This episode was recorded on the land of the Wurundjeri people of the Kulin nation. We pay our respects to their elders past, present and future.
Richard: Hello, and welcome to another episode of Precisely Property. I’m your host, Richard Temlett. I’m excited to have you with us today. If you’re here for the first time, thank you for joining us. I encourage you to listen to our previous episodes where we discuss all things property, with a focus on dynamic discussions with industry leaders. In this episode, we’ll be talking about the commercial office market in Europe with Tom Duncan, who’s the Head of Strategy and Product at Stoneweg. So, sit back, relax, and let’s get started.
Tom leads group level initiatives across real assets and alternatives with Stoneweg-Icona’s $16 billion global platform. With a proven track record in office investment strategy, Tom supports the strategic positioning of Stoneweg’s $2.3 million European office portfolio, which targets core and value-add assets. With two decades of experience, Tom has held previous senior research, strategy and product roles in Australia and Europe for companies including Cromwell Property Group, JLL, Colliers International, and Swiss Life, the latter being Europe’s largest institutional owner of real estate. He’s a renowned thought leader and industry expert on thematic and structural change in the office market. Welcome, Tom.
Tom: Thank you, Richard. It’s great to be here.
Richard: Tom, in today’s episode, we’re going to be talking about what’s happening in the commercial office in Europe, and then we’re going to talk about what’s happening in Australia or what that means for the commercial office markets in Australia. I’m keen to talk to you about what those risks and the opportunities might be both overseas and particularly as it applies to Australia. Because as we were talking about offline before this session, it seems that what’s happening overseas is 6-9 months or 12 months ahead of what’s happening in Australia. And I’m sure there are a number of listeners that would love to be able to hear what’s happening overseas and start to apply some of that information to the projects in Australia.
Tom, before we get into this session, I will start with an icebreaker question. And the question that I would love to learn a bit more about yourself is what’s one finding or theme about the current state of the European commercial office market that has surprised you?
Tom: I think one thing that surprised me and many other observers of the office market has been the performance of good office buildings over the last five years or so. We’ve long passed a debate about what the post COVID office utilisation trends look like, and I think we’ve really seen the evidence with very strong rental growth in certain locations and certain types of offices in Europe. I think what’s most surprising about that, and I’m sure we’ll talk about it further, Richard, is the dichotomy that at the same time you’ve got rising vacancy and aggregate demand is down. You’ve got extremely strong rental growth in certain select properties that do provide what occupiers want, and I think we can talk about it. But we definitely have several years’ worth of data now to understand what’s going on here and lift up the hood. But it’s quite a unique time for office take up and investment as well when you have rising vacancy, lower demand, but then very strong rental growth as well.
Richard: Great. I can’t wait to get into the main parts of this session. We’re going to break it up into three portions. We’re going to talk a little bit more about you, get your background and experience in the industry because I do like setting the scene for people to understand you’ve clearly got decades of experience, and you’ve gone through a number of market cycles. And I think, again, that’s important because listeners will be able to hear your depth and breadth of experience, both in Australia and overseas. We’re then going to talk about what’s happening in the commercial office space in Europe. I’m really keen to talk to you about things like, as you said, the vacancies, the tenant demand, supply, what’s happening with ESG, those types of issues. We’ll frame it in a risks and opportunities context, and then we can start to talk a little bit more and apply what’s happening overseas and start applying to what we think might happen in Australia. So, the first part of today, could you explain a little bit more to the listeners your background and your experience in the industry?
Tom: Sure. I’ve been working in the real estate industry in various different roles for 25 years or so now. I started off as a town planner in the UK, working on mainly retail schemes, involving the town planning element but also the modeling element. I moved over to Australia about 15 years ago because my dad was an Aussie, although my accent wouldn’t give that away. And then spent six years or so in Sydney working in a variety of roles in research and in consultancy. Latterly finishing at Colliers International as head of ACT and New South Wales Research covering all aspects of the property market within that geographical region, so not just offices. I moved back to the UK 10 or 11 years ago, started working for JLL in Central London, covering occupier markets, moved from there over to Swiss Life. As you’ve described in the intro, it’s the largest owner of real estate in Europe with a large office portfolio, and I was finished up as Director of Strategy and Innovation there, and then moved over to Cromwell Property Group covering their assets globally, and then latterly at Stoneweg and our platform of $14 or $16 billion or so assets under management in Aussie dollars. And that includes a significant allocation towards offices but also other asset classes including logistics, residential, small bit of retail, and alternatives as well such as data centers.
I like to think I can see offices in the context of the other investment classes that we have in real estate and definitely seen over the last 25 years or so a number of different phases of the office investment and occupier markets as well.
Richard: That’s a fantastic background. And I must admit, I was going to make the comment about you having experience in other asset classes, which I feel allows you with your role, with strategy to have a holistic view of what’s happening with different segments of the market that’ll help you with identifying the risks and the opportunities. So, let’s jump into the office markets in Europe. Are you able to please give us a bit of an update, what’s happened over the last 12 months, and also what your overall views are in terms of an outlook for the next 12 months?
Tom: I think a helpful place to start might be to compare the office markets in Australia to Europe because they do have unique characteristics. I mean, one thing to point out, which may be obvious to your listeners, but the European office market is much bigger than Australia. Australia, I think, has around 29 million square meters of office space, and that’s comparable to the broader Central London area. And, obviously, Central London is just one of the multiple different office markets that we have in Europe, so much bigger scale. Also, the age of the properties here, office buildings tend to be post war even, or some of them are built in the 70s and 80s.
In Australia, as you’d know, lots of the office buildings are much more modern, so post 90s high rise towers. And what that means is that the quality of stock in Australia from a structural perspective is much higher than what we see in Europe, and the market tends to be dominated by refurbishments in Europe because we are working within the confines of heritage listings or older properties. Whereas in Australia, it’s much more of a ground up development approach. And that blends itself, I think, to different characteristics that we see in the occupier and investor markets as well. But overall, as I was mentioning at the beginning, I think we are in an unusual time for offices in Europe because I think the post COVID trend is clear.
We have multiple years of data now to prove that this is the case, but what’s happening is very strong rental growth in select assets. Aggregate demand is down, but vacancy is rising. And that’s because the majority of occupier demand is concentrated on a minority of stock that is very undersupplied in the market. The occupier trends that we see tend to be occupiers taking lesser quality space but overall, they’re paying about the same as they were pre-COVID.
First of all, that’s because they’re taking less space, but also because the space that they are taking is very high quality, what we call grade A+, I would say, in Europe. And that is much more energy efficient building, so that manifests in lower service charges as well. So, the all in costs for occupiers are about the same, but then the type of space they’re taking and the location of that space is quite different from what we saw pre-COVID.
Richard: Very interesting, Tom. You say they’re taking less space. I might ask an obvious question to yourself because you live and breathe it, but why are they taking less space and why are there flights to quality?
Tom: Well, I think post COVID, it’s clear that the office is being used less often than it was. Recently in Europe, we’ve seen back to work mandates that the mandate five days in the office and that’s quite unusual. So, I’d say, generally, visitation rates to the office in Europe tend to be a bit higher than Australia. I think in Australia, they’re about 3.5 days. It’s probably edging up to four now in Europe, and occupiers don’t need all of that space all of the week. And also, I think office workers’ habits are much more flexible. So rather than spending four days in the office, they might spend three days in the office and then two half days out of the office. But in London, either at clients’ offices or at third spaces such as co-working facilities or cafes. And that means lower rental costs because lower space demand if occupiers need less space and can use it more flexibly.
So, it’s focused on efficiency of occupation, but we are now seeing as the return to work gathers pace in Europe that some occupiers are really oversubscribed and are starting to scale up their space again, but the market is essentially contracted around the smaller baseline level that we’re now starting to rise again. And I think there’s a number of reasons why in Europe we do have a slightly higher preference for office working. I think in Australia, properties tend to be larger, so more spacious, which perhaps makes working from home more appealing. And in Europe, our cities are more densely concentrated, and public transport and walkable is pretty good in Europe. So, I think for those reasons, we do see high utilisation rates and that’s manifesting in terms of some of the demand characteristics that we’re talking about.
Richard: Very interesting. Can I ask with that space, that less space, is it also being used differently? I’ve certainly noticed in Australia in the office layouts and what parts of the building are being used differently. What are you seeing in this space?
Tom: It’s certainly being used more flexibly. Larger proportion of space is being devoted to meeting rooms, to conferencing areas, or to breakout spaces. And the reason for that is that people come to the office for a reason nowadays, to meet people face to face and to have network and that type of thing for that social element as well. And offices are responding to provide that.
I think another trend which you may talk about, I’ve certainly noticed the amortisation of the office and often that space previously high-end cafes would have been provided within an office building, for example, or an office floor. But now occupiers are choosing office buildings with quite a high level of amenity on ground and first floor levels that they may not operate themselves, that are open to the public, but then their staff can use that as additional breakout spaces to have meetings or to meet contacts as well. So, I think another reason for the contraction, the office space take up is that they’re occupying higher quality buildings that provide that space almost as an add on amenity that then occupiers don’t need to pay for directly within their rent and their floor space footprint as well.
Richard: That’s very clever. I’d wondered because my question, you’ve started to answer for me anyway, was when you’re planning as a business, I’d wondered if it was business specific where you’d go. If we’re going to ask people to come into the office a certain number of days per week and we need a certain floor space per person, how are we going to use it? And how do we not get into a situation where on Tuesdays, Wednesdays, Thursdays, we’ve got everyone in the office and we don’t have enough space, and then conversely, Mondays and Fridays, we’ve got far too much space and if it’s being used more flexibly. But I think that’s quite clever. I haven’t seen that in Australia yet with using some of the retail on the ground floor and perhaps there’s an opportunity for some of the office owners or the managers to speak with the overall tenants in the building to help with that overlap or overfill, whatever the proper technical term is, when people are in the office at peak periods. But that’s very interesting to hear.
Tom: I think that is a constant challenge about how you spread use throughout the week. There are some interesting initiatives by occupiers here trying to incentivise people to come in on different days. For example, offering certain discounts on Mondays and Fridays if they come in, mandating certain team days on different days, so having a more stick approach, or providing free lunches, free breakfasts, or other events such as seminars or education sessions or even yoga sessions on a Monday or a Friday to try and spread that use throughout the week.
I think from an investor perspective, what is interesting is that I think one of my takes, if you’re investing on the positive side of the structural change trend in offices is that you do have a better ability nowadays to monetise the space that you let because there’s additional ways rather than the direct lease that you can drive revenue. And part of that is around offering more flexible spaces that you can offer to tenants on a short term basis at a higher rate or having quite sophisticated amenity offerings, retail, or cafe offerings that are a higher price point, but then you can capture additional revenue from your occupiers if they’re using it for that kind of breakout space as well. So, I think having more of an operational approach is something that I think points to this trend, and we’ll talk about opportunities later. But it’s definitely an opportunity for landlords with larger office buildings here now. You typically see up to about 30%, in many cases of the space being flexible floor space or flexible co working space or cafe, amenity, leisure space, that type of thing. The office is not a pure office building in the way that we saw 20 years ago with a small token retail element at the ground floor and then the rest of it offices. It’s much more of a dynamic and multifunctional building nowadays.
Richard: That is very interesting to hear. Can you talk to me a bit more about the old stock? I’ve noticed, and I’m getting asked a number of questions in Australia, across all the capital cities, but particularly in Melbourne and Sydney, you’ve got this B grade, C grade, even D grade stock. What’s happening to it? Is it fit for purpose? Is it being occupied? Is it starting to be refurbished? What are you seeing in that space?
Tom: I’d say in terms of office demand overall, the way we’ve talked about it in the past is that probably 70% of demand is concentrated perhaps on 30% of the stock and what happens to the rest of that stock? I think it’s difficult because some of the secondary and tertiary stock can’t be refurbished for offices because of the location. Micro location is key. I’d say when occupiers are looking at the space that they want to take in the post COVID world, there’s three factors which are most important. One is micro locations, so being close to transport and amenity. Second is ESG or aspects of sustainability that are important are operational ESG, so not embodied carbon, energy efficiency, air quality, that type of thing. And then the third factor, I think, is end of trip facilities, so the showers effectively. That’s the key one. If possible, additional amenities like cafes, yoga studios, even a podcast studio, that type of thing, as well as terraces and roof space. So, occupiers, I think, are prepared if the space isn’t available, which commonly it isn’t. They’re prepared to compromise on the sustainability angle or the amenity angle of the building, but certainly not on location.
Some stock is functionally obsolete because it doesn’t provide what occupiers want physically, but some of it is locationally obsolete. So, business parks, for example, extremely challenging now in Europe for most of those except for some exceptions like those around Oxford or Cambridge that have big life sciences hubs. And if you picked up and moved an office building into Central London, you might be able to do something with it, but the future for those buildings is challenging. We do have quite a lot of supply that’s been withdrawn. And at the moment, I’d say the market’s still trying to find a level as to what you can do with that space. Some of it’s suitable for residential, but then most of that low hanging fruit has already been picked over the last 10-15 years, I would say, in Europe. So those easy conversions to residential have been done.
Other uses which I’ve been seeing recently are around life sciences because of the nature of the floor to ceiling heights, the build quality often does lend itself to life science uses. But then the demand for that is relatively small in the amount of space that we have available for reuse. And other uses, I think educational uses can work quite well. But, again, the level of demand for that doesn’t equate to the amount of obsolete stock that I think we have coming down the pipe as well. So, the jury is still out on what we can do with that space and on an individual deal, I think, or an individual asset. It needs to be worked out on a case-by-case basis. But there have been some successful examples of investors that have successfully repositioned for living assets, for life sciences, and for educational uses as well.
Richard: Thank you for that. There’s certainly a number of ideas in there that I’ve not yet come across, but I have the privilege to speak with a number of the landlords here. I’m hoping that they are starting to look into that, or certainly, they can reach out to you to discuss further what they can or can’t do with some of these assets.
Let’s shift gears. Can you talk to me about capital values and yields? What has happened? Has the market bottomed out in Europe? Apologies for asking a silly question if it has because there’s debate right now about whether the commercial office market in Sydney has turned the corner, whereas in Melbourne, it doesn’t appear to have turned the corner. What’s happening in your neck of the woods?
Tom: The investment market is a very interesting facet of the office market as well because I think in the occupier market, as you’d know, it’s a case of the best in the rest or polarisation very strong. But I’d say in the investment market, it’s probably not sufficiently polarised in my view because the market is not distinguishing between different types of offices. So, what we’ve seen over the last few years is that yields have moved out in the office sector across Europe and for the last few quarters, they’ve stabilised, and they’ve reached their floor effectively. But then at the moment, we still haven’t seen a growth in office investment activity. In fact, Q1 office investment volumes in Europe, although they were quite high, in terms of aggregate terms compared to Australia, there were still 10 year low or 20 year low since the GFC. We still haven’t seen demand from investors return in force to the market, although there are some early movers into the market and making some big calls on the office sector.
But as we’ve been talking about, I think there is some clear opportunities in the office sector around that really good quality space, but the market at the moment isn’t differentiating between offices that are really good quality in good locations that can perform and those that are not secondary and tertiary stock that’s a high redundancy risk and needs to be repositioned. So, I think now is quite an exciting time to be an office investor in Europe if you can be bold and make some big calls. But the activity at the moment tends to be focused on core plus value-add opportunities and not so much on the core part of the market. We’ve yet to see buyers return in force there.
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Richard: In terms of peak to trough falls over the pandemic, are you able to let our listeners know what they were? I’m interested. I’ve read various articles talking about what they might have been, but I’m interested to know what you’ve seen on the ground, in particular when it actually came to the valuation of these assets. What was the peak to trough fall?
Tom: I think, as we talked about, Europe’s a large market with many different markets within it, submarkets. But I’d say, typically, it would be 25-35% in a capital value fall overall over that period. But then it does vary quite widely depending on location and individual assets as well. But I think there are investors that have bought at the right time and have still done quite well even over that period. So yeah. But that’s probably the range that we’re talking about now, although the market, I think, has settled.
Richard: Another major issue, or not really issue, but theme right now relates to ESG. I’m interested to hear what you’re seeing overseas. There’s a huge amount of discussion about how it’s going to emerge or is emerging in the commercial office space. What’s happening overseas in the various markets that perhaps our listeners need to be aware of?
Tom: One observation I have is that generally, because of the age of the office stock in Australia, it’s much more modern. Australia has quite a higher quality of office building when it comes to ESG and energy efficiency. And Europe’s been playing catch up for a number of years because we do have much older stock, much more energy inefficient. We’re still on that curve, I’d say, of improving our office stock. I think ESG in Europe is being legislated. EPC (Energy Performance Certificate) ratings are a measure of energy efficiency from April 2028. It’ll be illegal to let an office building that’s not a minimum C building, but the commercial market is way ahead of where legislation is. So, legislation provides quite a low floor and a minimum threshold but occupiers, investors, they’re demanding much more already. And that’s what’s leading the trend towards ESG rather than being something that’s being mandated by policy. I think that’s one perception I’ve noticed speaking to investors that aren’t based in Europe, believe it’s often being driven by governments whereas that’s actually not the case. It’s the market.
But I’d say Europe still has a long way to go. I think around 25% of the office stock in Europe is at the EPC grade B or A or above, and that’s definitely not where we need to be. There’s a lot of work going on around that, particularly with refurbishments, but I think the industry at the same time has moved past the debate in some way in the sense that ESG is something that’s essential and is incorporated in all of our other discussions about building viability and assessment alongside structural integrity, the building, M and E (Mechanical and Electrical), or whatever. It’s just part of the ether nowadays. And I envisage a day maybe in 10 years when we may not even have ESG teams because ESG is so embedded within the DNA of organisations and what we do with offices that it’s just part of all of the other factors that we have to consider. I think ESG, it’s just table stakes nowadays, and the industry is settled on what needs to be provided in that sense.
Richard: Very interesting. Talk to me about lease terms. I know prior to the pandemic, and you’ll have to excuse my depth of knowledge, but it appeared to me that you’d have pretty standard lease terms with lease renewals and things like that. Have they changed? Are they shorter lease terms? Is there more subleasing because of the uncertainty with the demand for floor space? What are you seeing as at 2025?
Tom: One thing that I’ve definitely observed in that regard is lease lengths are falling. I think typically in London 20 years ago, typical lease length would have been 15-20 years. At the moment, it’s around 10 years according to the data, but even that seems to me, based on the experience I’ve had with the occupiers in our portfolio, quite a long lease length and typically can be even lower than that.
Another thing I’ve noticed on this point is the length of time it takes to make decisions. Occupiers are definitely taking their time about these things. They’re thinking a lot harder, and you have to push a lot harder to get to the end goal even though there’s a shortage of space because occupiers need to make the right decision, and it can have a big impact on their performance in terms of their talent, productivity, attraction, retention. They are taking their time about these decisions a lot more than they used to be. That’s, I suppose, my main observations around that. I think that is a trend we’re probably going to see settle because my take on the market nowadays is that it is heavily undersupplied with really good quality space. When occupiers do get their hands on the space that they need, they’re probably going to be willing to hold on to it for longer than they want to. They want to secure that space. My sense is that we’ve reached the bottom floor of lease lengths as well, and occupiers are going to be starting to be more willing to take longer leases. If they do get space in a recently refurbished building or a new building, they really want to commit to it for the long-term, and then they can build their corporate branding around that. So yeah, that’s my take on that topic.
Richard: That makes sense. Right, well, over the next 12 months, what are some of the risks? Let’s start with risks and we’ll jump into opportunities. What are some of the risks that you see for the office market in Europe?
Tom: Two of the big risks, I would say on this, one is around obsolescence points. You’ve got functional obsolescence related to the quality of the building, so it’s physical format, and you’ve got locational obsolescence and the changing fortunes of certain locations that used to be prime, now becoming more secondary, tertiary, and vice versa. I’ve definitely seen it with some developers who’ve developed fantastic buildings that provide all the bells and whistles that occupiers want in today’s age, but in the slightly wrong location or a slightly off-pitch location. And then it’s difficult to attract occupiers to those locations that equally if you can make the right calls, I think that’s when there’s big money to be made there as well. So, I think a key risk is around obsolescence of location and of stock quality as well. Occupiers have been changing. They’ve been quite fickle over the last few years changing their requirements, but I do think we do have a good steer now on what performs in both of those regards, and then investors can be attuned to that and try to mitigate that risk.
Another risk related to the opportunities is where I see the investment cycle now is a great time to be going back into the market as an investor in my view because there is mispricing, and the market’s not being discerning about the quality of office stock, particularly given the rental dynamics that we talked about at the start. But then I think there is a bit of a risk in case the demand from more core buyers doesn’t return. They’ve been dragging their heels, I think, for a number of reasons recently. One is the fact that many investors have been overallocated to offices, and they’ve been quite shocked by the change in values that have occurred over the last few years. And offices have often been likened to having a retail moment in terms of the structural change that we saw in shopping centers over the last 15 years or so or when Internet shopping got going. But I think that’s a mischaracterisation because in the office market, it is quite different because secondary is tertiary stock. Sure, that’s having a shopping centers moment, but the prime stock has still continued to perform. But because investors are overallocated, I think that’s one risk that’s preventing them from entering the market.
I think the second big risk around that is that US offices are underperforming a lot more than what we’re seeing in Europe or what we have seen over the last few years. That tarnishes the whole sector from a US perspective with many investors. I think the third aspect is the sheep like behaviour, if I can put it like that, that you often get in real estate, and it’s easier to bring a deal for a logistics asset to IC, but much harder and more difficult to bring an office deal. I think that will change. When we were talking to investors six months ago and you bring up the word offices, it would be a straight no. But today, maybe you get questioned or we get questioned for 30 minutes about offices and dynamics, but then it’s still a no. But it’s a slower no. So, I do see the core money coming back into offices within the next 6-12 months. But there’s a risk if you’re using a value-add or core plus strategy based on the core money being there, then there is a risk that won’t happen or that it’s going to take longer for it to come to fruition.
Richard: Great. You started to also touch on the opportunities. Are there any other opportunities that you’re seeing on the ground?
Tom: I think in Europe, the two biggest opportunities from an investment perspective, one is around the core plus area, which is buying a building with a bit of risk or a bit of contained risk, I’d say. So, maybe it’s a building that’s partially vacant. You need to lease that space up. Maybe you need to do some minor refurbishment works. Maybe you need to change out some of the operators from the amenity space and then try and get new office occupiers off the back of that. Because the market is not pricing that correctly in my view, there’s a short-term opportunity to enter that market, make some calls, buy some good quality stock because the supply response is really low at the moment. I think if you can be bold and make those calls, you stand well-placed when the market does come back in the near term as I think it will do.
I think a longer term opportunity, because development has been so low in Europe, and it’s the case I think in Australia as well that the pipeline’s so low that if you can get the money together and get the sites together to do development, more refurbishments so value-add, then I think you can be confident that when you exit those properties or those finished assets that you will get outsized returns for the risk. I think that’s a great opportunity in the investment sector.
Another observation I have about the European office market is about the ability nowadays, as we touched on earlier, to drive additional revenue streams from your office building. That can be done through the amenity space that you provide. It could be done through property technology. So, layering on additional apps and providing that as a service to occupiers and users of the building but then charging an additional rent for that. I think another opportunity is around how you can maximise the value from your offices from a more operational nature. Perhaps adopting some of the ideas that we see in things like the hotel sector or the serviced apartment or serviced living space sector and trying to apply those to the office market. I’ve certainly seen some investors do that really well and get a higher return.
Richard: You’re certainly a wealth of knowledge, and I’ve been making a bunch of notes. Let’s jump into Australia. I feel a lot of what you’ve observed on the ground is also starting to play out in Australia, or certainly there’s opportunities for landlords, particularly in Melbourne and Sydney, which are the two largest office markets, as you well know, to start positioning themselves or their portfolios for what I can’t help thinking is going to be…Australia is going to follow some of the trends that we’re seeing overseas. But I’ll hand over to you. What are you seeing both in Sydney and the Melbourne office markets? I appreciate you might not be as close to them as Europe, but I detect that you still monitor them. So, what are your views? Let’s start with Sydney.
Tom: I’d say I still take a keen interest in what’s happening in Australia. I think that overall in Sydney and Melbourne really, the quality of stock is a lot higher than what we have in Europe as I mentioned before it tends to be more modern and NABRES rating is what the market has been using for some time to assess in many cases the ESG quality of a building and that in my view is hands down the best kind of metric because it gets to the heart of what generates carbon. I think the quality of stock in Australia is quite high.
Perhaps you’re not seeing the same trend as you do in Europe of a refurbishment and that level of undersupply that we have in Europe in terms of the really good quality space. But I think what you are seeing in Sydney and Melbourne is flight to location, and occupiers gravitating towards much more central locations and being more selective about micro location as well. The quality of stock is higher, but then that that micro locational movement trend, I think, is getting going. And that’s why I think it’s a really interesting time to be an investor in the office sector in Australia because I think there’s going to be good revenue generating opportunities to be made if you buy a good quality asset or you own one in one of those highly desirable locations because I believe that the level of rental growth that we’ve seen in Europe, some of that, it may not be as strong because the quality of stock overall in Australia is higher. But I certainly think that there’s good performance to be had coming down the pipe in Australia, in Sydney, and in Melbourne with select assets.
Richard: Can I ask…vacancy rates are very high, especially in Melbourne. Entering into the pandemic, I don’t have them in front of me, but the PCA (Property Council of Australia), I’m sure you’re well aware, does an office market report. If I remember correctly, in about 2019, I’m sure vacancy rates were around about 3%. We had a huge wave of supply that was under construction. It was actually pre-committed before the pandemic hit. Obviously, the pandemic hits, and the market has been badly distorted. All that stock was delivered. The vacancy rates, if I remember correctly, I think it’s about 17% in Melbourne. It’s not as high as in Sydney. Sydney also seems to be encouraging employees to get back to the office in greater numbers than in Melbourne.
Out of interest, what are the vacancy rates in Europe? Are they as high as in Melbourne and Sydney, or is that a function of getting people back into the office like you mentioned at the beginning of the session with what’s happening in Europe?
Tom: Yeah, I was looking at the vacancy rates in Australia this week. I think in the CBDs, they’re averaging around 14%, although there’s obviously variance in that depending on the CBD. They’re a lot lower in Europe because we have less stock here. It’s also more highly concentrated, so around about 8% is the current average across Europe, but varies again quite considerably. And in certain key markets like Paris CBD, for example, or the West End of London, it can get a lot lower, where there’s strong demand and an undersupply of space.
I think what is interesting is it’s increasingly hard to generalise about the stocks that occupiers want. In Europe, for example, grade A space we think is not a helpful metric to use anymore because there’s so much degrees of variation within what constitutes grade A that now we at Stoneweg have been using grade A+ and creating our own metrics about how to assess space. Grade A+ might be about 40% of what we consider grade A that the market is traditionally used to characterise space. And I believe in Australia, that’s also the case that you have a quite high level of vacancy rates overall of maybe 14% in CBDs. But then, if you’re looking at what do occupiers want in terms of micro location and maybe quality is not so differentiated in Australia than it is in Europe. But then I think you can segregate that vacancy down. If you look at it more on a micro locational level, I think you get under the skin of true vacancy and in certain locations, I’d expect it to be a lot lower than that. It comes down to having good research and granular data to segment the market. I think that’s going to be a key differentiator for investors going forward who can understand the markets, who can get under the skin of local market dynamics. And then those investors will be able to use that to unlock performance going forward.
Richard: Yes. Look, I did a body of work for an office landlord in the Melbourne CBD, and we broke it down into the various precincts. Your micro locations point is very well made because there’s certain precincts that have much higher or lower vacancy rates or have had much higher or lower rental growth. And certainly, it is. It’s the flights to quality and it is precinct specific. And I’d encourage investors and the operators, I’m sure they’re already across this. But when I look at Melbourne, because I’m based in Melbourne, you can see that there’s pockets that are functioning very differently, either better or worse, for various reasons.
I know we’re getting to the end of the session. I’m interested to talk to you for Melbourne and Sydney office markets, but let’s include Brisbane as well because it certainly is an emerging market in Australia. What are some of the risks and opportunities that you see or that the learnings that could be had for the office sector in Australia?
Tom: I think the risks are universal in Europe and in Australia around obsolescence being functionally obsolete or locationally obsolete and being guarded for that because occupier tastes do change, but that’s a constant risk. And also about the money side of things, when is capital going to come back in force? Australia tends to be a domestic focused market in that a lot of the capital investment activity comes from domestic investors. But I do see a risk or an opportunity is when more overseas capital becomes more saturated within Europe or looking to move money out of the States as we’ve seen in Europe. Europe’s been a beneficiary of that over the last few months. When that money reaches Australia, that’s going to have a big positive impact on the market.
I think another thing when we’re talking about micro locations, something I’ve observed savvy investors in Europe doing and I think the same could be done in Australia is using nontraditional metrics to work out which micro locations have really good characteristics for future office growth. The market hasn’t reflected that. Can you look at data from mobile phones? Can you harvest all these different types of data from users that we’re generating nowadays? Public transport accessibility, quality amenity provision. And if you can harvest that and harness that nontraditional real estate data, and then make decisions accordingly, I think that’s a really interesting opportunity for Australia.
In Stoneweg or Cromwell Property Group actually as it was at the time, we did have some experience of that in Italy where we took a tired office building that was on its own in a micro location of Milan, and then we did a proper job, proper refurb on that, which was quite a bold move at the time, several years ago just coming out of COVID. By looking at the characteristics of the area not from a real estate perspective, but from the demographic perspective, Internet usage and Internet data generated from phones, etc., and reposition that building, managed to let it all up above completion, and doubled its valuation as well. That’s a good example of when things could go well, and I think that’s what I’d be looking for if there’s any opportunities like that in this market where you can acquire stock at pretty good prices that won’t be around in a few years and then making some bold calls about repositioning or doing some work around the asset that you’ve got to align it to the growth dynamics that we’ve been talking about, the really good quality space that’s undersupplied at the moment.
Richard: Fantastic. Tom, before we close off the session today, is there anything else you wanted our listeners to know either about the office markets here in Australia or in Europe?
Tom: Thank you, Richard. It’s been good to talk to you today. I think in concluding remarks, I’d say that I’m really optimistic about the office sector in Europe over the next few years. It’s something we’ve been talking about with investors for a while, like I mentioned before, and it’s been quite a tough sell. But I think now is the time to go into the office sector in Europe, and we’ve seen evidence of some early movers doing that. And I think, in a few years, those will look like impressive moves.
I think the same is true in Australia as well. I think now we’re reaching a great opportunity to get back into the market either to reposition existing assets or to work your existing asset harder and make sure it’s ready for the next increase in demand that I think we’re going to see from occupiers and from investors or to maybe push the button on some development schemes or refurbishment schemes that are looking a bit scary now. I think in a year or two, when the market comes back and forth and the quality of stocks isn’t there are going to be in high demand in the market. So, now’s a great time to be entering, reentering, or solidifying your position in the office market.
Richard: Great. Thank you very much for those concluding remarks. I will put all your connections where everyone can contact you because no doubt there’ll be people that would like to reach out and pick your brain a little bit more on what’s happening in certain segments of the market. I wanted to thank you again for your valuable time. I know how busy you are and particularly if you recorded this from overseas, very early in the morning where you are now. So, thank you for making the effort to be available.
Tom: It’s been a pleasure. Thank you, Richard.
Richard: Thanks very much. Bye.
Hi, everyone. I hope that you enjoyed the session today with Tom. I found it absolutely fascinating to learn about what’s happening overseas and some of the more mature markets that are certainly ahead of where Australian markets are in the commercial market cycle. Please do reach out to Tom if you want to discuss things further. I’m sure that he’d be a wealth of knowledge, and he’s happy to share some of those insights.
In terms of the findings that I’d like everyone to leave today thinking about how they can apply it for their investment and their development decisions, there are a number of them, but the ones that jumped out to me were as follows.
I thought Tom’s finding or his observation about the age of buildings in Australia versus Europe was very telling. Obviously, the age dictates what can happen to some of these buildings. I think that certainly whilst we can learn a lot about what’s happening overseas, it does need to be applied, obviously, to Australia with the age of the buildings and then the confines in which everyone is working in. I think that was an important point that I’d not considered in enough detail.
The second one, I thought that the overflow space being used in the amenities, being used for overflow in the office building and how they are being used differently on the ground and even a first floor, I thought was the next evolution of the commercial office market. And I’m convinced that there’s opportunities for asset managers and the owners of these buildings to think outside the box more. I’m convinced that they’re already doing this to respond to the fact that the requirement for space has changed the amount and then also how it’s being used and potentially allowing the amenity to be used for breakout areas. I’m seeing this in some of the Sydney offices that I’ve been to in the last week where there’s breakout spaces that are being used by office tenants. I think that’s very clever.
Tom’s comments about the repurposing of slightly older buildings and some of the uses either being tailored towards life sciences or educational uses, I think is very clever too. Again, thinking outside the box and the market is evolving to respond to market demand, and the challenges in that segment of the market right now.
Offline, I jumped on a comment he made about investment coming out of the USA and going into Europe, and it does seem to be a lot of that is because of the uncertainty caused by Donald Trump. I do wonder what will happen when more of that comes out of the US, goes into Europe, and then does start hitting Australian markets and what those opportunities are. When you look at the investment stats, a significant amount already comes from the USA. They do like Australia. They do like office. And I suspect that there will be further opportunities in perhaps a more stable office environment than what’s happening overseas. So, perhaps there’s opportunities already there that’ll start to flow through.
The final point I’ll make is Tom made a really good point about basically functional and locational obsolescence. I certainly see that when I’m analysing markets and micro markets in the residential space, but basically talking more broadly about where these economic and employment hubs are and where they have been and where they are likely to go. Talking especially in the office space where these assets do last a number of years or a number of decades, obviously, having that both functional but then the locational obsolescence and the risks and the opportunities with understanding the micro location, I think is very well made.
Anyway, those are some of the ideas. No doubt there’s a bunch more that probably jumped out to you as you as I was talking, but I do hope that there’s some valuable stuff in this session. Have a great day.
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