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Spotting and extracting value in the office market

Lobby area of 8 St Georges Terrace office building
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A capital injection can make an older office asset attractive to tenants. Photo: Quintessential Equity

Spotting and extracting value in the office market

Australia’s office markets remain challenging, but savvy investors are nonetheless finding value and snapping up strong-performing assets in an uncertain market.

There is a positive climate for property investment in Australia. 

From both a health and economic point of view, Australia has fared much better than most countries, with activity largely returning, or already returned, to its pre-pandemic normal (prior to the latest outbreak).

Coupled with that, interest rates are at a record low, and last month the Reserve Bank of Australia announced that interest rates will be held at 0.1 per cent until at least 2024.

After an uncertain year, many challenges still lie ahead, but capital flows into property are likely to remain strong in 2021, as evidenced by recent deals.

According to new data from the Property Council of Australia’s latest Office Market Report, vacancy rates have risen – but this has been less affected by COVID-19 than was initially touted, and instead, three-quarters of the impact on vacancy rates can be attributed to new stock coming on the market.

As more new office stock is expected to come online over the next year, particularly in CBDs, landlords that can offer healthy and open working spaces with flexible terms will remain desirable and competitive in the market.

With low interest rates expected to drive further investment into commercial property, sound research will be critical for investors who want to find value and maintain income. 

The fundamentals of good investing

There are a number of core fundamentals when it comes to investing in commercial and industrial property to ensure investor capital is preserved.

The first is, never to be blinded by cash flow because that’s the first thing you can lose in the property you buy.

There are investors currently paying a lot of money for older assets, purely because they come with a level of income that they are already producing.

However, if your older asset loses that income, you may find it hard to replace it at the same level in an increasingly competitive market. You always want to make sure that the price you pay for your asset will give you a competitive advantage to retain your tenant and income. 

Secondly, always buy property below replacement value if you want to make money and preserve capital. It’s so important. As an investor and landlord, you do not want to be competing with newer stock that has a lower cost base.

Thirdly, the day you buy is the day you will make or lose money. When you buy well, you can win the race to the tenant because you have a competitive advantage. 

Finding assets that will attract and retain tenants in this current market is critical – that’s where the cash flow comes from and that’s where the capital preservation is embedded.

The last one is very pertinent. At times, you can actually make more money by not buying property than buying it. 

If you overpay for an asset, that’s where it can become very difficult. You don’t want to be managing properties for practices as you should always be aiming for an appropriate risk adjusted return for your investment. 

While the office sector has faced the brunt of real estate’s COVID-19 challenges over the past year, there are lots of opportunities for investors to find value in the market. 

Whether the market is going up or down, value is always there – you just need to find it.

Where value meets competition

It’s no secret – the Perth commercial market has the highest vacancy of all CBDs in Australia. 

Given its vacancy, it is one of the most competitive markets in the country. According to recent CBRE research, Perth is projected to be one of a few markets where vacancy rates are expected to decrease in 2021. 

Perth landlords are competing to secure and retain tenants by providing generous commercial terms, upfront refurbishment work and a host of incentives. 

In 2018, Quintessential Equity purchased 8 St Georges Terrace – an eight-level office building located at the heart of Perth’s legal epicentre. Purchased for $9.25 million, as part of our $112 million Master Fund, we were able to buy into Perth at the lower end of the market. 

Despite the competitive conditions, we saw 8 St Georges Terrace – which was fully vacant at the time – as a strong opportunity where we could offer the market a sophisticated building with highly competitive rental rates.

Embarking on a $5 million refurbishment, we focused on tenant wellbeing, securing a 4.5-Star NABERS Base Building Energy rating that assisted in attracting and retaining quality tenants, providing stabilised, long-term income to investors. 

After being vacant for many years prior to Quintessential Equity purchasing the building, it is now over 67 per cent leased, and on a pro-rata basis it is one of the most successful office buildings on the market. 

It is a top performer from both a vacancy reduction and deal value perspective – which is extremely positive given we launched in February 2020 (just before the pandemic).

Our upfront refurbishment was market-leading for Perth. This strategy has been key to its leasing success – providing agents with prime stock and extremely competitive leasing terms. 

This is a prime example of the aforementioned fundamentals for investing in commercial property. 

The building was empty when we purchased it in a distressed state. Because we purchased the building well, even after the refurbishment we were able to have a substantial advantage over competing stock as our cost base was lower and we were able to win the race to the tenants. 

Always ask yourself, what is the asset’s competitive advantage that will ensure you are able to maintain or get income? If you can’t answer that, you may be overpaying and being blinded by the current cash flow that you are at risk of losing. 

Looking ahead

We are looking forward and outward, as we continue to see great opportunity in markets that have been overlooked and assets that have been mispriced and mismanaged. 

The office sector will stabilise in our opinion with some structural changes that will offer opportunities for those at the forefront of what they offer their tenants. 

These changes may include total wellness and collaboration hub solutions to draw people back to the office as well as turnkey solutions for fit outs and flexibility, to name a few. 

In light of COVID-19, in our opinion we are going to see price adjustments on commercial properties that represent risk. 

While a recalibration of prices throws up many challenges, it will likely lead to opportunities for investors who are cashed up and ready to make prudent acquisitions to achieve commensurate risk-reward.

Distress in property is slow to present, however, there’s going to be great opportunities for those who can extract value, stick to the fundamentals, and are capital ready.

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