Melbourne s non-cbd office markets

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1 July 2012 Melbourne s non-cbd office markets Key Points There is limited space under construction across Melbourne s non-cbd office markets as access to capital and pre-commitment requirements remain a hurdle to development. Introduction Underlying demand over the long-term will be supported by the stability of tenants in strong growth sectors such as healthcare, education and business, scientific & technical services. Asset pricing looks attractive based on benchmark spreads as well as on relative pricing to CBD assets. The spread between prime yields in the CBD and suburban office markets is 125bp well above the long-term average of 95bp. In this Pulse paper, we take a closer look at Melbourne s non-cbd office markets, focusing on the market fundamentals, the current market anomaly and the medium-term outlook. The remit of this paper is to identify a number of themes and opportunities that exist in the current environment and how these are likely to play out over the coming years. Jones Lang LaSalle monitors 11 distinct office market precincts across Melbourne s non-cbd market. The inner precincts of Yarra, St Kilda Road as well as the inner suburbs from North Melbourne around to Port Melbourne are considered the inner fringe market. The six outer precincts, located between Hawthorn and Dandenong are classified as the suburban market. In total, Melbourne s non-cbd office market covers 2.90 million sqm of space. Over the past few years, a number of trends have emerged across non-cbd office markets. Despite the solid leasing market fundamentals, a disconnect exists between the leasing and capital markets. While the most frequent buyers for core CBD office assets are: foreign investors, super funds and domestic wholesale funds, these groups do not have a focus to acquire suburban assets, with this segment of the market dominated by private investors. Limited risk of oversupply due to barriers to development The fundamental strength of the leasing market is supportive of increased development activity, with vacancy below equilibrium and limited quality options within existing stock. However, capital market conditions are, for the time being, not favorable to development. As a result, the supply-side risks are likely to remain negligible over the next few years. Assets in the suburban markets have not experienced any significant yield compression from their peaks in 2010, which is pushing economic rents higher. Furthermore, construction costs have continued to rise and developer s feasibility models require average rents at roughly 20% above current market rents in order to make projects economically viable. Historically, the non-cbd office market has not been a precommitment market. Over the past 18 months, significant supply side constraints have pushed a number of tenants into this market segment, with very few large tenant options available within existing stock. Nevertheless, the bulk of pre-commitments in the current market are those within the business parks in Mulgrave and the State Government requirement in Dandenong which has now complete. Further demand side constraints exist due to broader volatility in the global economy. Tenants remain uncertain of their revenue outlook and therefore their future space requirements. Accordingly tenants are currently unlikely to want to pre-commit to a development on a long-term lease, as would be required by developers and their financiers. Conversely, the market is taking a breath to digests the economic circumstances and activity in the leasing market has slowed. A small amount of sub-lease space has come to the market and vacancy in the non-cbd market has pushed higher to 7.5% in June 2012 but remains below the long-term average of 8.0%.

2 Pulse A Case for Melbourne s non-cbd office markets - July Lenders have also maintained their conservative attitude towards non-cbd based commercial development and access to capital remains a hurdle to most projects. The bulk of lending to non-cbd development was from the second-tier retail banking sector. These groups have pulled back their exposure to commercial property lending with fewer alternative lenders to fill the void. Furthermore, banks continue to impose stringent lending criteria including low debt-to-cost ratios and long-term pre-commitment requirements on prospective developers. Consequently, speculative development has mostly disappeared in the current market, with only a few small speculative office developments in the pipeline. Figure 1 below highlights the historical supply delivered to the non- CBD office market in both square meter terms and as a percentage of total stock. The expected new supply in 2012 is higher than during the previous two years. However, supply remains below the long-term average. Figure 1: Non-CBD office supply growth. A high proportion of these businesses are located in non- CBD locations and they will be one of the long-term demand drivers for non-cbd office markets. Deloitte Access Economics estimates that the Health Care & Social Assistance sector account for 13.8% of white collar employment in metropolitan Melbourne. However, the sectors contribution to the growth between 2008 and 2011 was 34.5% across the entire metropolitan area. Looking ahead, this sector will continue to punch above its weigh and Deloitte Access Economics forecasts that over 20% of forward looking employment growth in the Melbourne metropolitan area will come from the Health Care & Social Assistance sector. Over the short-term, the non-cbd office market benefits from its lower reliance on finance & insurance sector based tenants. Furthermore, R&D investment remains weak in the current economic environment. When there is a recovery in R&D related expenditure, the market will further benefit from a pickup in demand for project space Figure 2 below shows Melbourne metropolitan s white collar employment growth by industry sector. The largest contributors to employment, between 2008 and 2011, include Health Care & Social Assistance (34.5%), Business, Scientific & Technical Services (12.7%) and Public Administration (10.1%). Figure 2: Melbourne s Contribution to WCE by sector Tenancy base a positive for non-cbd market The tenancy profile in the non-cbd office market maintains a broad level of diversity and stability. The relative stability of the tenancy base is a result of the economic growth outlook and inelasticity of industry sectors which dominate the non-cbd office market. The ageing of Australia s population will start to accelerate as the first cohort of baby boomers turned 65 years old in Over the next 30 years, the ABS estimate that the proportion of residents over 65 years old will increase from 14.3% today to 21.9%. This equates to over 7.8 million residents over the age of 65. This will benefit health care and pharmaceutical companies over the next decade. From 2002 to 2011, Deloitte Access Economics stated that the Health Care & Social Assistance sector accounted for 19.6% of the white collar employment jobs growth in Australia. Over the ten years to 2021, the sector is projected to account for 23.7% of white collar employment Vacancy remains tight despite peripheral conditions Tenant demand rebounded strongly following the GFC. Net absorption averaged 56,700 sqm per annum between 2008 and As a result, vacancy has tightened from a cyclical peak of 11.0% in late-2009 to 6.8% in 1Q12. As mentioned, some sub-lease space has come to the market as well as backfill space from the state government development in Dandenong. As a result, vacancy has lifted across the non-cbd office market to 7.5% in 2Q12.

3 Pulse A Case for Melbourne s non-cbd office market - July Tenants also remain nervous regarding short-term business conditions. This is limiting deal-flow as tenants sit on their hands for the time being to wait for further clarity in their business outlook. Figure 3: Non-CBD Office Markets Vacancy Rates & Stock The relative stability, however, of the key industry sectors which make up the bulk of the tenants within the non-cbd market will support high occupancy rates. This will also place downward pressure on incentives over the medium term which will support rent growth. Prime gross effective rents, as a result, are forecast to grow at around trend over the next three years, at 4.1% and 1.3% in the fringe and suburban markets, respectively. A lack of large space options remains a key theme across non-cbd office markets. For a tenant requiring over 3,000 sqm of A-grade space, there are only five options anywhere outside the CBD. Table 1: Tenant Options by Size Cohort Grade Market 500 to 1,000 sqm 1,000 to 2,000 sqm 2,000 to 3,000 sqm 3,000 sqm + Prime SES Fringe St Kilda Road Total Secondary SES Fringe St Kilda Road Total With few options in the A-grade market, tenants are being forced to remain in their current premises or redirect their enquiry towards the B-grade market or towards the CBD market. With more tenants remaining within their existing space, there has been somewhat of a slow-down in leasing market activity. Landlords of B-grade space are less inclined to offer the same level of rent concession and incentives than was the case in However, one of the risks for the market competing with CBD space is that owners will have to compete with the higher incentives available in the CBD. A disconnect between the leasing and capital markets Despite solid fundamentals and attractive pricing, a disconnect exists between the leasing and capital markets. Purchasers for the most part are seeking countercyclical opportunities and sales by distressed landlords. Price discovery, however, remains slow and landlords have persisted in their firm assessment of asset values. Purchasers, however remain on the conservative side and are probably overaccounting for downside risks in their due diligence process. The divergence in price expectations remains a hurdle to a number of transactions. However, with more assets now in due diligence, there are signs that price discovery is starting to feed through to the market. Debt funding continues to hinder activity in the non-cbd investment market in a similar manner to the funding impediments on new developments. Banks are reluctant to increase their exposure to noncore assets and traditional lenders in this space have reduced their appetite for the sector. We are, however, starting to see alternative sources of funding emerge. Where debt finance can be obtained, lenders are offering loan tenure that matches the WALE. Banks are also imposing lower loan-to-value ratios and remain highly averse to any vacancy or development risk. Capital constraints have, to an extent, been a blessing in disguise for some. The pullback in development activity has brought supply delivery to a near standstill. Vacancy has tightened and the rental outlook is fairly positive over the long-term. While there has been limited evidence of yield compression, income growth has pushed asset values higher. Market rents will require a healthy level of growth to close the gap on economic rents before most tenants would consider committing to new developments. The short-term conditions are unlikely to deliver the rent-growth that would be required to support a new development cycle. Acquisitions in the non-cbd slowed through the GFC, both in nominal terms and relative to the CBD market. Figure 4 shows transaction volumes in the CBD and non CBD markets. The blue line shows the non-cbd s share of total transactions. In the lead up the GFC, the non-cbd market s share of total transactions averaged 40% between 2006 and Through the

4 Pulse A Case for Melbourne s non-cbd office markets - July recovery, the non-cbd s share of total transactions has declined considerably to just 16% in In 2011, there were only three major office transactions above $10 million. However, in 2012 we have seen a number of private investors come to the market and transaction activity in assets over $10 million is starting to accelerate. Figure 4:Transaction volumes crisis, yield compression in the CBD has not been mirrored in the non-cbd market. As a result, the spreads between the CBD and non-cbd markets has pushed out to their widest level in over ten years. Currently the fringe market sits at 113 bps above the CBD market, with the suburban market at an even larger risk premium of 125 basis points. Figure 5: Pricing Spreads (CBD vs Fringe) Offshore investors are the price-setters in Australian institutional grade property markets. In 2011, they have accounted for 30% of transactions (greater than $5 million). However, there has been limited offshore (institutional or private) interest in non-cbd office markets. Figure 6: Pricing Spreads (CBD vs Suburban) The main exception is the joint venture between Abacus Property Group (A-REIT) and Heitman LLC (US investor). The fund is targeting a gross asset base of $600 million and has secured 484 St Kilda Road for $68 million the second asset for the joint venture after purchasing 32 Walker Street, North Sydney for $35.6 million. Private investors remain the dominant buyer profile for assets under $30 million. Transaction volumes, however, in this end of the market has slowed through divergent price expectations between buyers and vendors. Considerations & asset pricing trends Figures 5 and 6 show the historical relationship between equivalent yields in the Fringe and Suburban office markets, relative to the CBD. One would expect a positive spread between non-cbd and CBD office markets for a number of reasons: limited liquidity, higher leasing risk and financial stability of tenancy base, shorter WALEs, funding constraints, buyer pool limitations, management expense ratios and others. Historically, the market has priced the Melbourne fringe and suburban office markets at a risk premium over the CBD market of 84 and 94 basis points respectively. Through the recovery from the financial The question is whether this higher pricing of risk between the markets is structural or transitory. It can be argued that the balance of investment fundamentals between the markets has not deteriorated on the non-cbd side. Whilst the investment fundamentals have strengthened in the non- CBD market, peripheral issues continue to weigh on asset pricing. Institutions have sold down non-core assets, access to capital remains an issue and there is limited depth to the buyer pool. Those groups, however, that have acquired in the non-cbd market have done so on relatively attractive entry yields.

5 Pulse A Case for Melbourne s non-cbd office market - July Yield premiums in the non-cbd highlight an opportunity to acquire assets on attractive pricing metrics. Current pricing levels and market fundamentals appear to be attractive to investors with either a growth or a value based investment strategy. Even within the non-cbd market, it has been noted that yield spreads between A-grade and secondary grade assets remains wide. This gap is expected to remain wide as vacancy risk in the secondary market remains higher and general risk aversion places these assets out of favor. Outlook Melbourne s non-cbd office market will continue to benefit from its stable conditions and limited supply side risks. While the availability of debt remains an issue, alternative sources of capital are emerging. Vacancy is expected to remain at or below the long-term average and will support increasing competition for quality stock. As a result, the outlook for rents is relatively positive over the medium-term. Investor sentiment is starting to improve. In 2012, we expect to see increased investment activity in non-cbd office markets from wholesale funds, boutique fund managers and private syndicates. Furthermore, continued equity market volatility and a reduction in bank deposit rates could increase the pool of high net worth individuals seeking exposure to an asset class with a strong income yield and capital growth potential. Andrew Wood Managing Director - Victoria Jones Lang LaSalle tel: andrew.wood@ap.jll.com Steven Messina Director Investment Sales Jones Lang LaSalle tel: steven.messina@ap.jll.com Nicholas Wilson Senior Analyst Research and Consulting Jones Lang LaSalle tel: nicholas.wilson@ap.jll.com

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