Australia's office market is facing cyclical and structural threats. Heightened interest rates are an overall drag on the economy, and have led to rising financing costs and increasing capitalization rates for office REITs. The sector is also structurally vulnerable to workplaces adopting flexible working practices. These factors will continue to weigh on office asset valuations, earnings, and credit metrics.

S&P Global Ratings believes prime-grade assets will be better positioned than secondary-grade assets, given their strong tenants and ability to adjust to changing market conditions. The seven office-focused Australian REITs (AREITs) we rate showed resilience to our stress tests on rental and asset-value declines.

On March 31, 2023, we took various rating actions on eight U.S. office REITs on deteriorating fundamentals and near-term cyclical risks. Like the U.S., Australia is contending with evolving demand dynamics and the traditional office cycle, which we expect to persist and will likely erode rating headroom.

Rated AREITs Better Positioned To Deal With Stresses

We expect demand for office space to evolve as tenants progressively adjust and recalibrate their office floorplate requirements when lease expiries approach. Cyclically, new supply is hitting at a time of higher inflation and weakened business confidence. Meanwhile, enduring work-from-home habits will require shifts in broader strategies.

Vacancies could stay elevated

Vacancy rates will likely stay above pre-COVID levels (see chart 1). One issue is supply, as new developments delayed during the pandemic reach completion. Another depressant is weakened business confidence amid inflationary pressures and a higher cost of debt.

Chart 1

Elevated incentives highlight the vulnerability to subdued demand and the uncertain outlook for the sector. They also stifle net effective rentals growth. Office landlords have been negotiating record high incentives to attract and retain tenants. We see this across CBDs in Melbourne and Sydney where average incentive levels for prime-grade and secondary grade offices are around 30%-40% as at March 31, 2023 (Source: Colliers Research, Property Council Australia).

If this trend does continue, in our view, it will further widen the gap between prime and secondary grade office assets. For instance, average incentive levels for prime-grade in CBD markets of other Australian capital cities are about 4%-5% higher than that for secondary-grade offices as at March 31, 2023. Meanwhile, we anticipate landlords of lesser-quality offices may have to spend more to compete with demand pressures.

Out of office: Office demand weakening on structural shift

Corporates have begun to adjust and downsize their office floorplate requirements as employers and staff embrace flexible working practices. Office assets that are positioned to enable and support evolving requirements remain sought after. We expect our rated AREITs to maintain and enhance their assets to support the pivot toward flexible working arrangement. This likely includes modern, flexible, and purpose-built buildings with attractive end-of-trip facilities and environmental credentials.

Resilience supported by strong tenants and laddered lease profiles…

Our rated office AREITs are better positioned to withstand the cyclical and structural trends, relative to the sector average. They benefit from contractual rental income profiles with typically fixed or inflation-linked annual rental escalators. Tenants comprise primarily companies listed on the Australian stock exchange (ASX), large multinationals, and government tenants with minor exposure to small businesses.

Low counterparty risk was demonstrated during the economic shocks of the pandemic. Despite limited physical attendance rates in offices, the rental income and cash collections of our rated office AREITs were largely resilient.

Lease maturity management is another key mitigant to weakening office space demand. Landlords holding material lease maturity profiles, which are concentrated in the near-term and not evenly laddered over the longer-term, are susceptible to shifts in demand. This will likely diminish portfolio occupancy rates and earnings profile, which will reduce credit metric headroom. Nonetheless, our rated office AREITs hold even laddered leases, with on average about 6%-8% of leases expiring over the next 12-18 months.

…and a flight to quality

Prospective tenants that are shrinking their office footprint and were previously priced out of prime-grade office towers may look to reposition to higher-grade and refurbished office buildings with better green credentials. We believe this trend of a "flight to quality" will persist and offer protection to landlords with purpose-built, refurbished, prime-grade office buildings. Effective rental growth is trending upward for premium-grade assets (see chart 2).

Chart 2

Stress test 1: How much rental downside can our rated AREITs endure?

The test:   We test whether financial cushions can withstand three scenarios on lease renewal rates: at 60%, 70% and 80%, over fiscals 2023-2025. The percentage applied is to leases that are maturing in the forecast period. For example, if 10% of leases are maturing in the next year, we assume that 6%, 7% and 8% are renewed under the new respective scenarios. The residual is added to the current vacancy. For the purposes of this analysis, we assume no new leases are executed or commenced across our forecast period and retain existing development capital expenditure (capex) already included in our base case assumptions. Here's what we found:

The results:   Our stress test show the majority of our rated office AREITs are pretty sturdy in the face of weakening demand over the next two years. They are not invulnerable. Under our more severe tests, financial cushions erode.

• The majority of our REITs pass our stress tests at 80% and 70% lease renewal rates.
• About one-third of our REITs begin to breach their downside trigger at 60% lease renewal rates.
• These stress-case scenarios are more severe than our base-case assumptions.

Under The Spotlight: Office Asset Valuations

Office valuations face higher interest rates and capitalization rates. Total returns for public traded office AREITs declined about 15% over the past 12 months (ending Dec. 31, 2022) despite returns for unlisted AREITs increasing (see chart 3). The disconnect is an added pressure for the valuations of AREITs.

Chart 3

In our view, a lack of transactional data and the illiquid nature of property assets underpin unlisted property values. In some instances, office assets that were slated to sell have been withdrawn, with landlords seeming unwilling to part with assets at material discounts to book values. Hence, we expect some degree of convergence between the portfolio returns of listed and unlisted office AREITs, given the market realities. But the private and illiquid nature of unlisted assets may support information and pricing asymmetry.

Looming Liquidity Events Could Squeeze Ratings

Across our broader rated AREIT universe, which includes industrial and retail REITs, unitholder redemption have increased as pre-determined liquidity windows are activated. We recently downgraded APPF Retail and QIC Property Fund and revised our outlook on AMP Capital Shopping Centre Fund (to negative from stable) on redemption-related credit strains. We also revised our outlook on Australian Prime Property Fund Commercial (to negative from stable) on interest rate and balance sheet pressures.

Given the challenges in the office market and valuation mismatch between listed and unlisted assets, we expect capital redemptions from unlisted office funds to be cycled into listed property and alternative asset classes. Unlisted office asset divestments would establish new transactions and pricing datapoints for office asset valuations. In our view, the price divergence between listed and unlisted office funds to narrow, although it could take some time.

Office asset values could drop as landlords divest assets to meet liquidity events including unitholder redemptions and capital requirements. Another drag on asset values could come if flexible working arrangements became widely adopted, depressing lease renewal rates and rental income. During the global financial crisis, prime-grade asset values in Australia declined on average about 25% from peak to trough between March 2008 to September 2009, according to Colliers. Over this same period, secondary-grade asset valuations shrunk by about 31%.

Stress test 2: Three scenarios on asset values

The test:   We test against office asset value declines of 10%, 15%, and 25%. In particular, we assess whether these events would push gearing to the upper limits of financial policy frameworks.

The results:   The majority of our rated office AREITs can withstand up to a 10% decline in asset values from their current levels, without breaching their own articulated target gearing range (see chart 4). However, only two would stay beneath their upper limits during a fall in asset values similar to those that occurred during the global financial crisis.

That said, issuers do hold additional capital management levers including equity raisings, reduction of distributions and the introduction of third-party capital to continue operating within their gearing ranges. This was shown at the height of the pandemic, where some AREITs reduced or suspended distributions, raised equity or hybrid capital, or cut non-essential capex and development spend, and limited or delayed slated acquisitions.

Chart 4

What Are The Downside Risks?

Our view is that our rated office AREITs are better placed than secondary-grade issuers to confront structural and cyclical pressures. This is because they have competitive assets, relatively well-laddered lease structures, and robust financial policies with no material short-term refinancing risks.

In our view, equity holders would bear most of the brunt of deteriorating fundamentals. In some instances, issuers would need to take action to protect their credit quality and defend their financial policies. These actions could range from equity raisings, even at distressed unit prices, to asset sales or lower capex spending to keep gearing in line with credit profiles.

That said, even prime-grade office AREITs not immune to the challenges facing the sector. Ultimately, ratings stability is determined by the willingness of issuers to defend their financial policy frameworks.

Table 1

Related Research

• Australian Prime Property Fund Commercial Outlook Revised To Negative On Debt-Funded Growth Plans; 'A-' Rating Affirmed, May 18, 2023
• Various Rating Actions Taken On Eight U.S. Office REITs On Secular And Cyclical Headwinds, March 31, 2023
• AMP Capital Shopping Centre Fund Outlook Revised To Negative On Unitholder Redemptions; 'A' Rating Affirmed, March 15, 2023
• Credit FAQ: How The Rising Cost Of Debt Will Affect AREITs, July 25, 2022
• QIC Property Fund Rating Lowered To 'BBB+' On Revised Financial Policies; Outlook Stable, July 7, 2022