Forget remote work, office property has a more basic worry - The Australian Financial Review

Chanticleer

Despite a 20-year high in office vacancy rates and falling rents, the supply of new floor space is still rising as demand is getting weaker. Morgan Stanley says rents may be stuck for years.

May 17, 2023 – 3.10pm

Could Australia’s ugly rental market provide a little hope to our struggling office property giants?

HSBC’s local chief economist, Paul Bloxham, says rising house and rent prices will likely force behavioural changes across the economy.

Fears about the office market are weighing on ASX property stocks. David Rowe

“Sharply higher rents will likely mean an increase in average household size,” he wrote this week.

“Some renters may choose to move back into group housing arrangements, or back into a family home, while new migrants may also choose to move into housing in larger groups.

“Office occupancy could rise if work from home becomes less viable as dwelling rents rise.”

It’s an intriguing thought. But for now, Morgan Stanley analyst Lauren Berry says office giants such as Centuria Office REIT and Dexus have a more old-school problem to worry about: supply and demand.

She says CBD vacancy rates in Sydney and Melbourne are at 20-year highs of 13.7 per cent and 15.6 per cent respectively, well above post-GFC peaks of 10 per cent to 11 per cent. This has pushed effective rents down between 15 per cent and 20 per cent from their recent peaks.

But Berry says new property, equivalent to 3.2 per cent of floor space across the two markets, is coming in the next two years, and much of that new space is yet to be leased. In Sydney, 46 per cent of this new space has been pre-let, while in Melbourne, that figure is just 27 per cent.

At the same time, demand for space – even leaving aside the work from home question – is likely to weaken.

Morgan Stanley forecasts unemployment to rise sharply to about 5.3 per cent by the end of 2024, from just 3.5 per cent today.

“Our work suggests a tight correlation between job markets and CBD vacancy, with a 1 per cent increase in unemployment usually associated with 5 per cent to 10 per cent increase in Sydney vacant space,” Berry says.

Morgan Stanley’s view is that vacancy rates can rise even further from elevated levels. Even if they don’t rise markedly, Berry estimates that the sort of market tension that would push rents higher isn’t achieved until the vacancy rate gets to between 8 per cent and 10 per cent, “meaning we are many years away from seeing material effective rent growth in the Sydney and Melbourne markets”.

As she notes, Dexus and Centuria are trading at discounts to their net tangible assets of between 35 per cent and 40 per cent, while office transactions suggest office property values could be somewhere between 5 per cent and 20 per cent lower.

Some brave souls, like Wilson Asset Management’s WAM Leaders fund, are prepared to swim against the tide. But if Morgan Stanley is right, pressure on this sector will keep building.

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