Commercial office – The silent indicators of market value

• In Q1 2023, we saw the lowest volume of commercial real estate transactions since the COVID pandemic (Q1 2020) and the lowest level of office transactions since the GFC (Cushman & Wakefield).
• With less than $1bn of Australian commercial office transacting in Q1, down from $3.3bn Q4 2022, there’s a clear gap between bid/ask spread.
• This is consistent with our experience in 1H 2023 with prospective borrowers approaching us for +$2.0bn in finance to fund CRE asset acquisitions.
• Our visibility on future transactions is that there will continue to be divergent pricing spreads, with recently developed assets transacting at or near 2022 valuations and others where the seller needs to transact, at discounts 15-25% to 2022 peaks.
• Our senior secured loan portfolio is well positioned to perform as we have focused on recently developed commercial assets with several major loans expected to be repaid over the coming six months.

In the 15-25% discount to book value range, we see the most significant pricing corrections for older office assets with shorter WALEs and limited tenant demand. In a higher interest rate environment, these assets have not been able to pass through the same rental increases that many newly delivered prime office assets (Premium and A-grade) have.

We’ve actively prepared our portfolio for this possible correction, with highly selective investments into office that have key defensive features:

• modest loan-to-value ratios (weighted average office LVRs 61%), providing an equity buffer on each project of 35-40% against asset value declines;
• key locations in capital cities that deliver office space to development precincts where new public transport infrastructure is proceeding. We expect Melbourne and Sydney to disproportionately benefit from net migration with approx. 60% of permanent migrants settling in these two cities historically (ABS);
• prioritising new office assets with market-leading amenities around energy efficiency, functional designs and staff facilities with the bifurcation between this product and older, less desirable stock continuing to widen; and
• monitoring new rents achieved compared to valuations (across our seven office loans), we’ve seen 2023 rents in line with or above assumptions used in valuations.

With approximately 20% of our loan book exposed to the office sector, we anticipate a favourable lending environment to redeploy the upcoming repayments of office loans in this dislocated sector. The ongoing price discovery phase of office and commercial real estate will reset valuations. Our core strategy will continue to focus on new best-of-breed offices. However, as asset prices decline, we may deploy a small portion of our portfolio to support opportunistic buyers in very lowly leveraged loans of refurbished older offices. For example, we recently settled a loan for an Auckland office refurbishment project with initial and peak LVR of 28% and 50% respectively, forecast to return 11.6% to investors (net of fees and costs).