Quality office values likely to bottom in September Quarter

Prime office asset values appear to be stabilising after an estimated 15-25% price correction over the past 24-36 months. Our discussion with potential buyers (borrowers) suggests the bid/ask spread is narrowing as inflation drives net rents increases quarter-on-quarter. Forecasting is an imprecise science but with the top of the global interest rate cycle in sight and a lack of new floor space projected in coming years, borrower demand suggests the bottom for the sector may be found in coming months. None the less, we suspect there will be some headline grabbing distressed sales that mark the bottom of the cycle in coming months. From a lender’s perspective, we only have interest in precincts with implicit tenant demand, as deep value does not drive interest coverage.

Below, we detail the factors driving net rent growth and the strategic positioning of our senior secured office loans:

• Sydney, Melbourne and Brisbane’s CBD office markets experienced the first notable prime rental growth in Q2 2024, with respective effective rents (after incentives) increasing by 0.3%, 0.4% and 4.2% (Knight Frank). Melbourne showed the biggest turnaround from the negative annual growth of 6.3% as leasing incentives reduced.
• Vacancy rates are at multi-decade highs at 15-19% across eastern seaboard capital cities (JLL), but much tighter demand (<10%) for desirable CBD locations rather than precincts where oversupply has been delivered (i.e., Melbourne’s Docklands). No new office projects are expected in the Sydney CBD for 2025 and 2026, marking the first such hiatus in 50 years. This significant supply-side contraction, combined with robust demand for high-quality office spaces, is likely to tighten vacancy rates in 2025.
• Anecdotally, the York & Co building (32 York St, Sydney CBD) is one of our larger lending office exposures and will reach practical completion in the coming month. With 84% of the building pre-leased and the remaining floor space progressing to agreements the building will achieve a net effective income 22% above the feasibility upon which we based our loan. The higher income will offset the increased capitalisation rate required by valuers which should see an end value within 5-10% of expectations.
• Tenant demand is being driven by businesses prioritising high-quality office spaces that meet stringent ESG requirements, ensuring sustainability and energy efficiency. Companies increasingly seek workplaces that support productivity, wellness, and collaboration, aligning with their broader corporate objectives.
• The upcoming Sydney Metro project, set to partially open in August, will significantly improve accessibility between key Sydney office markets, particularly benefiting commuters from the north-west. This development is expected to bolster demand in the City Fringe and Lower North Shore markets as core stock gets absorbed, further driven by the NSW government’s emphasis on developing new housing near transport infrastructure.
• The Merricks Capital Partners Fund has benefited from increased exposure to prime office over the past two years amid reduced lending capacity and wider spreads. The Fund’s 29% exposure to the office sector is in a repayment phase, with three A-Grade office buildings under construction at 93% completion.

With over $200 million from completed office projects expected to return over the next six months, we intend to reweight the portfolio into defensive senior secured investments across agriculture, residential apartments, and specialised infrastructure.