Investors brace for major office valuation markdowns

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Commercial property investors are bracing for a major wave of valuation markdowns as the sector is hit with multiple headwinds of rising interest rates, structural changes in work habits and low sales volumes.

The full extent of the declines will be revealed in the coming reporting season, with analysts predicting a slump of up to 20 per cent in prime office values, and even more for lower investment-graded properties.

Many office towers have high vacancy rates and face valuation markdowns of up to 20 per cent.Credit: Paul Rovere

Equity investors are already factoring in the falls, with listed real estate investment trusts (A-REITs) trading at large discounts to their net tangible assets.

The valuation slump is expected to hit the office sector the hardest, with many towers having high vacancy rates, resulting in lower income, making them less attractive to investors if they are sold.

Winston Sammut, investment manager for Sequoia Financial Group, said that, until recently, there has been little meaningful transactional activity in the office sector.

In May, less than $500 million worth of transactions took place, he said, with the main assets traded focused on childcare, hospitality, and neighbourhood shopping centres.

‘The need to sell to meet [fund] redemptions will heighten as revaluations occur, so there’s a bit of choppy water ahead.’

“However, last week’s announcement of the sale by Dexus of a 26-storey A-grade office block at 44 Market Street, in the centre of Sydney, to Hong Kong private equity player PAG for $393.1 million – a 17 per cent discount its December book value – should provide a better guide as to commercial valuations, in general,” Sammut said.

“As a result, expectations are for capitalisation rates to expand to a greater extent than markets have seen since the last valuations took place in December last year.”

Superannuation funds are also assessing their exposure to commercial property, with Hostplus revealing it will close its property and infrastructure investment funds, and redirect customers into six new “pre-mixed”, or balanced, investment options.

Paul Burns, director – agency at Melbourne’s Fitzroys, predicts a wave of valuation markdowns and “choppy waters” ahead for the office sector.

“Many funds invested in retail property have taken their medicine, while funds invested in office buildings have resisted doing so. There is no doubt that some pain is on the horizon,” he said. “The need to sell to meet [fund] redemptions will heighten as revaluations occur, so there’s a bit of choppy water ahead.”

“There’s been a few properties offered and then withdrawn. Evidence is now going to appear and valuers will need to mark [them] down.”

In a report from ratings agency Standard & Poor’s, credit analyst Alexander Lisov said office landlords are dealing with rising financing costs and increasing capitalisation rates.

“Vacancy rates remain higher than the pre-COVID levels, and will likely stay elevated, given new supply coming online,” Lisov said. “Most of S&P’s rated office A-REITs can withstand up to a 10 per cent decline in asset values from their current levels, without breaching their target gearing range.”

Managing director of Jones Real Estate, Paul Jones, said the limited sales data available show evidence of a 10 per cent to 15 per cent decline in prime asset values from 2021 peaks, while secondary grade assets declines with high capex requirements are larger.

“It is likely that an owner who wishes to sell now may not achieve the same price they would have if they sold in 2021. However, if they elect to buy back into the current market, they will likely acquire at a price that reflects a discount to 2021 values, too,” he said.

Josh Rutman, JLL executive director and head of capital markets for Victoria, added that the dip in retail valuations of 12 to 18 months ago is now flowing through to the office market.

“Buyers and sellers have been sitting on their hands waiting for more price certainty. However, there has been a great deal more scrutiny on book values now we are seeing [some] transactions flow through the market.”

He said better-quality buildings could see a 10 per cent decline in book value, while lesser-quality assets may see even larger markdowns, as they are seen as less attractive to investors.

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