Commercial property sectors faring better than expected, producing superior returns

Commercial property sectors faring better than expected, producing superior returns

March 2021

Written by Per Amundsen, Head of Research, Thinktank

Amid perceptions of near-empty retail malls and reports of high-quality office  tenants preparing to sub lease huge swathes of space, investing in commercial property would not seem to be for the faint hearted.

Sentiment, of course, has not been helped by pandemic lockdowns, while the flight to e-commerce from physical shopping looks likely to be a permanent part of the retail landscape.

The gloomy vibe was reflected in the National Australia Bank’s commercial property survey for the September quarter, which showed expectations of a 6.2 per cent decline in retail rents and 3.5 per cent fall in office rents over the next 12 months.

Drawn from the survey of 380 property professionals, the bank’s commercial property sentiment index stood at -51 – a poor result but better than the -62 recorded in the June quarter.

But as with most asset classes, commercial property can’t be viewed as an amorphous lump: the pandemic era experience to date shows starkly divergent performance between the various sub-categories, with industrial property (warehouses) booming and some office and retail categories faring better than expected. Overall, the performance of commercial property continues to give relief to income-hungry investors chasing decent yields in an era of sub one per cent returns on risk-free bank term deposits. 

Nowhere is this becoming more apparent than in suburban commercial property. Investment dollars are finding their way to the suburbs into smaller office blocks, medical centres, and even shopping centres as investors look outside the CBDs for long-term tenants and healthy yields.

In the wake of COVID, this should not surprise. The exodus of workers from CBD buildings was a headline story in 2020, and the degree to which they will continue to work from, or closer to, home remains a story in 2021. In this context, the suburbs offer greater promise.

There are other factors at play. New developments and improvements to existing suburban commercial property is being encouraged by the upgrading of public transport and its attraction to certain industry sectors such as healthcare, technology and e-commerce, as well as government departments and agencies. All these sectors were relatively unaffected by the pandemic, so rental income was largely unaffected – a factor influencing investors with an eye to the long term.

Suburban offices typically attract long-term, stable tenants (leases of up to 10 years and even longer are not uncommon), with many smaller buildings single tenanted. By contrast, CBD buildings are usually multi-tenanted, pulling down the WALE (weighted average lease expiry) to single digits.

For small to medium-sized enterprises (SMEs) looking to grow in a post COVID world, suburban commercial space offers cheaper rentals, easier commutes, and, in many instances, closer proximity to their markets.

But if suburban commercial property is attracting investor interest, it’s not necessarily at the expense of CBD property. It’s not an either, or argument. According to agent Knight Frank’s 2021 outlook report, office yields remained relatively stable last year in Melbourne and Sydney CBD markets, with some tightening in smaller markets such as Perth. On average, the Melbourne and Sydney office markets yield an average of just over four per cent compared with just over 10 per cent a decade ago.

Although this decline may suggest such investments are unattractive, the margin between the rental return and the benchmark government bond yield has increased over this time. The firm also notes a flight to quality to prime assets underpinned by long leases.

Most commercial property is held by direct private means, or via unlisted property trusts or syndicates. As a result, it’s hard to get a true holistic picture of performance because of lack of data while insolvencies or forced sales may simply go unreported.

However, the ASX listed real estate income trusts (REITs) offer a transparent view, with the latest profit reporting season demonstrating the sector’s resilience amid a sea of troubles.

Major landlord GPT Group describes a “challenging year” in which it afforded $95 million in rent relief to tenants afflicted by the pandemic. Over at Dexus, the country’s biggest office landlord, says despite the pandemic the first (December 2020 half) showed increased leasing activity and “relatively strong rent collections”.

So, what should investors be thinking about? The numbers from MSCI offer a few clues – but not a definitive answer. [The numbers only look at office space.] The vacancy rate for non-CBD offices improved markedly in the six months to 31 December 2020 to below 5%, while CBD offices went in the opposite direction, rising to about 5.5%. A year earlier it had been slightly over 3%.

Income growth fell sharply in the last six months of calendar 2020, although it was more pronounced for non-CBD property, dropping to minus 1%. CBD office space was in positive territory – a touch under 2%. In terms of cap rates, non-CBD offices by December 2020 were about 5.4%, while their CBD counterparts were hovering around 5%.

That percentage differential between CBD and non-CBD office space reflects the historical norm. But these are far from normal times, and there are evolving yet cogent arguments why suburban commercial property is gaining more investor interest, a trend likely to continue at least until COVID is a distant (and hopefully) fading memor

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This article is for informational purposes only and does not constitute a product recommendation, taxation or financial advice and should not be relied upon as such.