“Do you prefer work at your kitchen table or at the office?”
- We wrote about our view on financing office developments below replacement costs last month but that was prior to the perceived impact of stage 4 restrictions in Melbourne.
- Changes in work practices due to the coronavirus and significant uncertainty have resulted in a significant demand shock for the commercial office markets. I.e. leasing is at a standstill
- We have engaged a multitude of experts and no one knows for certain the duration or permanency of tenants holding back from new pre-leases.
- What we do know for certain is a shift in supply dynamics due to tighter lending criteria and pre-commitment hurdles is happening.
- The number of high-quality borrowers seeking alternative finance for their mooted developments is a clear metric we can attest to and is indicative of impending supply constraints
- The shelving or delay of approved projects is expected to result in the market rebalancing by 2023
The impact of the COVID-19 pandemic has and will continue to be wide-spread, long-lasting and variable. Some things will quickly return to “normal”. Other aspects of our daily lives, including how we work, have clearly undergone a perceived shift. The following infograph from the NAB Australian Commercial Property Survey (Q2 2020) shows how survey respondents expect the office market to be affected by the impact of COVID-19 on working patterns
What this means for future demand for office space is both uncertain and yet very clear. The changes in working practices or, as Colliers puts it, the “place, space and pace” of work, will result in a significant structural shift in office demand.
Colliers notes in its CBD Office Second Half 2020 report, however, “that any short-term shock to demand is always met by a long- term impact to supply cycles”. They expect that project discipline will become even tighter post-COVID and developers will need higher pre-commitment to obtain funding to commence construction. Their analysis suggests that the higher rates of vacancy going forward will be absorbed through improving employment conditions from 2022, while supply constraints will apply as very few projects are approved over the 2020/2021 period. The net result will be an office market close to rebalance by 2023. In Melbourne, in particular, developers are facing a number of challenges and several projects that are either approved or mooted are expected to be pushed back or not go ahead at all.
Importantly, the expected impact on valuations continues to be minimal. The NAB survey shows participants expect office capital values to decline 4.8% over the next 12 months and 3.7% over the next 12-24 months. This is in line with our expectations of declines in headline values for prime grade office of sub 5% into late 2021, while vacant possession values are expected to deteriorate by a further 5% due to longer letting up assumptions and increased cash incentives required to transact new leases.We remain comfortable with the current risk premium for A-grade office projects. Average yields are currently trading at ~4.7%, or almost 400 basis points above the Australian 10-year bond yields, which is attractive on a risk-adjusted basis for the typical institutional investor taking a longer-term view. Rents are expected to soften slightly but this is likely to be through increased incentives. Incentives, whether through rent-free periods of fit-outs, have increased to 33% for Melbourne CBD office market compared to typical levels of 20-25%. The uncertainty on near term rental metrics is making it difficult for leveraged balance sheet financiers such as banks to maintain the same commitment as pre-pandemic to the office space. Banks need certainty of cashflow to underwrite the borrowed capital they are on lending. Our unleveraged balance sheet effectively means we are lending equity at what was bank driven loan to valuation levels. This is providing an excellent opportunity to lend against quality projects at well below replacement cost and at much higher rates than banks were achieving. After successfully financing two innovative and milestone projects in the Melbourne fringe market, we are currently reviewing several Melbourne and Sydney CBD office development loans.
For what it is worth an internal poll suggests the team at Merricks can not wait to be back in the office.
Partners Fund Portfolio Update
Our monthly newsletter will be out next week, however the portfolio is now back to run rating double digit annualised returns and is fully invested. Next week we anticipate adding a residual residential stock facility in Perth where we are achieving high single digit running interest at an LVR of 65%. The Perth residential market has vacancies of sub 1% after a prolonged period of supply constraints and the recent reboot of the mining sector.