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.

Rising risk and uncertainty: why change is occurring

Multiple factors are combining to foster rapid supply chain adaptation. The pandemic brought urgency to the need for change, ensuring that all businesses understand how fragile supply chains are and the need to ingrain resilience. Supply chain pressure rose immediately, reaching record levels in the Eurozone and the UK in June 2020 (figure 1). Pressure remains significant with global supply chain pressure peaking in December 2021. This reduces business output, erodes profitability and adds to inflation.

As with other structural changes though, the pandemic merely accelerated a pre-existing trend rather than creating it. Supply chains were becoming more localised and manufacturing activity was already nearshoring but the pace was much slower. The ability for supply chains to adapt is being fuelled by a variety of drivers (figure 2).

Ultimately the negative externalities of complex, lengthy supply chains and consolidated production have risen as uncertainty prevails and risk escalates. In parallel, the feasibility of nearshoring production and localism supply chains has increased. The cost/resilience balance is swinging in favour of the latter.

Significant floorspace demand: occupier demand will escalate

Greater inventory and nearshored production require physical floorspace. Occupier demand for logistics, warehousing and industrial/light industrial stock will rise, compounding the existing supply/demand imbalance in favour of landlords.

In terms of specification, storage space requires little other than volume. This may mean that demand is focused on more affordable secondary logistics and warehousing space with height. The need for physical proximity to customers and producers implies that all European countries are likely to absorb rising demand and that transport connectivity will be a locational driver. Space near major transport nodes such as seaports, airports and multi-modal terminals may be most desirable.

Although modern production processes have lower labour requirements, labour is still needed. This suggests that Central and Eastern European (CEE) countries where labour is cheaper and more readily available along with lower operational costs may be most attractive. Western European markets are still easily accessible from the CEE. The BCI Global survey established that respondents considered CEE countries to be the most sought-after European countries for nearshored production. That said, the primacy of resilience over cost means that demand is directed towards western European countries too. Demand is expected to be focussed largely on industrial/light industrial space.

Production facilities typically rely on support from suppliers and logistics subcontractors. As such, the emergence of new nearshored production facilities will stimulate broader occupier demand in their surrounding localities. They are demand catalysts.

Rising risk and uncertainty: why change is occurring

Multiple factors are combining to foster rapid supply chain adaptation. The pandemic brought urgency to the need for change, ensuring that all businesses understand how fragile supply chains are and the need to ingrain resilience. Global supply chain pressure rose immediately and remains near a record high (Figure 1). This reduces business output, erodes profitability and adds to inflation.

As with other structural changes though, the pandemic merely accelerated a pre-existing trend rather than creating it. Supply chains were becoming more localised and manufacturing activity was already nearshoring, but the pace was much slower. The ability for supply chains to adapt is being fuelled by a variety of drivers (Figure 2).

Significant floorspace demand: occupier demand will escalate

Greater inventory and reshored production requires physical floorspace, and this greatly favours commercial real estate operators. Occupier demand for logistics, warehousing and industrial/light industrial stock will rise, compounding the existing supply/demand imbalance in favour of landlords.

In terms of specification, storage space requires little other than volume. This may mean that demand is focused on more affordable secondary logistics and warehousing space with height. Transport connectivity is likely to be a locational driver. Space near major transport nodes such as seaports, airports and multi-modal terminals may be most desirable.

Demand emanating from reshored production facilities is expected to be focused largely on industrial/light industrial space. Whilst modern production has lower labour requirements than in the past, access to skilled labour is still needed. This suggests demand will be focused near cities or other clusters offering ready access to specialist technical or manufacturing labour.

Production facilities typically rely on support from suppliers and logistics subcontractors. As such, the emergence of new reshored production facilities will stimulate broader occupier demand in their surrounding localities. They are demand catalysts.

Light industrial shift

Light industrial stock comprises space used for manufacturing, production activities such as part assembly and repackaging or research and development. Typically light industrial has higher office content than logistics stock and may comprise smaller assets or multi-let tenancies. Like logistics it benefits from exposure to cyclical economic and structural growth in online retail and supply chain recalibration but at more compelling entry prices.

Light industrial accounts for a large proportion of German industrial and logistics supply. Much of this is situated in urban areas where land competition is intensifying due to urbanisation. This underpins land value and offers future upside potential from densification for either co-located light industrial/logistics with other mixed-uses, or potential conversion to other uses entirely such as residential. This has the potential to deliver better performance.

Unlike logistics though, light industrial stock is far more differentiated and bespoke to the occupier and purpose. To acquire stock with resilient income and growth potential, investors must apply a granular approach to stock selection. Although granularity is needed, the right specialist can still build scale quickly, comparable to a logistics portfolio. Partnering with investment managers who understand local markets, are well connected to occupiers and can make informed decisions is vital.

Broader allocation will deliver income

In summary, we expect that compelling long-term fundamentals in the logistics sector coupled with low distribution yields in core logistics will prompt a growing number of investors to diversify. Diversification will encompass acquiring higher-yielding light industrial stock in Germany which benefits from exposure to similar occupational drivers and often has underlying land value. It will include European diversification to gain exposure to stock likely to benefit from rapidly escalating occupier demand at more compelling yields. Such diversification also spreads risk and smooths income returns.

Effectively executing a diversification strategy of this nature requires partnering with an informed investment manager with a true pan-European presence. This is a sophisticated approach which relies upon detailed knowledge of evolving occupier demand and how that relates to real estate. Local markets must be thoroughly understood in order to understand their unique characteristics and identify the most attractive investment opportunities. Local relationships with landlords and occupiers will also help to maximise performance potential.