• Over the past 18 months, our exposure to commercial office loans has decreased from 33% to 16% in the Merricks Capital Partners Fund as borrowers successfully refinanced new office projects with banks.
• In a post pandemic environment, demand for prime (Premium and A-Grade) office is bifurcating from secondary grade spaces (B, C, D-grade) and prime supply is likely to remain tight for the next three plus years. Our view is that low grade office will continue higher vacancy or undergo transition to other uses.
• In our opinion, the need for new buildings with environmental credentials and a new form of amenity that attracts staff back to the workplace will be well sort after.
• With a trend firmly established, we are increasingly comfortable financing new office buildings and generally avoiding older redundant buildings.
• In light of this strategy, we are likely to increase our office segment exposure by 5 to 10%.
• Our new investments will target prime developments in Australian capital cities with strong sponsors providing an equity buffer of 35-40% of the asset price.

A key trend within the latest office market data is that businesses are continuing to vacate older, lower-quality buildings for newer, premium-quality ones. According to Property Council of Australia’s (PCA) February 2023 Office report, across Australia’s office markets, prime office net absorption (tenant demand) totalled 305,068sqm whereas 211,059sqm of secondary (B-Grade, C-Grade and D-Grade) office space was vacated by tenants over 2022.

A significant driver for this “flight to quality” is tenants are increasingly focused on the attraction and retention of staff with Australian unemployment at a four-decade low (~3.7%) (ABS). While the COVID-19 pandemic has made working from home a common practice, offices remain crucial as part of employers’ strategies to attract and retain employees in a historically tight labour market.

The tenant preference for better quality office space is highlighted with the prime vacancy rate of the Australian office market sitting at 12.3% compared with the secondary office vacancy rate of 14.7% as at January 2023 (PCA). Significantly, higher quality office spaces are better at incorporating ESG principals, reflected in NABERs ratings and improved employee experience. 2022 research by CBRE showed 4%-11% higher occupancy rates for NABERS 6 Star and 5.5 rated assets.

Looking ahead, total Australian employment is forecast to increase by 1.18 million (+9.1%) over the next 5 years (PCA), boosting the need for further office accommodation. While 751,700sqm of office space is scheduled to be delivered across Australia’s office markets this year, the amount of new supply is forecast to halve in 2024 with 321,700sqm (PCA) highlighting the need for the development of office space to meet the demand of today’s workers.

The Merricks Capital Partners Fund expects to deploy $80-$125m into prime office investments in the first half of 2023, when there is a strong demand for prime developments and undersupply forecast for the next 2-3 years.