What the work-from-home movement means for office REITs
The shift to hybrid working remains a challenge for office building landlords post-Covid. But not all assets are equal, with the negative sentiment creating buying opportunities among ASX-listed REITs.
Mentioned: Coles Group Ltd (COL), Amazon.com Inc (AMZN), Commonwealth Bank of Australia (CBA), Charter Hall Group (CHC), Dexus (DXS), GPT Group (GPT), Mirvac Group (MGR), Telstra Group Ltd (TLS), Wesfarmers Ltd (WES)
The landlords behind the modern CBD towers housing strong, big-name tenants are expected to benefit from a flight to quality as companies upgrade their office space.
While the office market remains challenging with hybrid working the new normal post Covid, high-quality assets are expected to perform better than lower-quality buildings.
After a rough year for the sector as interest rates rose, Morningstar believes the big office real estate investment trusts (REITs) are now undervalued.
The REITs with modern office towers and strong tenants
Morningstar equity analyst Alex Prineas says the REITs own much of the best-quality office space in the CBDs - modern buildings that are best suited to hybrid working.
"The REITs tend to own the A-grade and the premium assets, which very much dominates their portfolios," he says.
Prineas says the big office REITs like Dexus (DXS), GPT Group (GPT) and Mirvac Group (MGR) focus on the prime office assets in the CBDs, which are typically tenanted by the likes of the big four banks and large listed companies.
Dexus is one of the biggest office landlords with stakes in many high-profile trophy assets including Sydney's iconic Australia Square, which it co-owns with GPT.
Dexus is also funding, developing and investing in software giant Atlassian's new $1.4 billion headquarters, a 40-level sustainable office tower due for completion in 2026, in Sydney's Tech Central precinct.
"Atlassian is a solid business with fast-growing revenue and its products are widely used by corporates around the world," Prineas says.
"However, even if Atlassian vacated at the end of the 15-year lease, this will be a modern building and given construction commenced in 2022, we think it will have features that are attractive to tenants who may use a hybrid working model."
Charter Hall Group (CHC), another large office landlord, owns Telstra's Melbourne headquarters and last year acquired a $1 billion half-stake in Melbourne's Southern Cross Towers precinct, with tenants including the Victorian government and Australia Post.
Telstra's Melbourne headquarters is owned by REIT Charter Hall Group. Picture: Getty
Prineas says the major REITs, which have diversified portfolios across sectors including offices, all have a very strong list of tenants that are unlikely to default.
"From the landlord (and investor's) perspective, it's about having tenants who reliably pay the rent on time. Tenants are typically locked into long leases, but the lease is only as valuable as the tenant's ability to pay.
"Being a large brand is one aspect that helps, as it can be indicative of a solid business. Equally important is the tenant's balance sheet strength and the business that they are in."
Charter Hall, for example, has a strong list of tenants in its overall portfolio where Morningstar expects near-zero rent defaults. The biggest is the Australian government and other top tenants include Wesfarmers (WES), Telstra (TLS), Coles (COL), Commonwealth Bank (CBA) and Amazon (AMZN).
Prineas notes the modern, higher-quality office buildings owned by the large office REITs also tend to have the best energy-efficiency and environmental ratings, which tenants prefer.
PropTrack economist Anne Flaherty says tenant quality is also of high importance to commercial property investors, particularly as economic conditions become more challenged.
"Buildings occupied by tenants in resilient sectors such as healthcare and education will be more appealing, whereas those occupied by tech companies may be seen as higher risk."
Flight to quality favours modern CBD towers
Tenant demand for premium office assets has surged, as CBD businesses prioritise amenities and employee wellness to attract talent and entice workers back into the office.
"In the wake of the remote and hybrid working habits that formed over the pandemic, companies recognise that offices have to be more than just a place to sit and work," Flaherty says.
"Instead, they are viewed as hubs to promote collaboration and creativity, and spaces that facilitate the changing purpose of the office will see greater tenant demand."
Flaherty notes that in all states occupancy rates remain below their pre-Covid norms, and companies are rethinking their space requirements.
"A key trend has been a reduction in total office footprint leased and a move to higher quality space."
She gives the example of Medibank reducing its footprint from 30,500sqm to 17,000sqm when it moves from A-grade 720 Bourke Street to a premium-grade tower in Lendlease's Melbourne Quarter development.
Premium office buildings are expected to outperform secondary grade office assets.
The latest Australian Real Estate Quarterly Review from Dexus Research notes high-quality assets are likely to outperform secondary or fringe over the next few years given both occupiers and investors are gravitating to higher quality buildings.
Flaherty also says the divergence in the performance of prime versus secondary grade office assets is likely to continue over the coming years.
"This can already be seen in vacancy rates which have risen more sharply in secondary grade.
"For investors looking to purchase a discounted asset, this can present a value-add opportunity," she adds.
Flaherty says office investors are likely becoming more cautious in light of the higher vacancy risk post Covid.
"However, because commercial assets are valued based on their rental returns, investors in a position to weather a period of high vacancy may be able to acquire a discounted asset."
Opportunities in undervalued REITs
While challenges remain in office markets, Prineas says the big, quality office REITs are undervalued, highlighting Dexus, GPT and Mirvac.
"There is a lot of significantly bad news priced in," Prineas says.
"The office REITs are trading at very big discounts to net tangible assets, typically anywhere from 15% to 30% discounts to their NTA."
Net tangible assets (NTA) is the value of a REIT's assets minus its liabilities.
Prineas adds that the NTA doesn't include the intangible value of the REITs' funds management and development interests.
Higher interest rates have been depressing commercial property valuations and Prineas says Morningstar does expect further valuation falls for offices, but not as much as has been priced in by the market.
Prineas says there is bifurcation in the office space, with high-quality offices in demand ahead of lower-quality, B-grade or suburban assets that tend to be owned by private players or smaller REITs.
"That's where we think a lot of the pain will be, and that's what we're seeing."
That's in contrast to the A-grade and premium CBD properties owned by the major REITs.
"Mirvac has a vacancy in its office portfolio in the low single digits, compared to vacancy north of 10% across the market and even higher than that in some locations," Prineas says.
Prineas emphasises the importance of diversification for investors and not putting everything into one name, even a high-quality name.
"Having said that, all of the big REITs are diversified in terms of the number of properties they have, diversified across the geographic parts of Australia and diversified across a wide number of tenants as well."
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