tohigh occupancy rates and increased pricing power for data centre operators.
“Healthcare has performed well, and we have trimmed our position, but we remain overweight based on an aging population that can fuel demand for skilled nursing and senior living facilities.”
Elanor Investors Group co-head of real estate David Burgess agrees data centres are going to be a driving force in the sector over the next few years.
“We’re going to see a real rise in alternatives in the real estate sector. A lot of the alternatives sectors in Australia are at the infancy stage; things like healthcare, data centres, self-storage,” Burgess says.
“We’re also seeing a lot of capital looking at the residential space in Australia, which is a core asset class in the US, but still in it’s infancy in Australia.”
Follow the money
Recent research has found that sophisticated and high-net-worth (HNW) investors have also been flocking to the real estate space in the current environment.
In fact, Brisbane-based fund manager Natgen recently expanded its Queensland office portfolio to keep up with strong demand from sophisticated investors for office-backed real estate assets.
“Office stock in strong regional locations has shown greater resilience during the post-COVID period. Whilst much has been made of the resetting of capital city CBD office assets world-wide due to a purported long-term mass exodus of workforces to alternative work settings, regional offices do not suffer from the same negatives. For example, travel time to regional office localities is far less than CBD locations,” Natgen managing director Steven Goakes says.
“Sophisticated investors understand the merits of property and the tax advantaged income stream it can yield. That’s why demand has been significant for this fund.”
Meanwhile, Zagga senior executive, investments and funding Erica Geddes says while investors seeking yield opportunities in commercial property may feel nervous, the sector is diverse and there are plenty of opportunities.
“While certain asset types – including multi-tenant office towers, single-tenant commercial, and highly specialised assets – may require extra scrutiny and due diligence given the current high inflation, high-interest rate environment, many sub-sectors are still performing well,” Geddes says.
“As a commercial real estate debt (CRED) manager, we’re focused on high-grade assets in the deepest and most liquid markets. Assets such as mixed-use commercial, boutique office, small-scale industrial, childcare centres, and non-discretionary retail are the most understood and well received by investors.”
Geddes says astute investors are aware of the opportunities in the CRED market and says there has been a growing number of HNW individuals jumping on the bandwagon.
“The search for reliable, risk-adjusted income has seen many investors turn to CRED for its unique attributes, which can provide a diversified, defensive layer to investment portfolios while also hedging against rising infla-
tion. This is especially the case post-COVID, given inflationary conditions and volatile asset prices,” she says.
“Property investors, more broadly, are also switching from capital investment to debt-funded income investments, owing to unfavourable market conditions.”
Geddes says institutional investors are also getting in on the game with many showing preferences for shopping centres, build-to-rent, industrial and other commercial asset types that are benefitting from the tailwinds of rising population growth and the housing shortage – in short, investments that tend to pay regular returns.
She says the CRED sector is being driven by a substantial shortage in residential dwellings and building approvals, and it’s unlikely that will change any time soon.
“Australia has experienced material population increases over the last 10 years (23 million to 27 million) but is experiencing the same building approval levels (13,000-15,000 per year),” she says.
Geddes adds that regulatory requirements, such as Basel III, make it difficult for banks to compete effectively in certain market sectors, such as construction and project finance.
“This has allowed non-bank lenders to cherry-pick opportunities with favourable risk dynamics, underpinned by high-grade assets, that would traditionally have gone to the major banks,” she explains.
Hedging your bets
While Geddes points out that the real estate sector has many facets, it’s not surprising that when market volatility hits, investors across all sectors get spooked.
We witnessed this at the start of August when the ASX suffered its worst day since March 2020 with $102 billion wiped out in a single trading day. And while the market recovered in a matter of days, it’s still a good example of human nature.
The global market wipe out was spurred by mediocre jobs data in the US that sparked recession fears thanks to the Sahm rule. The rule holds that a recession is likely underway if the three-month average of the unemployment rate rises by half a percentage point in a year.
While the Sahm rule has been an effective indicator, many experts agreed the subsequent global sell-off was a little premature.
Burgess says the market volatility was a good example of why holding some real estate in your portfolio can protect you.
“Market volatility can actually assist in returning a focus to hard assets,” Burgess says.
“The market volatility resulted in the forward yield curve coming down significantly, which makes funding for hard assets a lot cheaper.”
Burgess says – despite a tough few years – it is a good time for investors to consider coming back to real estate.
“Whether it be now or in 12 months, I think we are in the latter parts of the downturn. We’ve had a couple of years of this material downturn, and generally speaking it’s a cyclical sector,” he says.
“You can never pick the bottom, but I would think we are at the latter stages of this downturn. This is probably the third real downturn that we have seen over the last 30 years in commercial real estate, and that would suggest this is a buying opportunity.”
Eliza Bavin
