MELBOURNE (S&P Global Ratings) July 29, 2024--Australia's wholesale office funds face a dilemma: sell assets at reduced valuations, or risk a potential downgrade. Managers of rated wholesale office funds are leaning toward the former and aim to sell more than A$2 billion of Australian office assets over the next 12 months.
Proceeds will reduce debt and repair weakened credit metrics. The measures will address deteriorated cash flow and coverage metrics, which have weakened over the past two years amid rising interest rates, debt-funded capex and softening tenant demand.
Issuers have struggled to sell assets as no buyer wants to try catch a falling knife. Since 2023, office transactions have been anemic largely due to gyrating long-term interest rates, and structurally weaker tenant demand from hybrid working.
"Dynamics have created a valuation disconnect among market participants, with muted sale volumes unravelling price discovery mechanisms," said S&P Global Ratings credit analyst Ambrose Beaney. "With few recent transactions on which to benchmark new deals, valuers have been gradually increasing the discount rate to reflect long-term interest rates, and to accommodate softening tenant demand."
Issuers are increasingly using debt to fund development due to a lack of liquidity in Australian office markets. The business model of Australian wholesale office funds has relied on asset liquidity to sell noncore assets and recycle proceeds to fund new developments. The pause in transactional activity in combination with higher financing costs has weakened the sector's credit metrics.
For some issuers, equity redemption requests have further exacerbated the strain on credit metrics as they fund these sizable cash outflows. Funds are awaiting a return of asset liquidity to stop the escalation in gearing and retire debt.
Chart 1
CONDITIONS ARE NOW PUSHING ISSUERS TOWARD DIVESTING
Entities will need to execute on planned divestments in the next six to nine months to repair gearing. "Issuers' willingness to accept falling values as they increase asset sales will test their commitment to our ratings on the entities," said S&P Global Ratings credit analyst Aldrin Ang.
Among the motivations are eroding covenant buffers and articulated target gearing ranges. For the latter, most entities are approaching the upper limit, and some have already exceeded it.
Those firms that fail to liquidate face a risk of further valuation declines, weakening the potency of future asset sales in repairing metrics. Further asset value declines are likely, as indicated by the disconnect between the current 2.5% spread for office discount rates in the eastern seaboard central business districts, compared with the 4.2% long-term average. Hybrid working trends are also likely to hit the value of noncore assets.
While our economists believe Australian rates have peaked, a return of uncertainty around long-term rates may stymie issuers' efforts to sell assets. This would prolong breaches of our rating credit metric thresholds, leading to further rating actions.
Equity raisings to remain challenging over the next 12-18 months. "Equity raisings among our rated portfolio would provide the quickest fix for issuers looking to remedy credit metrics. However, this lever, like asset sales, has become less effective over the past two years," said Mr. Ang. In our view, property valuations will need to be stable for at least two quarters for investors to participate in equity raisings.
Issuers will need to balance the drag on future shareholder returns resulting from dilutive equity raisings with the more immediate need to protect credit ratings. Moreover, declining payout ratios, potential future redemption demands, portfolio and sector reallocation, and the relative attractiveness of other real estate classes will all work against near-term equity raisings from wholesale office funds.
THERE COULD BE UNINTENDED CONSEQUENCES
Asset sales could also weaken the business risk assessments of Australian office REITs. Asset divestments will reduce the scale and diversity of these office funds. Funds typically balance divestment with fresh acquisitions or developments to maintain their competitive position.
"However, we have already seen office funds delay or abandon development opportunities to ease forward capital commitments and adjust to weaker demand," said Mr. Beaney. "Somewhat ironically, asset divestments could cause us to lower our business risk assessment, adding to downward ratings pressure."
Related Research
- Research Update: Charter Hall Prime Office Fund Downgraded To 'BBB-' On Sustained Weaker Credit Metrics; Outlook Stable, June 25, 2024
- Research Update: Mirvac Wholesale Office Fund 'A-' Rating Affirmed; Outlook Remains Negative, May 13, 2024
- Research Update: Australian Prime Property Fund Commercial Downgraded To 'BBB+' On Debt-Funded Growth; Outlook Stable, April 5, 2024
- Research Update: GPT Wholesale Office Fund 'A-/A-2' Ratings Affirmed; Outlook Stable, Nov. 10, 2023
- Research Update: Investa Commercial Property Fund Outlook Revised To Negative On Asset-Recycling Risks; 'A-' Rating Affirmed, Sept. 11, 2023
This report does not constitute a rating action.
AUSTRALIA
S&P Global Ratings Australia Pty Ltd holds Australian financial services license number 337565 under the Corporations Act 2001. S&P Global Ratings' credit ratings and related research are not intended for and must not be distributed to any person in Australia other than a wholesale client (as defined in Chapter 7 of the Corporations Act).
The report is available to RatingsDirect subscribers at www.capitaliq.com. If you are not a RatingsDirect subscriber, you may purchase a copy of the report by sending an e-mail to research_request@spglobal.com. Ratings information can also be found on S&P Global Ratings' public website by using the Ratings search box at www.spglobal.com/ratings.
| Primary Credit Analyst: | Ambrose Beaney, Melbourne +61 3 9631 2137; ambrose.beaney@spglobal.com |
| Secondary Contact: | Aldrin Ang, CFA, Melbourne + 61 3 9631 2006; aldrin.ang@spglobal.com |
| Media Contact: | Richard J Noonan, Melbourne + 61 3 9631 2152; richard.noonan@spglobal.com |
No content (including ratings, credit-related analyses and data, valuations, model, software, or other application or output therefrom) or any part thereof (Content) may be modified, reverse engineered, reproduced, or distributed in any form by any means, or stored in a database or retrieval system, without the prior written permission of Standard & Poor’s Financial Services LLC or its affiliates (collectively, S&P). The Content shall not be used for any unlawful or unauthorized purposes. S&P and any third-party providers, as well as their directors, officers, shareholders, employees, or agents (collectively S&P Parties) do not guarantee the accuracy, completeness, timeliness, or availability of the Content. S&P Parties are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, for the results obtained from the use of the Content, or for the security or maintenance of any data input by the user. The Content is provided on an “as is” basis. S&P PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT’S FUNCTIONING WILL BE UNINTERRUPTED, OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs or losses caused by negligence) in connection with any use of the Content even if advised of the possibility of such damages.
Credit-related and other analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and not statements of fact. S&P’s opinions, analyses, and rating acknowledgment decisions (described below) are not recommendations to purchase, hold, or sell any securities or to make any investment decisions, and do not address the suitability of any security. S&P assumes no obligation to update the Content following publication in any form or format. The Content should not be relied on and is not a substitute for the skill, judgment, and experience of the user, its management, employees, advisors, and/or clients when making investment and other business decisions. S&P does not act as a fiduciary or an investment advisor except where registered as such. While S&P has obtained information from sources it believes to be reliable, S&P does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives. Rating-related publications may be published for a variety of reasons that are not necessarily dependent on action by rating committees, including, but not limited to, the publication of a periodic update on a credit rating and related analyses.
To the extent that regulatory authorities allow a rating agency to acknowledge in one jurisdiction a rating issued in another jurisdiction for certain regulatory purposes, S&P reserves the right to assign, withdraw, or suspend such acknowledgement at any time and in its sole discretion. S&P Parties disclaim any duty whatsoever arising out of the assignment, withdrawal, or suspension of an acknowledgment as well as any liability for any damage alleged to have been suffered on account thereof.
S&P keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities. As a result, certain business units of S&P may have information that is not available to other S&P business units. S&P has established policies and procedures to maintain the confidentiality of certain nonpublic information received in connection with each analytical process.
S&P may receive compensation for its ratings and certain analyses, normally from issuers or underwriters of securities or from obligors. S&P reserves the right to disseminate its opinions and analyses. S&P's public ratings and analyses are made available on its Web sites, www.spglobal.com/ratings (free of charge), and www.ratingsdirect.com (subscription), and may be distributed through other means, including via S&P publications and third-party redistributors. Additional information about our ratings fees is available at www.spglobal.com/usratingsfees.