Ask the analyst: Is the worst over for office REITs?
Morningstar’s Winky Tan on hybrid working trends, interest rate expectations and which companies could benefit.
Mentioned: Dexus (DXS)
Welcome to Ask the analyst, where I put questions from Morningstar readers (and some of my own) to our equity analysts. If you have a question about an ASX company or industry in our coverage, please send it to [email protected] for consideration.
Today’s topic
Today’s questions came from your author. I’ve noticed that sentiment towards office REITs has picked up from where it had been.
Several of these securities have held up better than the market recently and commentators from within the industry just seem a bit chirpier than before.
With that in mind, I thought it would be good to catch up with Winky Tan, who recently stepped up to the role of REITs analyst at Morningstar Australia.
How we got here
The last five years haven’t been overly pleasant for office REITs as an asset class. In fact, you could say they were hit by a double whammy.
First, you had the pandemic’s longest lasting side-effect: millions of people now working some or all of their week from home. Then you had the spike in inflation and subsequent interest rate hikes, which are rarely good news for property owners.
Against this backdrop, office REITS performed poorly. At many times during that period, you could even have made a case for office being one of the world’s most hated assets. It certainly felt that way for a while after I bought an American office REIT in 2022!
For an example of how poor sentiment towards office assets has been, consider how Dexus (ASX: DXS) has performed versus the broader Australian market since January 2020.
The return from each $100 invested in Dexus since then is shown in blue, while the green line shows the return from Morningstar’s Australia All Cap index.
Figure 1: Dexus versus Morningstar Australia All Cap Index from January 2020. Source: Morningstar Direct
My first question for Winky was why sentiment towards these assets seems to have improved recently.
Although there are other factors that we’ll look at later, Winky says the market’s falling interest rate expectations have played an important role.
Rates important, but not everything
Investors are still pricing in three more interest rate cuts this year, Winky said, and are essentially betting that February 2025’s rate cut was the start of an RBA interest rate easing cycle rather than a one-off. This feeds through into higher office REIT valuations in several ways.
The most obvious one is the impact of lower interest rate expectations on the “cap rate” that investors are willing to pay for office properties. A cap rate represents net operating income as a percentage of the price paid for the property. A lower cap rate means a higher building value, and vice versa.
Investors will often compare income from a property against the income available elsewhere at different levels of risk. Higher yields on “risk-free” government bonds, therefore, generally lead to higher cap rates and lower values. The converse is also true: lower bond yields usually bring lower cap rates and higher values.
Lower interest rate expectations also funnel through into lower financing costs for potential buyers, which can bring about an uptick in office transactions. By the end of December 2024, Winky says that transactions had picked up sharply and that both GPT’s and Dexus’ office portfolios showed smaller increases in cap rates versus six months earlier. After a tough period, then, values and sentiment towards the asset class appear to have stabilised.
What about the future of work?
Another source of uncertainty in recent years has been how the “work from home” trend will shake out.
According to Winky, the hybrid working landscape is still evolving but looks like it could be here to stay. Recent data from Cushman & Wakefield, for example, showed that virtually none of the 50 biggest office occupiers in Melbourne are mandating five days in the office, and over 50% have no mandated office days at all.
But is this necessarily a bad thing for owners of office buildings? Winky doesn’t think so in all cases. Instead, she sees hybrid working as a boon for owners of higher quality assets.
“Offices in the best locations, with the best amenities, with people-centric fit-outs are more likely to attract staff to come in”. This could potentially lead to companies buying ‘less but better’ office space that their staff are less reluctant to commute into.
Winky sees GPT Group and Dexus as potential beneficiaries of this trend, given that both companies’ portfolios are dominated by premium and A-grade properties in the CBDs of Sydney and Melbourne.
Supply backdrop improving? It depends.
Another headwind for Australian office in general has been an oversupply of space. This has contributed a situation where office building values have been slower to recover despite the replacement value of these assets rising as a result of higher material, labour and financing costs.
The supply balance could be set to improve going forward, with Winky noting that the number of office jobs in Australia is growing faster than the supply of new office space. This could be supportive for rents, but it’s worth noting that the situation can differ significantly by city.
In Sydney, for example, CBD office supply is expected to remain below the 10-year historical average for the next three years. Melbourne, on the other hand, is still absorbing the large amount of space introduced in 2020/21, with more big developments completing over the coming year.
As a result, Winky forecasts higher rent growth for Sydney-based offices than in Melbourne.
Figure 2: Office locations of Dexus and GPT Group. Source: Morningstar
What are the key numbers to watch out for?
When it comes to tracking the potential recovery in office and the performance of individual companies, Winky looks at several metrics including occupancy rates, leasing spreads (the difference in rent between new and old leases for the same space) and capitalisation rates.
Winky says that investors should also track the level of incentives being offered by landlords to tenants. Dexus, for example, handed back 26% of gross rents to tenants in 2024 through discounts and other incentives like rent-free periods.
This compared to 28% of gross rents in 2023 and this slight fall was seen as a sign of resilience. Yet Winky says that 26% is still high compared to history, suggesting that a recovery could still have some way to run. In Dexus’ case, she expects that incentives can return to the mid-teen levels seen before Covid.
Dexus pick of the bunch?
A few names in the ASX’s Real Estate sector currently sport four-star Morningstar Ratings. However, Dexus is the only one to feature in Morningstar’s list of fifteen Best Australia and New Zealand equity ideas in April.
It also features on Morningstar’s global Best Ideas list. Morningstar Investor members can use this link to access the latest Best Ideas lists.
When you consider some of the trends Winky has highlighted for us today, this makes sense. Dexus has exactly the kind of buildings that may benefit from tenants buying ‘less but better’ office space. Its skew towards Sydney CBD office space also looks like a positive in the medium-term.
Winky says that Dexus’s office assets have performed admirably in what has been a challenging decade, with like-for-like rental income matching inflation at an average of 2.5% per year, despite huge headwinds for the sector. She sees this as testament to the quality of Dexus’ portfolio and tenant base.
Winky’s nomination of Dexus for the Best Ideas list also notes healthy growth opportunities for its fund management business and the ‘under-rented’ status of its smaller industrial real-estate portfolio. This could add another earnings tailwind as these leases should be re-priced at market rates upon expiry.
At a recent price of around $7.12 per security, Dexus traded well below its net tangible asset value of just below $9 per security and offered a distribution yield of 5%. As a result, Winky feels that investors are being well compensated to wait for the potential recovery in office to continue.
Previously on Ask the analyst:
• Will lower booze consumption and gambling rules hit Endeavour?
