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.
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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 |
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