Asia-Pacific office REITS and landlords face dilemmas similar to peers elsewhere in the world. Tenants are downsizing. Vacancy rates are elevated and new supply could exacerbate this burden. Higher interest rates are pressuring capitalization rates and asset values.

All that said, we believe this region's office-focused REITs are in better shape than global peers.

Hybrid-working practices are taking root in this region, but not as disruptively as elsewhere. The allure of working from home is not as strong in Asia's high-density cities, where residential spaces are generally small and commute times short. Real estate specialist Jones Lang LaSalle (JLL) says return-to-office levels typically range from 70%-100% in Asia-Pacific, higher than 40%-65% in North America and 65%-85% in Europe.

S&P Global Ratings has stable outlooks on 12 out of 15 office-focused rated REITs or landlords in Australia, Hong Kong, mainland China, Japan, and Singapore. We've taken only two negative rating actions on this group over the past 12 months. By way of comparison, we recently downgraded a number of U.S. office REITs, and have negative outlooks or CreditWatch placements on six of 11 rated issuers in this space.

We performed stress tests on the 15 rated issuers across Australia, Japan, Hong Kong/mainland China, and Singapore. These entities are office-focused REITs or landlords, with exposure to office assets exceeding 50%. Most of these entities have some buffer against stress scenarios. One, however, faces "fallen angel" risk--i.e., the rating is at risk of falling from investment to speculative grade.

New Supply, Weakened Demand, Higher Funding Costs

Heightened inflation and borrowing costs, combined with weak global trade and economies, are weighing on business sentiment across Asia-Pacific. Many companies are losing earnings momentum and seeking to cut costs. Add to this a degree of entrenched hybrid-working habits, and the upshot is most companies are not in the mindset to expand.

The mismatch between demand and supply will keep vacancies elevated and weigh on rents. Take Australia, where new supply was planned pre-COVID due to record-low office vacancy rates. Construction that was paused during the pandemic has come back on line, resulting in higher completions in 2023. This will keep vacancies rates elevated across central business districts (CBDs) in Melbourne, Sydney, and other cities.

New office space hitting the market will tilt negotiating power even more toward the tenant. In Hong Kong, as one example, grade-A office vacancy remained high at 12% as of end March 2023, a level not seen in more than a decade. We forecast the city's office rents will compress by a further 5%-10% in 2023, and remain well below the pre-pandemic level.

Tokyo's new office supply in 2023 is about 30% higher than the three-year average over 2020-2022. We forecast vacancy rates of office buildings in central Tokyo will rise further to 7.0%- 7.5% by end-2023, from 6.5% at end-2022.

Still, the situation in Asia-Pacific is sturdier versus U.S., where broad-market vacancy rates for downtown offices are much higher at 18% based on first quarter 2023 data from by CBRE, a real-estate services provider. Moreover, vacancy rates for the rated Asia-Pacific entities are better than the broad market (see chart 1).

Chart 1

Hybrid Working And Flexible Workspace: The Structural Impact Has Yet To Be Fully Reflected

Like elsewhere in the world, tenant needs are changing in Asia-Pacific. Many companies are rationalizing office floor space as WFH/hybrid working become more prevalent. This will require changes in floorplates and other types of modifications to respond to changing needs. If conditions stay weak, the onus of reconfiguration costs could fall on landlords.

Most markets in the region will not, however, face the degree of structural change likely in some global cities. In high-density cities like Hong Kong, Tokyo and Singapore, residential spaces are often smaller and commutes to office shorter. This is likely to explain why in Japan, as one example, employees are now back at the office 80% of the time, up from 40%-50% in 2021.

Cultural habits also play a part. In some countries, domestic firms and government tend to offer less hybrid-working flexibility compared with multinationals operating in the region.

Key Australian cities will face higher pressure from hybrid practices. According to JLL, the office re-entry rate for Sydney remained 30% below pre-pandemic levels and the lowest among the key Asia-Pacific gateway cities.

In the U.S., such practices are more extreme among the tech sector. For example, in tech-heavy San Francisco, cell-phone traffic is only 32% of the pre-COVID level, according to data from the University of Toronto. This compares to 75% in New York City--which has a much higher dependency on financial companies. Asian cities like Hong Kong are financial centers with small tech belts.

Rated Asia-Pacific REITS And Landlords Can Deal With Stresses Better, At The Expense Of The Broader Market

"Flight to quality" eases rental and vacancy pressure for the rated REITS and landlords.  Landlords with prime assets, offering green credentials, end-of-trip facilities, flexible spaces are better positioned to negotiate with tenants, supporting tenant stickiness. 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 more modern office buildings.

High quality tenants, well-laddered lease profiles and tenant stickiness also provides resilience.  The rated office REITs are better positioned to withstand the cyclical and structural trends, relative to the broader market. These market leading REITs and landlords have strong lease maturity management resulting in a well-laddered lease profile. The Australian office-focused REITS (AREITs) also benefit from contractual rental income profiles with typically fixed or inflation-linked annual rental escalators, providing downside protection.

The exposure of rated Asia-Pacific REITs to high-quality tenants also lowers counterparty risk which was seen during the pandemic and through the global financial crisis (GFC).

Most rated office landlords have disciplined financial management.  Most have a track record of "living up" to their financial policies and defending their credit quality through different cycles. We believe many have options at hand to reduce their gearing or other debt metrics to within the companies' own stated tolerance levels. While levers are available, in our view it may be harder for the landlords to achieve their desired timing or valuation in realizing assets or raising new equity funding in the current environment.

But our stress tests show, some of these companies are less immune to severe stress

It's hard to know precisely when the current cyclical pressures will ease, or when the hybrid-work reconfigurations will peak. Our base case assumes that vacancies will stay elevated over the next few years, with varying degrees of rental pain inflicted on the Asia-Pacific gateway cities (see city/jurisdiction section below). This will erode cash flows and earnings for landlords.

What if the fallout is deeper and longer than our expectations on rental cash flow? We have simulated several scenarios to stress test the resilience of the rated entities.

The tests: Three scenarios  We test whether the financial cushions of rated issuers can withstand three scenarios on heightened vacancy rates: assuming 20%, 30% and 40% of annual maturing leases over fiscals 2023-2025 remains vacant. For example, if 20% of leases are maturing next year, we assume that 16%, 14% and 12% are renewed under the new respective scenarios. That would then push up the overall vacancies rates by 4 percentage points (pts), 6pts, and 8pts respectively. Vacancies are cumulative over the forecasted period.

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: Rated China, Japan office REITS are sensitive to falling rents  China's Yuexiu Real Estate Investment Trust has no headroom for any rental deterioration. Its debt-to-EBITDA ratio is already breaching our downside threshold. This is reflected in our negative outlook on the 'BBB-' rating. That said, we expect the company to take measures, including asset sales, to bolster its financial position.

The majority of the rated office-focused REITs in Japan would breach our downgrade trigger for cash flow adequacy (funds from operations (FFO) to debt), in a scenario where 20% of leases are not renewed at maturity. Such a scenario would push up their average vacancies to 6.7% by end 2023 from about 3.7% as at end-March 2023.

Hong Kong landlords would also breach our financial leverage (debt-to-EBITDA) downgrade triggers as early as 2023, even under the least severe scenario. However, their gearing ratio of debt to debt-plus-equity remains resilient under all three scenarios.

For the seven AREITs, only two breached our downgrade trigger on cash-flow adequacy in 2023 under a scenario of 20% of leases not renewing upon expiry. The most severe scenario of 40% non-renewal rates reflects conditions similar to the GFC; under this scenario, five out of seven would breach our downgrade triggers.

Table 1

Office Asset Valuations: Another Shoe That Could Drop

Heightened interest rates are putting upward pressure on capitalization rates. This in turn is a weight on asset valuations and will narrow headroom against the financial policies, gearing covenants limit, and/or regulatory limits for the rated entities.

In our view, a lack of transactional data and the illiquid nature of property assets means the strain on property values have not been fully reflected. 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.

Rising financial pressure on landlords, REITS and wholesale funds will see more office assets offloaded and we believe prices and valuation will be tested to the downside.

The tests: 10%-25% declines  We test against office asset value declines of 10%, 15%, and 25%. We assess whether these events would push gearing to the upper limits of the entities' financial policy frameworks, bank covenant and regulatory limits, whichever is lower.

The results: Japan most resilient  Japan is most resilient to falls in asset valuations, in part due to unrealized gains and our view that cap rates will remain stable. Moreover, asset values don't have a direct impact on key metrics such as loan to value (LTV) ratios because the country's REITs use a cost-accounting approach.

China's Yuexiu REIT is most sensitive to falling office valuations, in part because the financial leverage of the Guangzhou-based trust jumped during China's prolonged COVID lockdowns.

Singapore's CapitaLand Integrated Commercial Trust (CICT) can withstand up to a 15% decline in asset values before breaching the regulatory limit on aggregate leverage. In Singapore, that limit is 50% for aggregate leverage (total debt over total deposited properties) for REITs with interest coverage of over 2.5x.

Table 2

Looming Liquidity Events Could Squeeze Ratings On Australia Wholesale Funds

We expect a price divergence between listed and unlisted office funds to narrow, although it could take some time. This convergence will strain office-asset valuations. In our view, unlisted assets held up better only due to their illiquid nature and the lack of transactional market data for these assets. Listed assets better reflect the market expectations for individual issuers and the sector.

Across our broader rated AREIT universe, which includes industrial and retail REITs, unitholder redemptions have increased as pre-determined liquidity windows are activated. We recently downgraded two such trusts on redemption-related credit strains.

We think office asset values could drop as landlords divest assets to meet liquidity events including unitholder redemptions and capital requirements.

Regional Focus: Rated REITs, Landlords By Jurisdiction

Australia

Hybrid working: Companies are downsizing office needs amid enduring work from home

• Corporates are increasingly seeking to adjust and downsize their office floor plate requirement as employers and staff embrace flexible working practices.
• We expect hybrid-work habits to be enduring in Australia's major CBDs. This will require shifts in broader strategies for office landlords. This likely includes modern, flexible, and purpose-built buildings with attractive end-of-trip facilities and environmental considerations.
• Rated office-focused AREITs derive some protection from this trend because their prime assets benefit from trading up and flight to quality. For example, tenants that need less floor space may seek higher-quality space.

Office demand and supply balance: tough conditions

• Vacancy rates will likely stay above pre-COVID levels. 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.
• Elevated incentives could stifle future net effective rental growth. We also believe it could widen the gap between prime-grade and secondary-grade offices. We anticipate landlords with lesser quality assets may need higher capex requirements to compete with demand pressures.
• The majority of the rated REITs pass our stress tests at 20% and 30% non-renewal rates.
• About one-third of the REITs begin to breach their downside trigger if 40% of lease aren't renewed.

Chart 2

Asset valuation: Downside is likely

• Office valuations are squeezed as higher interest rates pressure capitalization rates. We note that listed office assets have fallen while unlisted ones have held up. Listed assets are more liquid and better reflect the market realities in our view. We expect a convergence--in short, more downward pressure on asset valuations.
• The majority of the rated office AREITs can withstand up to a 10% decline in asset values without breaching the companies' own articulated target gearing range. However, only two would stay beneath their upper limits with a GFC-style fall in asset values.

Table 3

Hong Kong/mainland China

Uncertainty and U.S.-China tensions are the main weights on office demand in Hong Kong

• We forecast a 5%-10% decline in rents in 2023. Grade-A office vacancies were 12.0% as of end-March 2023-but 9.0% in the prime Central district.
• New office supply is substantial but more than half is located in non-core areas such as Sham Shui Po and Kwun Tong.
• Slowing global growth and financial market volatility have hurt business sentiment.
• But closer integration with mainland China and an improving economy in Hong Kong should provide some relief and underpin demand.
• As an example, financial companies have been downsizing in Central, dragging on occupancy rates and rents. Mainland companies nonetheless have been more active in taking over spaces in Central area, given a narrower rental gap between core and non-core areas in the city.
• As a result, recentralization (where tenants relocate from non-core areas back to Central) and flight to quality will likely alleviate the pressure on rated landlords.
• A more severe sector stress than we forecast could slow deleveraging. The rated office-focused landlords have already breached one of our downside triggers(debt to EBITDA) in fiscal 2022 given significant COVID disruptions in the city.
• However, their occupancy rates remain solid and these landlords also have retail assets that are seeing a fast recovery from reopened borders. And their gearing (debt-to-capital) ratios have a lot of buffer given their prime assets and conservative investment spending.

Hybrid working won't entrench as deeply as for other Asia-Pacific gateway cities

• Small homes, short commutes, and convenient public transportation will forestall a major shift in work practices.
• In a survey conducted by CBRE in 2022, 90% of respondents in Hong Kong worked in the office at least three days a week, a higher rate than global and regional averages.
• Multinationals are more likely to offer WFH flexibility. Local and smaller firms, as well as government departments, have been returning to pre-COVID office practices.

Hong Kong asset valuations: Downward adjustments will continue for 2023 but only mild for rated landlords

• Lower rents and higher interest rates will exert pressure on office valuations over the next 12 months.
• Offices in non-core areas will see greater valuation strains given higher vacancy rates. Rated landlords, supported by higher occupancy rates, will only have mild valuation pressure over the next 12 months. We believe most of this downside has already been reflected over the past two to three years .
• At end-2022, the capital value of Hongkong Land's offices in Central were down 1.6% year over year, after three year of decline of 1.7%-9.2%, driven by lower rents and a slight expansion in cap rates. IFC's office asset valuations dropped by a similar percentage in the fiscal year ended June-2022.
• The issuers have ample headroom to absorb potential decline in asset valuation. None of the rated office landlords would breach their financial policy targets or bank loan covenants even with a 25% decline in asset value.

Chart 3

Mainland China: Yuexiu REIT's financial leverage is stretched

• We have a negative rating outlook on the one China-based REIT that has office exposure, Yuexiu REIT. This trust's debt-to-EBITDA ratio is the highest among other rated REITs in Asia-Pacific, due to China's more prolonged COVID lockdowns and its aggressive expansion in the past years.
• By end 2022, Yuexiu REIT's own portfolio vacancy had surged to 14.5%, from below 10% the previous year.
• We expect China's reopening will drive the business recovery of its office buildings. Yuexiu REIT's assets are located in prime locations in higher-tier cities in China (85% of revenue was generated from Guangzhou in 2022).
• The management has telegraphed deleveraging plans to meet its deleveraging targets. It plans to sell assets and restore its credit metrics within the next three to six months.
• Hybrid working does not constitute a structural threat in China, given a low adoption rate. Any prolonged pain in the office sector would come from a macro recovery that is slower than expected.

Table 4

Japan

Hybrid-working flexibility has taken root

• Some 80% of Japan-based companies have adopted hybrid-working practices, according to various surveys.
• Nonetheless, the average office attendance rate has recovered to about 80%. This compares with roughly 40%-50% in 2021.

Coming supply will exacerbate the situation in central Tokyo

• The supply of new office space in 2023 will be about 1.3x greater than the three-year average over 2020-2022.
• We forecast vacancy rates of office buildings in central Tokyo will slip further, to 7.0%-7.5% toward the end of 2023, from 6.5% at end-2022.
• However, the office-focused companies we rate have high-grade assets and stickier tenants. We project their vacancy rates will remain low, at 3.0%-5.0% in 2023. Demand is still good for high-grade properties in favorable locations.

Chart 4

Thin buffers if vacancies exceed our base case

• We tested a scenario in which 20% of expiring leases are not renewed. Since the average lease term for a Japanese REIT is about five years, this implies the vacancy rate would worsen by 4 percentage points in a year.
• Such a jump in vacancies would be significantly negative for cash flow ratios and credit quality. Three of the rated four would breach the downside thresholds in 2023. The remainder would breach its downside threshold in 2024 .

Asset-valuation decline is not a major risk

• Japan's rated office-focused companies have sufficient gearing buffers against declining asset value, in part due to their large amount of unrealized gains.
• Declines in asset value do not have a direct impact on gearing such as loan-to-value (LTV) because Japanese companies use historical cost-basis accounting.
• In addition, cap rates have remained generally flat year on year, with no decline in real estate prices so far.
• We forecast a moderate rise in Japan's key policy rate this year but it will remain much lower than in other countries.
• Even in a scenario of a 25% decline in asset values, three of the rated companies would maintain their LTV target or current leverage level. The other one would be able to withstand under a 15% decline in asset value.

Table 5

Singapore

Peak supply in 2023 introduces more leasing options

• Some 2.6 million square feet will be added this year, about 40% higher than the average annual additions over 2017-2022.
• This could shift the bargaining power to tenants.
• Singapore's prime office rents have recovered to pre-pandemic levels since late 2022, providing landlords more downside buffer relative to other gateway cities in Asia-Pacific.
• The vacancy rate of CICT is 3.3% in Singapore compared with 3.9% for the CBRE Core CBD (Grade A) as of March 31, 2023.
• CICT has financial headroom even if 30% of office leases failed to renew at maturity over fiscals 2023 to 2025. As of March 31, 2023, CICT had a year-to-date retention rate of 95%.

Chart 5

Hybrid working: A high level of physical attendance limits downside.

• We expect hybrid work arrangements to be a mainstay in Singapore. According to May 2023 report by JLL, the office re-entry rate has reached 90% of pre-pandemic levels Singapore.
• The relative high level of physical office attendance will limit the impact from tenant right-sizing floor space.
• Furthermore, a flight to quality as part of the right-sizing will continue to support demand for prime office assets.

Asset valuation should be the most resilient among the key gateway Asia-Pacific cities.

• In our view, valuations for grade-A offices to remain largely stable in 2023. This is underpinned by the low vacancy rates and resilient demand in Singapore. That said, we note that expansionary pressure on capitalization rate could persist as monetary conditions tighten.
• Considering CICT's high quality and diversified asset portfolio, its portfolio valuation is likely to be stable over the next 12-18 months. On a like-for-like basis, CICT's portfolio valuation increased by 0.5% year on year as of Dec. 31, 2022.
• CICT can withstand up to a 15% decline in asset valuation without breaching the regulatory limit of 50% for aggregate leverage (total debt over total deposited properties).

Table 6

Writer: Cathy Holcombe

Digital design: Evy Cheung, Halie Mustow

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