Prime Grade’s Rise Accelerates as Office Trifurcation Takes Hold

While the end of the office sector’s turbulent times remains out of sight, it has become clear that the divide between Prime, A and B-grade office values will continue to widen. This office ‘trifurcation’—the split of A-grade into the higher and lower ends, followed by B-grade—offers a diverse picture in which prime or premium grade offices are being partially protected from headwinds that have plagued lesser values. “The flight to quality happens at every cycle—they perform the best because they are either the most resilient or come out with the most positive returns,” MSCI head of real estate research, Pacific, Benjamin Martin-Henry says. Knight Frank Australia chief economist and head of research and consulting Ben Burston says that whether expressed as bifurcation, trifurcation or flight to quality, “lower net absorption and higher vacancy have driven vastly different outcomes within the office sector”. “Demand has been weaker in aggregate, but this is not impacting the market evenly as tenants continue to migrate to better quality buildings, which in turn feeds through to investors’ perception of different levels of leasing risk for different assets, hence different valuation,” he says. Return to work? The ‘return to office’ movement driven by the C-suite has been at the centre of conversations about office real estate. “[But in Australia] workplace strategy has not been disrupted to the same extent as in the United States, and this is leading to more resilient market performance and smaller declines in asset values,” Burston says. Overall the impact of work-from-home might be becoming less important. “Some investors are tired of the whole idea that offices are struggling due to work-from-home, because we’re getting back to the normal cycle now,” Martin-Henry says. ▲ The Salesforce tower, an example of modern premium office space at the top of the market, opened last year. But changing work patterns are having an impact on the value of different office typologies. “Workers aren’t going to be rushing back to C or D-grade offices,” Martin-Henry says. “They want to go back to the likes of 50 Bridge Street and the Salesforce tower in Sydney—it is the quality of the office that will entice them to come back.” A situation of higher vacancy rates and changing needs for businesses means that higher-end offices are actually in reach for businesses for the first time. “While rents have taken a battering, tenants are now able to get pretty good deals, so they’re moving into those offices which means vacancy rates at prime level are a lot lower than secondary class assets,” Martin-Henry says. “Tenants are taking advantage and as those offices start to fill up they become better investments.” Changing floorplates and fortunes But one aspect likely to change is office configurations. The fact is, it has for many years been rare to take up desks that will accommodate 100 per cent of the workforce, Martin-Henry says. “You don’t necessarily lease 100 desks for 100 people. Some might have sick or annual leave, and right now people take enough space for about 65 to 75 per cent of their workforce. “We didn’t track occupancy to any great degree pre-Covid, but it is estimated at 75 to 80 per cent [of the workforce which would have been in the office] and asset mangers are saying they’re already there because not everyone comes to work or the office every single day ever.” Capital value change ▲ Source: MSCI What smaller office requirements might mean for the market is that the era of big offices is over. “In the short term, premium offices will be fine, but I do hear more questions about the medium-term outlook; do people want those massive floor plates? Is the demand for massive floor plates going to reduce?” Martin-Henry says. He says this means that the fortunes of offices are becoming less tied to cyclical trends and more towards the characteristics of a specific asset, especially those which can better adapt to the needs of tenants over time. Asset specific While trifurcation is putting prime assets at the top of the pile, that might not mean all prime assets do well. “Within premium offices, the worst performing lost 25 to 30 per cent of value while the best performing might have only lost 5 per cent, so even within premium grade there is a huge disparity,” Martin-Henry says. For example, the sale of 1 Castlereagh Street in Sydney for $196.4 million even after a major refurbishment represented an 11 per cent loss on when it last sold, in 2019 for $220 million. ▲ Eleven per cent loss: 1 Castlereagh Street, Sydney. “The assets most in demand offer the requisite mix of location, amenity, flexibility and sustainability credentials that tenants are seeking to enhance and future-proof their workplace experience,” Burston says. When vacancies where closer to 3.5 per cent there was often little tenant movement. “Obviously vacancies are higher now and there are better deals and opportunities elsewhere—at say 7.5 per cent vacancy or more, there’s more space and therefore more churn,” Martin-Henry says. So what the future holds for the office trifecta remains uncertain, premium remains the best bet. “After the GFC it took prime office values 7.5 to 8 years to recoup. Things do move faster these days, but I don’t know if secondary will recover this time because we’re seeing not just a cyclical but a structural change,” Martin-Henry says. Change in transaction volumes ▲ Source: MSCI “If you’re better located you’ll perform better, but also those who can be more flexible in their office space will recover losses quicker. “On an average basis we’re getting there and the office sector is close to bottoming out, with Sydney prime already there, but there are massive differences between secondary and prime, or offices in Melbourne, Brisbane and Perth.” The valuation cycle has lagged behind market sentiment, according to Burston, but well-located core assets are now being repriced. “In 2025 we expect the market to begin a cyclical recovery, starting with core assets in Sydney CBD before gradually extending to other markets. “Acquiring assets at this time in the cycle, post a major decline in values and prior to a rate cutting cycle, has invariably resulted in strong returns over the long-term. “The market now offers excellent value for investors, with strong prospects for cyclical recovery and long-term growth.” You are currently experiencing The Urban Developer Plus (TUD+), our premium membership for property professionals. 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Prime Grade’s Rise Accelerates as Office Trifurcation Takes Hold

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