By Jason Huljich

Australian office property will continue to be a mixed bag in 2017. Despite the weight of offshore money flowing into Sydney and Melbourne in search of a safe-haven from global volatility, a measure of overall weakness in the Australian economy and the on-going effect of the demise of the mining boom are contributing to some very different fundamentals.

Nonetheless, according to Jason Huljich, CEO of Unlisted Property for Centuria, it’s not all doom and gloom – there remains opportunities for attractive yields and solid returns from office property for the well-researched investor.

According to the Property Council of Australia’s (PCA) most recent office property report, the Australian CBD office vacancy rate remained steady over the six months to January 2017, declining only slightly, from 11% to 10.9%. However, this steadiness belies significant differences in the markets which make up the index.

While Sydney and Melbourne remain robust, the residual effects of the end of the mining boom continue to negatively affect exposed markets. Perth has been particularly exposed to the fallout of the mining boom, and Brisbane is also feeling its impact. In South Australia, the overall economy remains weak with flow-on effects to the Adelaide CBD office market.

So, what does 2017 hold for the major office markets? The bottom line is that we are seeing little change from 2016.

Sydney and Melbourne the pick

Sydney and Melbourne are the pick of the major markets. According to the PCA, at the end of January vacancy rates were 6.2% and 6.4% respectively. Both markets benefit from strong underlying fundamentals.

In Sydney, over the past two years, we saw B-grade office rents double, which is clearly unsustainable. With some tenants now paying excess of $1,000 per sqm, flattening is to be expected this year.

The trigger for rapid rental growth was the ongoing withdrawal of B-grade office stock for the Sydney Metro and residential conversions. We don’t foresee major additional withdrawals in the near future, which should keep rental growth capped. At the same time, demand remains strong for A and B-grade stock, and we continue to see suites of sub 1,000 sqm leased before the previous tenant vacates. Vacancy rates will fall particularly in the B grade market however, in our view, both demand and the resulting rental levels are now stabilising.

On the sales side, we are starting to see an injection of new stock into the market. Over the past few years, most owners believed that the office market still had some way to run, and as a result, were unwilling to sell. However, now there is growing divergence in views with some believing that the market may be close to its peak. We therefore expect more stock to come up for sale. This is good news for buyers, who at the very least will be presented with more opportunity and more activity than they have seen in past few years.

Sydney metro markets benefit from stock withdrawals and infrastructure

Sydney metro markets continue to go from strength-to-strength. Withdrawal of office stock for residential conversion in metro and CBD markets has been dominant driver of demand for office space in these markets, and as A and B grade office space has become more scarce and more expensive in the Sydney CBD, businesses have looked to move further afield. North Sydney was the first recipient of overflow demand from the CBD, followed by St Leonards, and now Chatswood on Sydney’s north shore.

Centuria recently purchased a property in Chatswood. This created The Centuria Zenith Fund, which is already proving to be strong performer for investors. Leasing deals are coming in at rents up to 10% higher than we forecast, and the recent re-valuation of our stake in the property saw it rise from our purchase price of $279 million to $301 million – all of which is good news for investors.

The fact that the NSW Government is investing heavily in infrastructure has been a contributing factor to rising demand in metro markets. Parramatta is worth mentioning. Situated in the heart of Sydney’s rapidly growing western suburbs, and with new transport links, Sydney's "second CBD" is now one of the strongest office markets in the country. Quality assets are in hot demand, and this has resulted in upward pressure on prices.

Melbourne is solid, but remains tightly held

Demand for office space in Melbourne is strong. Over the past six months, it grew at 3.5 times the historical average – yet Melbourne continues to be tightly held, and supply is constrained. As a result, we expect vacancy rates will continue to fall throughout 2017.

However, despite the lack of new supply, we expect demand for office property to continue to be strong throughout 2017, as investors seek safe property havens in markets with strong underlying leasing market fundamentals. Offshore money continues to pour in – and we expect offshore groups to dominate the investment landscape looking forward. In 2016, 10 out of the 14 office purchases were made by offshore groups, and this kind of ratio is unlikely to change.

Rental levels have held up well on the back of strong tenant demand, particularly at the Premium end of the market, where landlords have gained some face rental growth. In the A and B sector, however, rental growth has been more subdued, and landlords are finding they need to offer a competitive product to appeal. This means taking an active property management approach – speculative fitouts and upgrading and refurbishing of common areas such as lifts and lobbies have been key to success.

Other markets are struggling, but there are opportunities

Outside of Sydney and Melbourne, capital city markets are weaker. Brisbane, Perth and Adelaide remain weak early in the year. Both Perth and Adelaide saw a sharp contraction in rental levels during 2016 as demand for space fell and vacancy rates rose.

The Perth market is struggling and landlords are offering very significant incentives, in some cases up to 50% incentives to secure quality tenants. Incentives like this are a feature of weak markets, because when there is plenty of available space to lease, landlords compete to attract tenants in one of two ways – by contributing to the tenant’s fitout, or by offering rent-free periods.

On the upside, the Perth Landlords has been saved from complete disaster by on-going low interest rates, which are allowing owners to continue servicing debt despite the poor returns.

The most recent figures from the PCA saw Brisbane picking up. Over the six months to end January 2017, demand for office space grew at over five times the historical average. Nonetheless, conditions remain tough. Money is continuing to flow into the market looking for yield, helping to keep conditions more positive. The fundamentals are weak but should improve during 2017, all of which means we may have seen the bottom and come out the other side!

Little significant change overall

Office CBD markets have not changed significantly since the end of 2016, and our view is that in most cases the fundamental drivers of return have not changed. While Brisbane may have seen the worst and should improve from low levels, Sydney and Melbourne remain our top picks. Given that there is no major new supply in either city (albeit expectation of some new stock in Sydney), we expect to see both markets perform well through 2017. 

 Source: Property Council of Australia

 Colliers International, Research and Forecast Report, CBD Office, First Half 2017

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.