I read with some interest, and not a little amusement, about the fabulous opportunities available for investment in the Brisbane office market. Some appear to have swallowed the sales marketing material hook line and sinker without checking to see whether it was true.
It’s not. The Brisbane office market is significantly oversupplied. The development of new buildings was sustained at the tail end of the mining boom just as demand fell. And, given the lead times in office development, there is still substantial supply to come on stream. It’s a disaster.
The vacancy rate is now around 15 per cent in the CBD. Biz Shrapnel’s latest Brisbane commercial report has it going to 19 per cent in two years. We think it will stay above 10 per cent for the rest of the decade. And that’s assuming that the decline in office demand is over.
Net absorption has been negative, with occupied space falling by 150,000 square metres in the CBD over the past three years. Most of that has been due to the fall in mining investment, a substantial part of which is serviced out of Brisbane.
But mining investment has further to fall. We’re only about a third of the way through the fall in mining construction in Queensland, with the rest to hit over the next two years. The part serviced out of Brisbane — particularly the planning, design and regulatory components — is front-end loaded. But there’s more to come.
It’s not all bad news. The fall in the dollar will stimulate non-mining trade-exposed industries such as agriculture and tourism. But the impact on Brisbane will be slow to come through.
That makes me a little wary about assuming that the fall in net absorption will stabilise and start to increase this year. The demand risk is on the down side.
And the supply risk is on the up side. In our analysis, we assumed that very little new stock would be built for the rest of the decade — nothing in the CBD and only moderate amounts in the suburbs. However, at current rents and property values financial feasibilities still stack up for new development, even with high incentives. The problem is that precommitments to new space will leave backfill space high and dry. And make the oversupply problem worse.
Perhaps the saving grace is that some potential office sites and older stock are being used for residential developments. But we think there is a limited life in the current residential boom.
Added to the downside in demand, the risk is that oversupply could end up worse and last longer.
How does that affect investment in existing office buildings? For me, the real issue now is how far rents and property prices will fall.
They have already fallen. So far, the fall in the face rents has been moderate — around 17 per cent from the pre-GFC peak for A grade space, less for premium and more for B. But incentives have blown out dramatically to around 40 per cent so that effective rents for A grade space are down by 60 per cent.
That has softened the impact on property valuations and prices, with A grade space now 38 per cent below the peak. Most of the impact was immediately post-GFC. But, unlike some other markets, prices never really recovered.
However, given the weakness of the leasing market, yields have remained extraordinarily firm. Indeed, they are still firming. That doesn’t make sense. Once the extent and duration of oversupply is understood, we think that yields will soften. Both rents and prices will fall further.
That makes for dismal investment returns. Rental yields may look reasonable compared with the bond rate. However, on a five year horizon, most of the yield return will be offset by capital losses. We are looking at internal rates of return of around 1 per cent.
Some investors are looking at property as a yield play, arguing that a long lease will see them through any downturn in prices. Maybe so. But it will feel dreadful along the way as we ride the rollercoaster of softening yields any recovery Wouldn’t it be better to wait until the market has finished falling before investing?
There will be a time to invest in Brisbane offices. But it’s not for some time yet. It will take some time for the market to finish falling. And the risk is on the down side.
And it’s not just Brisbane. Office markets in each city are each working on their own individual logic.
Perth is worse. Adelaide isn’t too flash. Canberra is at the tail end of a long oversupply with recovery some time off.
On the other hand, recovering demand and moderate supply in Sydney and Melbourne mean tightening leasing markets and strong growth in rents and prices over the next five years.
Given the strength of these shifts, cyclic swings will dominate investment returns. Believe the marketing hype at your peril. Let the investor beware.