Investment returns in property portfolios controlled by REITs and property investment funds are underpinned by existing lease agreements and on-going tenant demand patterns. Future demand patterns of tenants, manifested by the willingness and ability to pay rental, will determine future income growth and ultimately property asset values. Although some investment analysts analyse the underlying business fundamentals of major tenants in portfolios, there appears to be less analysis of future changes to business models and how these may impact aggregate demand for office space. Too often, it is assumed that empirical market analysis provides a clear indication of the future demand patterns. Many investor and developer strategies appear to be based on bigger, better and greener ‘build it and they will come’ models. But are past behaviours reasonable indicators of the future tenancy requirements, market demand levels and office portfolio investment returns?
Structural changes in demand
Economics, ultimately leading to financial performance, is all about human behaviour patterns – behaviours that change constantly based on evolving personal beliefs and values, social pressures and influences, innovation and technological advances. Business performance is likewise impacted by collective human behaviours such as: • Consumption choices between an ever-increasing variety of goods • Production decisions based on emerging technologies • New enterprise models responding to emerging needs • Evolving distributed workplace accommodation solutions. Collectively, these decisions may result in fundamental structural changes in the way industries or markets operate. Contrast these structural changes with cyclical changes re-occurring in regular patterns, albeit with varying amplitudes and timing. Cyclical changes are incremental and usually predictable, based on empirical evidence anticipating demand and supply cycles. Although not without challenges, corrections in business models and production output can be made to meet predicted future cyclical changes. Structural changes are different. If resultant opportunities are missed, these are unlikely to re-occur and the market will re-price unchanged products accordingly.
Office investment strategies
The debate about the future of shopping centres in competition to online purchasing continues to rage. Probably the only certainty is that purchasing patterns will evolve and shopping centres will need to evolve. However, there has been less debate about the future of office buildings as investment assets. Currently office investment strategies appear to default to prime CBD trophy assets underpinned by long-term bankable lease covenants. Analysis of historic trends indicates that growth in net office absorption is correlated to ‘white collar’ employment growth trends, albeit generally ‘out of kilter’ over shorter periods of analysis (as shown in graphs A and B). But structural shifts in office space demand and usage, despite still being linked to employment growth, will likely impact future investment returns. The behaviour patterns and decision-making now being displayed by many tenants will likely impact future office investment returns. Ever-reducing office space utilisation rates, based on alternate workplace models, are likely to lead to reduced office accommodation demand that is unlikely to be reversed in the future. Revised corporate location models are leading to greater demand for offices in decentralised locations. And increased uncertainty in business models is leading to the need for reductions in lease durations and flexible use arrangements, probably directly impacting weighted average lease expiry (WALE) profiles in office markets.
Reducing floor space utilisation
The past decade has seen ongoing reductions in floor space allocations per employee. Although comprehensive published data is difficult to source, anecdotal evidence from new workplace solutions indicates the extravagance of 20+ sqm per person has reduced to current allocations closer to 10 sqm. This reduction, enabled by new ubiquitous information technologies, is supporting alternative workplace models. This evolution continues to move through the open-plan, desk-sharing, ‘work-from-home’, activity-based working and the third space debates. However, whatever the workplace solution, with office demand linked to white-collar employment and space allocations per employee reducing, the implications are clear: the growth in future office space demand will be lower than projected employment growth.
Displaced demand
Compared to American and European markets, the move to decentralised office locations in Australia has been slow. Reasons include the lack of road and public transport networks, planning restrictions and the reluctance of developers to provide supply. However, market supply statistics, as illustrated in Graph C, show that decentralised office locations have increased over the past decade. Facilitated by technology- enabled distributed workplace models, there is growing impetus for business models that include decentralised locations. Initiatives of global corporates and well-publicised state government decentralisation moves underpin this trend. However, most office REIT investment strategies currently seem to preclude any investment in decentralised and regional locations such as Parramatta, Newcastle and Wollongong in NSW. This displacement of demand to non-CBD locations will likely challenge current office investment strategies in the next decade.
Lease duration
WALE analysis is an oft-quoted key investment metric for office funds. Common wisdom being that low WALEs deem investment properties risky, exposed to losing key or many tenants, whilst WALEs that are too high may indicate a limit on medium-term rental growth (and possibly missing the next up-cycle in demand). But WALEs are of little significance to tenants who are demanding flexibility in their office portfolios built around core ‘mother-ship’ space. Supplementary space requires flexibility in the form of call and put options, shorter leases and flexible use agreements – all likely to attract rental price premiums. Structuring office investment portfolio strategies in the future will likely be a trade-off of long-term leases supporting WALE objectives and accepting shorter term, more flexible lease instruments, priced at a premium, to achieve portfolio rental growth meeting rental index patterns. There is no easy answer in structuring an office investment portfolio, but part of the solution may be having consistent, ongoing dialogue with key tenants to understand and respond to customer needs. The investment approach of ‘build it and they will come’ of yester-year will likely perform below industry benchmarks. Future top performing office REITs may have more diverse location criteria and lease structures focusing on rental price premiums.
Published: 23 January 2013
