The bifurcation of office markets
Pitcher Partners Investment Services (Melbourne) | The information in this article is current as at 10 October 2022.
There has been much written, and the debate continues on the long-term impact of the working from home (WFH) phenomenon. However, the office market is also experiencing another force of structural change that is leading to a two-tier market.
The change is multi-faceted, but the primary driver has been regulation forcing commercial building owners to operate with greater energy efficiency. At the same time, tenants along with their employees, are also pushing landlords for more modern space – with access to natural light, sophisticated air ventilation systems and independently verified sustainability standards. These powerful expectations are leading to a sector bifurcation between buildings that can meet the needs of the future and those that cannot.
In Australia, there exists a Commercial Building Disclosure Program (CBD) which stipulates that office owners of >1,000sqm must obtain a BEEC (Building Energy Efficiency Certificate) prior to marketing the asset for sale, or for lease / sub-lease.
This program, which has been in place since 1st November 2011 must be renewed every 12 months and contains two key metrics:
- NABERS Energy: National Australian Built Environment Rating System measures and compares the environmental performance of Australian buildings and tenancies via a 1-to-6-star ratings process.
- TLA: Tenancy Lighting Agreement measures the power density and the capacity of the installed lighting systems.
There are NABERS rating tools for commercial office buildings to measure greenhouse gas emissions, energy efficiency, water efficiency, waste efficiency along with indoor environment quality. It is worth noting that there are also similar ratings tools for hotels, shopping centres and data centres.
Not surprisingly, in the early years of the CBD regime, only c.15% of office buildings were rated with 5-star NABERS energy or higher. Since then, the NABERS rating process has evolved such that by FY21, 45% of Australian buildings had 5 stars or higher, with NSW at an impressive 55% and Victoria at a weaker 35%.
Whilst the key office markets vacancy rates are expected to remain elevated going forward (JLL forecasting Sydney vacancy to remain at >10% until 2027, and Melbourne until 2028), it is not as bearish as what the headline figures would suggest. Nationally, businesses / office occupiers are increasingly leading a trend towards embracing sustainability initiatives. For instance, various technology companies, members of the Big 4 banks, as well as large organisations such as Telstra, have all announced various targets to reduce their carbon emissions profile.
The move to increase regulatory oversight is also being driven by local councils as evidenced by the City of Sydney recently endorsing plans whereby all new office, retail, and hotel buildings as well as redevelopment of existing assets, must:
- be rated a minimum 5.5 stars NABERS energy from Jan ’23, and
- procure renewable energy equivalent to net zero carbon from 2026.
There is no requirement for existing buildings to be rated 5.5 stars by 2023 as the new standards only applies to new projects but over time, this will naturally create a bifurcation of the office market.
Obviously, there is a chance that councils around Australia will also adopt these more stringent green standards thereby placing pressure on owners of the older stock of office space to upgrade their ratings to stay competitive. This growing focus on energy efficiency and sustainability, coupled with the concept of flight-to-quality in terms of office tenants’ preferences, highlights that in the longer term, landlords with stronger sustainability metrics should outperform the broader market on financial operating metrics.
In the listed space, landlords such as Dexus (DXS), Mirvac (MGR) and GPT already have energy ratings across their office portfolios of 5 stars or above (average across their portfolios). Recent data from the commercial real estate agents suggests that the average NABERS rating across Australian office assets is currently 4.3-4.4 stars, so the leading listed office REIT managers are well positioned, in the current challenging market. It’s also worth noting that the national office market is very fragmented which is supported by the recent data that shows that across the 4 major capital cities in Australia, DXS, MGR, GPT, and Charter Hall Group (CHC) only own a combined c.25% of existing stock.
Interestingly the 50% Mirvac owned office property where Pitcher Partners have their Melbourne office has a 6-star NABER rating. This is 1 of 4 in their 21-office property portfolio that has this premium energy rating.
Australian composition of office stock by NABERS rating (FY21)
Source: NABERS
Over time, the more strongly capitalised listed market is expected to be well positioned to maintain their highly rated office portfolios whilst the non-institutionalised owners who have been reluctant to upgrade their buildings, may find it more challenging to maintain their occupancy levels.
The pressure to upgrade an office building will grow, either via refurbishment or redevelopment but not all the older more inefficient stock are expected to be upgraded in the near term given:
- Costs: The capex costs to upgrade are likely to be substantial
- Offline: To fully refurb an old building may take 1-2 years which along with the leasing up period results in an extended period of disrupted income
- Capital constraints: Non-institutionalised owners may not have adequate funding to retrofit an ageing asset.
However, should a building be well positioned but suffers from a high vacancy rate along with a sub-optimal NABERS rating, then these sites are likely to be identified as office developments of the future. For the likes of DXS, MGR and GPT who have dedicated development platforms, subject to acquisition, become growth options to create premium rated offices of the future
The office market is rapidly evolving in many ways, but the more enduring dynamic have been the changes brought about by regulatory, social, and technology trends. Over the past decade, it is the NABERS energy rating tool in particular that importantly has created a positive alignment of interest for the many key stakeholders of the office environment.
