There's going to be an office boom but have patience and think long term.
Frank Gelber - The Australian 24 February, 2011
What should we do to position for the coming office boom?
That's right - I said "boom". By over-reacting on the cautious side after the global financial crisis, by decimating finance for development and hence new construction, we've set up the office markets for a long period of undersupply. We've set the preconditions for a boom.
It won't happen quickly. There is still plenty of vacant space for businesses to lease. This year will be solid rather than spectacular; next year will pick up pace. But it will take time to build momentum into a boom peaking in five to six years.
And it won't happen uniformly between the cities. Canberra is oversupplied and will miss any upturn. Melbourne will be first, followed by Sydney and Adelaide, and Brisbane and Perth will be later.
In some cities, we are looking at a doubling of office rents and property values over the next five years, with internal rates of return between 15 and 20 per cent.
That's returns to passive investment, no gearing. Geared returns will be higher and so, too, returns from refurbishment and new development.
Why is this happening? It's not just lack of available sites, though that will play a role in Sydney. The $6 billion Barangaroo urban regeneration project in the CBD and the Central Park development on the city fringe at Ultimo will help. But they won't be given away and aren't big enough to make a huge difference.
Sydney is an overflow market, with CBD development constrained and most development taking place in North Ryde, Parramatta and South Sydney. Rents will have to rise a great deal before it is worth tearing down existing buildings to consolidate CBD sites. And that will take time.
The availability of sites is less of an issue in the other cities. But even Melbourne, where ready availability of reasonably priced commercial land kept a lid on rents and prices for a decade, will run out of space in the Collins Street part of Docklands in the coming cycle.
Why the strength of returns? Because we'll be caught short of office space with solid demand in tight leasing markets, which will continue to drive up rents for three to four years.
The supply of new buildings to lease is limited, with development having collapsed during the GFC.
Office rents are 20 per cent below replacement cost levels and neither banks nor equity investors are likely to underwrite significant speculative activity. Certainly, we'll get a few projects away quickly. But if I had a good site, I'd wait -- you give away too much cash flow and value if you develop too early. And even when rents get to levels sufficient to underwrite development, there's a long lead time before space becomes available.
Meanwhile, demand is already increasing and will grow a great deal further. During the GFC, both demand and net absorption collapsed, with vacancy rates blowing out as projects started before the credit crisis hit came on stream. Now, there's plenty of space available for tenants. But that won't last long.
Already, office space is being leased at a faster pace.
As leasing markets tighten, incentives fall and effective rents rise, we'll start to build again. Even so, once development resumes it will take three to four years to bring significant supply on stream. And that means long periods of tight leasing markets, with a shortage of space driving up rents. Hence our aggressive rent forecasts. And property prices will follow.
The commercial property markets are full of anomalies and opportunities. And the basic reason is excessive caution.
During the financial engineering boom which preceded and brought on the GFC, office markets were risky. Most players were over-geared and the weight of money meant that property was overpriced. And, had the boom continued, the market would have become oversupplied.
Those risks are gone. The major listed real-estate investment trusts have recapitalised with equity, though many smaller players remain vulnerable. Certainly, there are risks associated with some investment vehicles. But those risks are limited to the players, not property markets.
This is not the time to sit and wait. There are lots of things we need to do to prepare for the upswing.
For investors, the opportunity is to buy buildings below replacement cost.
The recapitalised REITs are a bargain. We get the property at less than market price and the attached business free.
Banks need to understand that the GFC correction got rid of most of the market risk.
Developers should look at buying sites, particularly office sites, cheaply and preparing them for development three to five years hence.
Tenants need to lock in leases before rents rise.
Owners need to manage their lease portfolios with a view to locking in leases when rents have risen.
Property is a long game, not a short game.
Forget the GFC disaster -- the correction has taken most of the risk away.
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