Hidden value lies in non-CBD office sector

Diverse opportunities in the non-Central Business District (CBD) office sector mean high net worth investors can invest through pooled/syndicated vehicles or directly. Peter Cashmore, NAB Senior Real Estate Equities Analyst, outlines what investors need to know.

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Diverse opportunities in the non-Central Business District (CBD) office sector mean high net worth investors can invest through pooled/syndicated vehicles or directly. Peter Cashmore, NAB Senior Real Estate Equities Analyst, outlines what investors need to know.

The non-CBD office market includes a broad range of sub-markets across key metropolitan areas. On offer are office assets offering an attractive initial yield of more than 7.5% but with shorter leases (three-four years). This means the total return comprises tenant retention, market rents and capital values. Alternatively, assets backed by strong tenant covenants (federal/state government tenants) on lease terms of more than 10 years with fixed annual reviews, offer more passive exposure, with total return risk skewed to tenant retention/replacement at lease expiry.

Non-CBD office markets tend to be less volatile than CBD office markets. This is linked to their greater dependence on income returns which contribute more than 75% of total returns. This higher weighting to income returns puts a focus on initial yields which at December 2014 ranged from 0.8% (North Sydney) to 2.25% (Norwest) above reported CBD yields in the Sydney office market, for example.

While CBD office markets tend to be clearly defined, non-CBD markets may be a looser combination of defined markets such as North Sydney, Chatswood and St Kilda Rd and precincts served by a major arterial road network, for example, the Melbourne (south east/south) market. We can add stand-alone office assets which don’t fit into a defined market but offer returns similar to monitored non-CBD office markets.

AREIT Growthpoint Properties Australia’s Cambridge Park asset, fully occupied by Hydro Tasmania, a state government agency, is an example. The asset has a weighted average lease Expiry of 9.3 years and is held on a capitalisation (cap) rate of 9%. The cap rate is the annual net operating income divided by the asset’s cost (or current asset value).

Other discrete characteristics of the non-CBD office market include:

  • The effect of residential conversions from office stock has reduced B-grade stock, plus the economic rents needed to justify new office developments are materially above passing rents meaning developing new assets requires rents well above what the current market can support. New supply has reduced, causing net absorption statistics to move more materially than underlying fundamentals from growth in office space demand would suggest can be otherwise achieved.
  • Equilibrium vacancy rates in non-CBD office markets have historically been higher than CBD markets due to factors including smaller tenants and their willingness to move down from say A to B+ space to achieve affordability gains.
  • Headline vacancy rates in most non-CBD office markets sees vacancy rates move materially on the back of small deals which sees overall market rents follow a similar pattern.
  • Selected non-CBD office assets offer several layers of optionality including not only a potential residential conversion but potentially strata plays for assets with suitable floor plans.
  • The typically higher yields in A-grade office assets in the non-CBD office market versus the CBD office market reflect a mix of unrated tenants on leases which are five years or less.
  • Quality non-CBD office markets can offer fully tenanted assets backed by strong covenants from government tenants or a credit-rated tenant like Qantas, that is a tenant at Cromwell Property Group’s Mascot asset in South Sydney.
  • Car parking capacity is typically higher than for CBD office assets reflecting inadequate public transport infrastructure to service locations in emerging markets.

 Affordability

The following chart plots gross effective rents across the non-CBD office markets as a percentage of the respective CBD office market – which is one measure of affordability. The data indicates that Sydney’s Norwest sub-market (35km from the Sydney CBD) offers a 60% discount versus Sydney CBD rents. With Chatswood (11km from the CBD) and St Leonards (7.2km from the CBD) both offering about a 40% discount on Sydney CBD rents, this raises the possibility of tenants switching between these two markets given geographic proximity.

However, while chart metrics are interesting, they assume non-CBD tenants trade-off CBD rents as part of a location decision. This may be true in some cases but mostly the decision considers options within a defined geographical boundary. Arguably CBDs in relatively close proximity to non-CBD office markets such as Brisbane Fringe and Melbourne Fringe do represent alternatives to CBD options.

 Non-CBD office market categories Australia-wide

We can dissect the collection of non-CBD office markets into several categories:

  • Category 1 comprises mature non-CBD office markets which still hold a material ranking by Gross Leasable Area. The category comprises a mix of asset grades (Premium to D grade); features residential conversion activity but has seen a shift in demand as emerging non-CBD office markets have attracted tenants. The Optus (Telco) departure from 101 Miller St in North Sydney to Macquarie Park to be replaced by Genworth (Insurance) and an Australian Government department is one case. Others include North Sydney, St.Kilda Rd, Melbourne and Adelaide Fringe.
  • Category 2 non-CBD office markets comprise at least 40% of modern office space measured by Grade A space as a proportion of total stock and comprise private/public sector tenants. Examples include Chatswood, Parramatta and Brisbane Fringe.
  • Category 3 non-CBD office markets are sub-markets with around or below the non-CBD market average weighting of A-grade stock (about 30 per cent of total stock) plus C/D-graded stock representing up to half of total stock. Examples include Crows Nest/St Leonards, West Perth and Gold Coast.
  • Category 4 non-CBD office markets are new-generation office sub-markets sponsored mostly by first-generation tenants often in IT/media/communications with a workforce reliant on cars. Examples include SOP/Macquarie Park, Homebush/Rhodes and Norwest. Large tenants in SOP include financial (Commonwealth Bank of Australia); fast-moving consumer goods (Lion Nathan); and electronics (Samsung).
  • Category 5 comprises geographical precincts located on the CBD Fringe which offer office accommodation to specific user groups in A-grade space like Fairfax Media, Google and Channels Seven &ten all located in Pyrmont. Tier 5 markets also include Melbourne Fringe (Southbank).
  • Category 6 non-CBD office markets tend to be smaller, located outside metropolitan areas and driven by office space demand from state/federal governments and/or small office space users (less than 500m2). Examples include Newcastle, Wollongong and the Sunshine Coast.

The above categories assist in identifying risk-adjusted returns on offer in the non-CBD office sector. Typically, we would expect high- net worth individuals to get exposure to these opportunities via a syndicated offer. If so, category two and six offers are most likely. If an individual is investing directly, this is a broader category opportunity, which would make categories one-to-three and category six look attractive.

This article was first published in Private Word magazine (Winter 2015).

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