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The Outlook for Office – Structural Impacts and the Post-COVID Environment
14th April 2021 / 12 mins read
Chris Cawson
Consultant
Irene Zabala
Investment Analyst
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The domestic office market experienced a period of considerable expansion over the last decade. Australia’s two largest markets, Sydney and Melbourne, recorded its lowest vacancy rates in 30 years (5.0% and 3.4% respectively ), while capital values and rental growth reached unprecedented levels.  Prior to the COVID-19 global pandemic, it was generally accepted that the office market had the ability to remain at these levels over the medium term. 

As concerns grew over the pandemic’s severity in early 2020, Governments around the world were forced to implement strict lockdown and social-distancing measures in an effort to curtail the spread of COVID-19, resulting in the majority of office employees being required to work from home over an extended period of time. This fundamental change to the utilisation of office space caused a shift in general perceptions toward the sector, impacting the short to medium term outlook and raising questions about office demand in a post-COVID environment.

The perceived effects of COVID-19 on the Office Sector

The below summarises the perceived impacts and outlook for the office sector arising in 2020:

Valuation Impacts
  • In 2020, capital values were expected to experience pressure in the short to medium-term due to reduced occupier demand and softer net effective rental growth. Transactional evidence to date is generally supportive of prevailing valuation metrics.  
  • There is likely to be significant bifurcation of asset values by quality, Weighted Average Lease Expiry (WALE) and tenant covenant. Secondary assets of poorer quality are likely to be under significant pressure; whereas long WALE, high quality assets are more likely to appreciate in value.
  • The lower for longer thematic will continue for the foreseeable future and risk premiums (being the spread to bonds) remain near historical highs (~4%+).  
Rents and Rental Growth
  • Minor impact on face rents is expected, while incentive expansion is projected across the major markets, resulting in lower net effective rents (down ~5-15% in the shorter-term).
  • There is likely to be a flight to quality which will put increased pressure on secondary assets.
  • Affordability will be a major driver in the current environment, and there is likely to be softer rental growth over the short-term. Melbourne and core metro markets are anticipated to be more attractive due to relative affordability in rents.
Demand
  • During the height of the COVID-19 crisis in 2020, occupier demand was expected to reduce given the impacts on the labour market from a recessionary environment. In 2021, tenant demand is expected to remain soft given the potential downside risks associated with the gradual withdrawal of stimulus measures such as JobKeeper and rent abatement schemes.
  • In 2020 floor space requirements were expected to significantly decrease as working from home (WFH) became prevalent. However, at the start of 2021, it is evident that businesses are choosing to maintain their office space as a ‘hub’, while a certain percentage of staff worked from home on a part-time basis.
  • While sublease space may remain elevated, it is conside4red to be ‘reactionary’ space and could decline as sentiment continues to improve. 
  • Demand from government, technology and healthcare sectors is expected to drive growth moving forward, while business and consulting services will be more subdued. These sectors in particular are looking for high quality tenancies with strong ESG credentials.
Supply and Vacancy
  • Vacancy is expected to remain at double-digit levels for the short term from historically low levels of 3-4% in Sydney and Melbourne.
  • Construction activity across the other major markets is expected to remain modest and led by major tenant pre-commitment.
  • Backfill vacancy is expected to rise across secondary grade assets.
  • Medium-term projections of supply is likely to reduce until occupier demand recovers and the market rebalances to equilibrium.
 
The impacts of Working from Home (WFH) 

It is anticipated an average of 50% of the workforce is expected to WFH at least two days a week in a post-COVID environment, potentially resulting in a reduction in floor space for some tenants.  The severity will depend on the quality and duration of the asset’s underlying lease profile. Older assets with shorter lease expiry profiles are more likely to be discounted due to the material short term impact to the occupier market, while newer longer leased assets will be less impacted. While it is possible that re-pricing may occur over the short term as the structural risks arising from the impacts of WFH become better understood better quality assets will be more resilient

Despite these perceptions, JANA notes that leasing activity within the major domestic markets has demonstrated resilience at the start of 2021, bolstered by the news of a vaccine rollout and the easing of quarantine restrictions. A noticeable increase in new tenancy requests has been observed, though accompanied by significant increases in prime incentives within the Sydney and Melbourne markets which increased ~70bps to 30% and ~220bps to 35% respectively.

Effects on Future Demand 
Office


At its peak, COVID-19 triggered a global and domestic recession, accelerating long-term structural trends underway in the office sector, including the increased adoption of technologies aimed at facilitating flexibility for employees to work remotely. JANA believes that future office demand dynamics are complex and the increasing WFH trend is one of several factors that will influence future office demand.  

Longer term, office demand has been correlated to population growth and urbanisation. In a post-COVID environment, population growth is forecast to continue increasing, as per the chart from JLL. In addition, there may be de-densification, whereby workspace ratios may increase (currently 1 worker per 8-10 sqm) in response to physical distancing requirements. 
Office stock is driven by Australia’s total population and population growth, and while recent population growth has stalled  the population is still forecast to reach circa 32 million by 2040. This growth has the potential to generate more than 6 million sqm of additional office space demand over the next 20 years (based on long-term historical correlations). White-collar employment is also projected to increase over time, given the ongoing shift towards a greater services-based sector output. The increased adoption of working from home may change the correlation, but not significantly as businesses will likely need to maintain a central location to run operations.

The Enduring Role of Office as ‘The Workplace’ 

An enduring trend in the utilisation of the office space is to view the office as the central place to grow culture and collaboration. This was a major trend prior to the pandemic, catering for younger generations entering the workforce which require greater engagement, culture and collaboration. Human interaction will always be the key reason for coming into the office, allowing people to build and maintain social and professional networks. Maintaining a physical office in a CBD location has been proven to be the most productive solution for knowledge-based industries such as the legal and finance sectors, as companies generally benefit from clustering together. Post-COVID, the office is expected to remain a key part of any future workplace ecosystem, though the utilisation of the space may change from a mandatory everyday destination to more of a ‘hub’ in a partial WFH scenario.

Collaboration studies have shown that the majority of employees view face-to-face collaboration as preferable to working from home, as offices enable more spontaneous interaction between employees, and an opportunity to build and maintain social and professional connections. Organisational culture is also enhanced by enabling ad-hoc social interactions, promoting cohesion between teams. These interactions provide an opportunity for junior staff to learn by observation, as studies have shown that ~70% of learning comes from experience, including informal on-the-job learning from more senior staff. 

2. Office


 Australia’s response to COVID-19 has been successful, allowing firms to make more decisive real estate decisions. This has ensured the office environment remains relevant in business models. As illustrated by the adjacent chart from CBRE Research, though space reductions resulting from increased flexibility are anticipated, on average, space reduction in Australia is expected to be less compared to the global average. In addition, while it is broadly accepted among occupiers and corporate real estate providers that changes in real estate use may emerge in a post-COVID environment, this does not mean a permanent shift away from office space, but the increased adoption of more flexible work solutions.

As restrictions began to ease in Australia, and the Melbourne lockdown began to lift toward the latter end of 2020, commercial leasing agents observed a general uplift in space enquiry. Overall, in Q4 2020 the market recorded a 3% increase in the number of leasing enquiries, and a 9% increase on area requirements compared Q4 2019 – a positive trend despite what has been a challenging market environment. 

 

 

WFH is an existing pre-pandemic structural trend that has been accelerated by COVID-19, though it is unlikely to significantly impact demand over the longer term.  The full impact of WFH on the office sector is currently unknown, however JANA is of the view its medium to long term impacts will not be as detrimental as first thought. Office space will remain critical for business operations as occupiers and landlords alike generally view the office as a place to nurture collaboration and culture; along with promoting a beneficial work-life balance and sense of belonging among employees. 
 

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