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Commercial Office – Lending on Fundamentals, Not News Cycles

Commercial real estate

This week two prominent listed real estate investment trusts (REITS) Dexus and Charter Hall, released indicative 30 June valuations for their office portfolios showing 3-8% declines from December 2022 peaks (Dexus down 7.7% and Charter Hall down 3.7%) (Investor reporting ASX). These declines reflect capitalisation rate (cap rate) expansion in the range of 29-32bps.

In January, we articulated our core view that real estate prices would fall up to 25% from 2021/2022 peaks due to cap rate expansion and then rise 10%+ as rental yields increase over the next two years. With this as our base case, we believe that the current market concerns around listed REITS or office values coming off 10-15%, after base interest rates have increased approximately 400bps is not cause for alarm.

The Merricks Capital Partners Fund (the Fund) has six office loans with a total allocation of 20% for the Fund. The assets financed over the last two years were specifically underwritten to be defensive given our expectations of market declines. Each represents premium or A-grade developments at a weighted average LVR of 62% and located in Melbourne, Sydney and Auckland’s CBD. These investments have an effective equity buffer of 35-40% of asset value or cap rate expansion of 220-250bps before risking principal and accrued interest.

Several news headlines have focused on specific assets, like Dexus’s 44 Market Street Sydney, which transacted this month at a 17% discount to book value. This data point is informative but should be viewed in the context of that particular asset – a lower quality A-grade office outside the core Sydney CBD, constructed in 1978, refurbished in 2019 and with a short weighted average lease expiry (<2.7 year WALE). Clearly, this is a differentiated product to newly constructed office in strategic CBD locations with prime grade amenities.

Our view on the core office sector remains, however deeply discounted valuations on new finance opportunities in lower A grade is so compelling it is now coming into the mix in reviewing new opportunities as existing loans are refinanced.

Core office lending thesis

  • Prime tenant demand continues to focus on ESG requirements, including NABERS energy ratings that for the most part can only be achieved by new builds, along with high staff amenities and strategic CBD locations as key requirements for prime office space (Plan1). We have particular focus on capital cities with short prime supply forecast and high expected tenant demand from corporates and government for these specific assets.
  • Current net migration and forecast labour growth in Australia and New Zealand is a key driver for office demand in the locations identified above. Over the next 3 years, an estimated 500,000 new ‘white-collar’ jobs are expected to be created in Australia (National Skills Commission 2026 outlook).
  • Bond markets anticipate interest rates nearing their peaks in Australia and New Zealand, with forward curves falling by the end of 2023. We expect the spread between prime commercial office cap rates and 10-year bond yields (4.0%) to stay in the range of a 100-175bps over the next 12 months.
  • Supply for new prime is forecast to remain tight with elevated construction costs, up 20% between 2020-2022 and estimated to rise a further 8% over the next two years, which has caused many developers to pause on new projects (CoreLogic’s Cordell Construction Cost Index).

Opportunistic lending against low LVRs on A and B-grade offices

A degree of market concern about correcting asset prices across prime and secondary may enhance new deployment opportunities, especially where this aligns with what we’ve been expecting, and our senior secured loans offer protection against further falling asset prices. By example, we’re in due diligence for afear and market dislocation allows us to lend at 70-80% below replacement cost and still earn equity like returns.