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OtherStaff WriterThu 24 Nov 16

Sydney Office Still The Pick, Cromwell

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By Damian Horton, Cromwell

This is an uncertain time for property market investors. Demand is strong, prices continue to rise, and everyone is questioning whether property is overvalued.

While there are differences between all the geographic markets, our pick remains the Sydney office market, where we see good returns over a five year time horizon.

To recap, from an economic perspective we still expect interest rates to rise, albeit slowly. At some point this will have an impact on property values.

While firming yields have largely driven price increases in recent times, weak demand has kept a lid on rents. The next phase of the cycle will involve rising rents driving property values, compensating for the impact of rising interest rates. This will not however happen uniformly in all markets.

Investment decisions however need to look at expected returns. They are driven by forecast rents and yields and that depends on property market conditions into the future. These conditions will also differ market by market and geography by geography.

As we have highlighted previously, the office markets are out of sync. The mining cities - Brisbane, Perth and Darwin - are being hit by weak demand and oversupply. Rents have been falling and will probably fall further, particularly in Perth.

On the other hand, the non-mining markets, especially Sydney and Melbourne, were casualties of the mining boom. They now have the best growth prospects and Sydney is still the pick.

In Sydney, demand has picked up moderately and we expect to continue to improve but the key difference with Melbourne is that supply has evaporated post-Barangaroo, with little forecast new stock to come on stream over the next two to three years.

Continuing office withdrawals associated first with residential conversions and now also with the new Metro rail and office redevelopments are having an impact.

Vacancy rates have already tightened in Sydney. In early 2015 they were hovering at around their long term average of 9%. Source JLL. Some forecasts now have them below 5% in 2017. If this is the case it will make it very difficult for businesses to find the office space they need.

Low vacancy rates, and hence tighter leasing markets will change the balance of power between owners and tenants leading to increases in rents. Incentives will be the first to go, driving effective rents higher. Then rising face rents will increase and drive prices and firm yields. This cyclical upswing will offset the negative impact of rising interest rates.

The cycle in Sydney has some way to go but the question is how far? We don’t really know yet as it depends on how strong the cyclical upswing becomes. Our core forecast is for a moderate cycle peaking in approximately 5 years’ time when developers see an impending oversupply of new stock and stop building.

What does the cyclical upswing mean for the types of property we want to buy? In recent times market focus has been on the security provided by long WALEs but in a tight market, incentives will come down. This means being locked into a long term contract will preclude you from benefitting from the drop in incentives and increase in rents.

The drop in incentives has already begun, from circa 30% to 35% a year ago they have nearly halved and will continue to drop as the balance of power continues to shift to owners.

Our preference therefore is for Sydney office property, in established metro areas, that can be re-leased near the peak of the cycle to crystallise the rise in rents during the upswing. Ideally we want properties with a WALE of 2 to 4 years.

The fall in incentives also brings refurbishment and re-positioning strategies back into play. For a site that could be used for either commercial or residential development, the best value use is currently residential. Within three to five years’ time, we think that will have reversed.

The question is how many sites will still be available and can you acquire them? This unfortunately, is the key issue.

For no matter how strong we think the market will be acquiring the right property is extremely difficult. Sydney is now truly established as a ‘gateway’ city and a destination of choice for international investors. Trying to outbid them can mean overpaying for a property and leaving investors with future losses.

Our forecast is for Sydney CBD prime effective rents to rise strongly and provide an internal rate of return (IRR) on a five year horizon of approximately 13%. Importantly however this is not a ‘set and forget’ market, as our 10 year return is just below 5%, reflecting weak returns once the market corrects. Sydney office is still the pick but only for properties with specific lease profiles, if you can acquire them, and on a particular timeframe with a clear exit strategy.

 

Damian Horton is Head of Property of Cromwell, responsible for the performance of Cromwell’s Australian property assets and leadership to the property, leasing and project teams. Damian joined Cromwell after more than two years in private consultancy.

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Article originally posted at: https://www.theurbandeveloper.com/articles/sydney-office-still-pick