The state of the office market

As businesses countrywide adopt hybrid work models – and employees are encouraged back into the office – the market continues to adapt to the diverse needs of tenants and occupiers. Vacancy rates are shifting slightly across CBDs, Knight Frank predicts that short-term market disruption is more likely to be in the form and function of office space – there is a growing expectation that building owners create office space experiences to entice work-at-home staff back into CBDs.

In the six months to January 2023, tenant demand outstripped supply in Brisbane, pushing the vacancy rate down from 13.9% to 12.9%. The PCA found that there is less than 100,000sqm of office space coming online in Brisbane over the next three years, 72% of which has already been pre-committed.

Similarly, vacancy declined marginally in Perth from 15.8% to 15.6%; and Hobart recorded a drop from 2.7% to 2.5% – now its lowest rate since 2008.

In other capitals, vacancy rates rose slightly – from 8.6% to 8.9% in Canberra; 10.1% to 11.3% in Sydney; and 12.9% to 13.8% Melbourne. Adelaide’s vacancy increased from 14.2% to 16.1%, driven by above average supply additions – as a result, the South Australian capital now has the highest vacancy rate in the country. In those markets where vacancy increased, there were moves toward prime stock over secondary stock. Non-CBD areas saw a decline from 15.2 to 15.1 per cent, with tenant demand lifting 0.3%.

Australian office space trends

There is a consensus among Australian property experts that the following represent the most prevalent emerging trends in the local market. These include:

• Workplace change is set to continue – hybrid working environments are now the overwhelming majority in most of Australia’s capital cities. As such, businesses are set to continue to evaluate, and adapt to, employees’ changing working preferences. Workspaces will continue to be reworked and refined over the foreseeable future to accommodate occupiers changing needs.
• The need to create a workplace experience – Knight Frank has found that there is an increasing expectation by building occupants that owners provide experiences and opportunities, including upgraded end-of-trip facilities, wellness centres, food and beverage options and more.
• Tenants’ ESG interest – ESG concerns are increasingly becoming front-of-mind for building occupiers and tenants, as well as the general population. As such, building owners will need to invest in environment and sustainability in their key decision-making processes going forward.

Examining office rents

According to the latest Cushman & Wakefield Marketbeat report, premium grade gross face rents rose 6.0% in Brisbane over the final 2022 quarter – to average $965 per square metre – one of the largest rises in recent years. A-grade also recorded an increase in gross face rents, though slightly more modest – at 1% QoQ (6% YoY) – and B-grade rents remained stable over the final quarter of 2023.

In the Sydney CBD, prime face rents held at an average of $1,410 sqm per year, increasing 4.2% over the course of 2022. Premium, A-grade and B-grade gross face rents averaged $1,525, $1,335 and $1,045 per square metre, respectively.

Summary

In summary, the consensus among industry experts seems to be that 2023 will be a year that Australian markets will begin to shake off the impacts of the COVID-19 pandemic and war in Ukraine. 2022 saw some recovery in selected metrics, and the next 12 months will be largely determined by expected interest rate peaks, as well as ongoing inflation concerns. Though a large amount of uncertainty still remains for investors, Australian markets as a whole are expected to outperform others across the world.

Smart technology

‘Smart’ technology refers to any network in which software and hardware are connected to provide immediate information. When applied to buildings, smart technology allows 24/7 visibility over operations, which enable efficiencies to be optimised in real-time. Heating, lighting, and air conditioning systems can be automated, for example, meaning that they are adjusted up or down in accordance with how heavily parts of the building are being used.

As such, smart buildings make the building more attuned to user needs. Perhaps more crucially though, they minimise needless consumption of precious water and energy resources. Smart buildings are an essential prerequisite to creating more sustainable, environmentally friendly real estate. After all, you cannot reduce what you cannot measure.

An example of this is Cromwell’s partnership with Deepki – a consumption data tool for analysing energy, water, waste, and carbon dioxide use – within our European portfolio. The Deepki platform comprises an ESG data hub that provides a comprehensive view of the current efficiency of every asset. It means we can identify where improvements can be made to align to Paris agreement climate change objectives or when assets may become stranded, thereby allowing proactive management or divestment.

Closer to home, smart technology is a key component in our ongoing refurbishment of 400 George Street, Brisbane – a 44,000sqm building that comprises of office, retail, and childcare uses. We have delivered best-in-class end-of-trip facilities using smart technology and fixtures that measure water consumption in real time. We have also upgraded the building access control system to Schneider Electric EcoStruxure Security Expert.

Our focus is now transitioning to refinement and upgrading of the building management system (BMS) to the EcoStruxure platform, which will allow continuous monitoring of equipment and operations. The upgrade will allow us to improve performance and undertake pre-emptive maintenance before issues emerge as well as easing reporting. This type of smart technology typically results in 80% of issues being resolved remotely, a 29% fall in unscheduled maintenance and 20% lower energy costs.

Occupier engagement

Proptech allows human users to understand and interact with the building in new ways, usually via smartphones. So-called occupier engagement apps can offer automated building/guest access, direct temperature/lighting control, food/coffee pre-ordering or pre-booking of desks or meeting rooms. These features can connect individual users to the wider community within the asset through message-boards or meet-ups, or to the local community by offering discounts at local businesses or advertising nearby events. It makes it easier for any building faults to be reported directly to the asset manager meaning faster resolution – trip hazards can be photographed and logged immediately on the app for example.

Occupiers can derive information on energy or water use at a touch of a button or gain deeper insight on how their staff use the space. For landlords, occupier engagement apps can provide valuable data on how occupiers use their buildings, including where pressure points are and where improvements can be made. Apps like these create a more collaborative relationship between landlords and occupiers which assists to meet compliance obligations, achieve ESG objectives, and build long-term value.

Occupier engagement is a priority for our 400 George Street refurbishment. By adding an app connected to a smart framework, developed by Schneider Electric EcoStruxure, we expect to increase the appeal of the asset to occupiers. In addition to aiding occupier retention, apps can increase brand awareness, increase occupier satisfaction, provide data for better asset management, and ultimately deliver a higher investment return.

Operational efficiencies

Proptech offers significant potential to remove some of the hurdles that have traditionally impeded the efficient occupation and management of real estate. Virtual lease or contractor contracts, for example, can be used to lessen the time it takes to formalise occupier agreements, engage services, and lower associated legal costs. Virtual data-rooms can be established to centralise access to building information preserving data that may otherwise be lost, and accelerate the due diligence process when assets are traded. AI can be used to automate data collection and analysis.

While the technology is at a fledging stage, Cromwell has already experimented with using AI technology to enter historic leases into Yardi, our asset management software, and explored virtual data room technology. Though being an early adopter in this space may be disadvantageous if dominant providers emerge, it is still critical to monitor developments and be ready to adopt suitable solutions at an appropriate time.

The real estate industry is just beginning to harness the power of proptech to make buildings and their management better. It is a journey without an end, given that technology will continue to evolve and iterate at an accelerating rate as one advancement builds on another. It is crucial for landlords to understand the transformational impact of proptech, and to adapt accordingly. Investors, occupiers, and building users are coming to expect proptech solutions within real estate. Those assets with the best technology will deliver superior performance; those without will under-perform. While it has been slow to get going, the proptech revolution promises to profound and utterly transform real estate.

It is crucial for landlords to understand the transformational impact of proptech, and to adapt accordingly. Investors, occupiers, and building users are coming to expect proptech solutions within real estate. Those assets with the best technology will deliver superior performance; those without will under-perform. While it has been slow to get going, the proptech revolution promises to profound and utterly transform real estate.

Government Bonds: Closely correlated with real estate yields

Government bonds are viewed as proxy for the ‘risk-free rate’, which is the theoretical rate of return for an investment that has no risk of financial loss. An increase in interest rates encourages saving and deters borrowing and in so doing raises the required rate of return for real estate investment.

In figure 1, we compare Eurozone government bonds to prime Eurozone office yields. A score of 1 means two variables are perfectly correlated, meaning they move in unison. A correlation of 0 means there is no relationship between them. The correlation between Eurozone government bonds and prime office yields over this period is 0.89. This implies a strong relationship and the long downward trend in real estate yields since 2001 is heavily linked to the fall in interest rates.

Although there is a strong correlation between the two variables, the magnitude of moves in real estate yields and bond yields has differed significantly over the past two decades. Figure 2 shows that real estate yields fell by an average of 280bp across major European markets from peak to trough, while bond yields reduced by 495bp over the same period. This suggests that real estate yield movements, although in line with bond yields, are far less volatile and are subject to other forces.

Figure 3 shows the spread between prime UK office yields and 10-year government bonds, and we have used data from the UK office market due its stable history. The spread at the end of 2021 was around 476bps, compared to the long-term average of 306bps. While there is no mathematical rule to indicate the spread which can trigger repricing, we believe the bond yield must first rise to reduce the spread to levels comparable with the long-term average before exerting direct upwards pressure on real estate yields.

Figure 2 also shows that since 1992, there are two periods where the spread between UK prime office yields and 10-year government bonds significantly reduced: between 1993-7, and 2005-8. In both periods the UK was experiencing inflation above the Bank of England (BoE) target of 2%. This suggests that investors are willing to accept a lower spread between real estate yields and government bonds in periods of high inflation due to the perception that real estate is an inflationary hedge.

Conclusion: Interest rates are important but not the only factor

The combination of positive rental growth expectations brought on by encouraging supply/demand dynamics, the versatility in the debt markets, and sheer amount of money allocated towards real estate suggests that the spread between 10-year government bonds and real estate yields will be lower in the future. This would therefore reduce the rate of yield softening brought on by rising interest rates. Although we have used data on the European real estate market to explore this topic, the same trends permeate all western markets, and the implications are likely to be the same.