Ross Stitt takes a look at why the outlook for Australian CBD office property is challenging

In three short years, a pandemic and a spike in interest rates have dramatically changed the environment for investment in Australia’s office towers. In Sydney and Melbourne in particular, the market now faces rising vacancy rates, rising operating costs, and falling values.

And there’s no immediate prospect of a turnaround.

According to data from JLL Research reported in the Australian Financial Review, the CBD office vacancy rate for Sydney hit 14.4% in the June quarter. In Melbourne, still recovering from the country’s severest Covid-19 lockdowns, the rate rose to 16.2%.

Two factors are driving this trend – general economic uncertainty and the ‘working from home’ (WFH) phenomenon. The former is here for the foreseeable future, but it will eventually pass.

The latter is permanent, although it’s still unclear how it will evolve and to what extent it will impact on the CBD office market in the medium term.

Increasing numbers of subleases suggest that many employers are looking to make do with less office space.

That’s likely to reflect a combination of prudent downsizing and greater use of hotdesking as employees spend more time working from home.

However, for some employers it’s still far too early to make decisions about long-term office needs because they haven’t resolved WFH arrangements with their staff. Most employers had no control over the arrival of WFH. It happened practically overnight when governments introduced Covid-19 lockdowns and gathering in offices became a health hazard.

Unsurprisingly, many staff have now acquired a taste for WFH and are reluctant to give it up – less time and money wasted on commuting, greater flexibility in managing childcare, and four-day ‘weekends’.

Significantly, the post-Covid labour shortage has limited the ability of employers to demand that their staff return to the office. That may change if and when unemployment starts to rise and the bargaining dynamic shifts in favour of employers.

The federal government hasn’t helped private sector employers wanting to at least partially unwind WFH. It has negotiated an extremely WFH-friendly agreement with the Community and Public Sector Union, the union responsible for the Australian Public Service (APS).

Under that agreement all workers in the APS are entitled to request flexible working arrangements, government agencies are “required to lean towards approving requests”, there are “no caps” on the number of days staff can work from home, “agencies will only be able to refuse requests after genuinely trying to reach agreement, considering the employee’s circumstances, and only if there are clear business reasons not to approve”, and staff can seek “independent umpire oversight” of decisions they don’t agree with.

Only time will tell what ramifications this will have for public sector productivity.

Australia’s banks are also major employers of white-collar workers and are at the forefront of the current WFH debate. Earlier this year it was revealed that on average National Australia Bank staff were spending just 1.2 days a week in the office. NAB CEO Ross McEwan recognised that this was problematic. Part of his response was to order 500 senior managers to return to the office full-time.

Since then NAB has negotiated an agreement with the Finance Sector Union (FSU) on pay and conditions.

This includes a right to request WFH with a bias toward approval and a decision review process.

The Commonwealth Bank of Australia hasn’t been so lucky. It set a policy requiring staff to spend at least half their working hours in the office, with effect from 17 July. However, the FSU is going to the Fair Work Commission to challenge what it calls CBA’s “edict to force employees to return to the office”.

The FSU National Secretary says that “We will be asking the Fair Work Commission to order CBA to offer all affected staff remote working arrangements on mutually agreeable terms”.

None of this augurs well for the demand for CBD office space in Sydney and Melbourne. And that flows through to soft values for office towers.

Of course, the last year has seen an even greater destroyer of value than WFH, namely higher interest rates. As interest rates rise, so too do the capitalisation rates used to value commercial property. Greater cap rates equate to lower valuations.

Or at least that’s the theory.

The last 12 months have witnessed something of a limbo period in which the volume of sales of CBD office towers has been low. That’s not a surprising response to the sudden and dramatic change in the interest rate environment – potential vendors and purchasers having very different expectations about price movements. The problem is that when sales volumes are low, it’s difficult for professional valuers to accurately assess market cap rates and values.

On 15 June, major property group Charter Hall released its expected valuation update for the six months to 30 June, based on independent valuations. That update revealed a 3.7% devaluation of office property based on a new, higher cap rate of 5%. (Retail property also took a hit, although logistics and industrial recorded a small gain.)

Dexus, another major property player, released its valuation update on 21 June, again based on independent valuations. The result was a 7.7% decrease in the value of the Dexus office property portfolio.

By far the largest direct holders of commercial property in Australia are superannuation funds. They regularly review and revalue their property portfolios. In the year to 30 June, that involved some significant write downs of office property, in some cases more than 10%.

Arguably, one of the best indicators of changing property values is the traded prices of listed A-REITS (Australian real estate investment trusts). Most have dropped sharply over the last 12 months, some by more than 20%. That reflects the market’s view on the decline in value of the underlying commercial property held by the A-REITS.

Of the few actual office property sales recently, notable was the sale announced last month by Dexus of a 26-storey office tower in Sydney. It was sold for $393 million – a discount to book value of more than 17%.

Too many sales at that sort of discount would necessitate substantial devaluations by the owners of Sydney and Melbourne CBD office towers.

Add to that the expectation of further interest rate hikes by the Reserve Bank of Australia, and the outlook for CBD office property looks challenging.

*Ross Stitt is a freelance writer with a PhD in political science. He is a New Zealander based in Sydney. His articles are part of our 'Understanding Australia' series.