[+] Brown Out: Office Sector ‘Great Divergence’ Imminent

The “great divergence” of the office sector is on its way and it will deepen the divide between the haves and the have-nots in the market.

Covid-19 has accelerated the flight to quality trend across the office market and JLL head of strategic research Annabel McFarlane says B-grade assets risk becoming stranded assets.

“B-grade assets will need capital expenditure to remain relevant,” McFarlane says. 

“Occupiers are considering space with a different purpose—it’s about attracting and retaining talent.

“Though economic uncertainty is impacting some decision making, while unemployment remains low and business conditions remain strong, we expect solid demand from smaller tenants.”

And the recent announcement from the City of Sydney Council to move towards Net Zero for the city’s commercial buildings will put greater pressure on the B-grade assets. 

City of Sydney is the first local government in the country to compel developers to build energy efficient buildings in Australia’s economic engine room.

The policy changes will require new office buildings, hotels, shopping centres and other commercial buildings to comply with minimum energy ratings from January next year and to target net-zero energy use from 2026.

▲ Brown discounts will become more prevalent as the office sector is bifurcated.

McFarlane says the policy decision would be a catalyst for further regulatory change across the country. 

“This will impact office markets and the concept of a brown discount for assets that don’t meet the demand from occupiers or investors for more sustainable assets will start to become more pronounced,” she says.

“Governments, tenant organisations, investors and capital partners are making bold sustainability emissions targets. 

“It’s already clear that there aren’t enough highly sustainable or net-zero carbon office assets to meet future demand.”

But the capital continues to flow into Australia’s office sector, according to Colliers head of capital markets Adam Woodward, with Sydney recording a 10-year high for offshore capital investment in the first of 2022. 

“There’s a lot of global capital in APAC, the office sector is seen as a growth sector, particularly in Sydney and Melbourne,” he says.

“Australia and Japan’s office sectors are the two key markets for global capital mandates in the Asia Pacific region, they’re seen as the best markets to invest and divest in.

“On a risk-adjusted basis the spread has really attracted the market.”

But Woodward says the bifurcation of the office sector will be “within the next couple of years”.

“The post-Covid driver is very much a flight to quality and that’s very much following where the tenants are going.

“The capital values are holding for high quality assets … but there are not enough transactions at the lower end to understand flow-through effect yet. Asset owners holding out.”

Australian office investment by origin

▲ Source: Colliers

But the bifurcation of the market doesn’t spell doom for asset owners, according to Woodward. 

“I think there is a real opportunity for those asset owners to reposition those assets. Just like the primary assets, secondary assets can attract new markets.

“ESG is very much on every investor’s radar. But its end value long term is undetermined at this point. 

“If you look at the flight to quality, better buildings and newer facilities are achieving good leasing outcomes. Occupiers want to attract and retain staff in a tight labour market. ”

There will be a tipping point where B-grade office asssets will be cheap enough for investors to drive their renewal, but Woodward says this shift will happen gradually and investors will have different investment mandates. 

Confidence in the sector is growing. Sydney recorded its strongest net face rent quarterly growth since 2019 with a 2.6 per cent uplift, and 5.8 per cent year on year. 

Woodward says recent interest rates are not deterring investors in the office sector with transactions continuing to flow through the market. 

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Article originally posted at: https://www.theurbandeveloper.com/articles/office-sector-divergence-on-way