What’s the appetite for office REITs in 2023?

While real estate investment trusts (REITs) are well positioned for an environment of elevated inflation and low growth, office spaces could face double headwinds in a rising interest rate environment and the adoption of hybrid work, according to portfolio managers.

Office REITs were the worst-performing sub-sector in Australia and globally over 12 months, VanEck’s Cameron McCormack noted, which cemented the fund’s underweight position in this asset class. Instead, it favoured industrial and retail REITs in Australia.

“The US economy is likely to contract at the end of the year with the unemployment rate expected to rise, reducing demand for office space. This environment will give businesses more buying power when negotiating office leases,” he said. 

“Office REITs will also need to expand capex to further attract tenants, putting downward pressure on margins. Senior executives mandating employees back to the office will be muted given the economic slowdown anticipated.

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“Being selective in office REIT exposure is prudent. Quality office REITs with sought-after space in good locations and amenities will remain attractive. We expect that top-tier office towers to provide uplift in rental growth, while older office buildings will likely be less favourable.”

Australian office REITs exposure was preferred relative to global due to a smaller impact of the Great Resignation compared to the US, McCormack added. 

“The Australian economy is also better placed considering the anticipated influx of skilled migrants in 2023, creating further demand for office space.”

Around 300,000 people were expected to migrate to Australia in 2023 after several years of border closures significantly reduced migration figures. 

Heading into the February reporting season, Pengana had highlighted office spaces as the sub-sector with the highest downside risk in its High Conviction Property Securities fund. 

“The growth outlook for the sector remains weak with the challenges of the WFH (work from home) thematic still playing out, combined with high vacancies and incentive levels holding back net property income,” the fund stated. 

Speaking at an adviser roadshow in Sydney, Stephen Hayes, global head of real estate securities at First Sentier Investors, agreed that the office sub-sector had witnessed major disruptions. 

“In Australia, the average lease terms of corporate lease in a CBD office building are around seven years. For the next year, as these leases roll off — and we’re already seeing this — large corporates are looking at their office footprint and looking to reduce their space, therefore taking small amounts of space. Lease rates in places like Sydney, Melbourne, Brisbane are all up around 15%.”

According to Matt Sgrizzi, LaSalle Investment Management Securities chief investment officer, the woes of the office market had been “well documented”.

He said: “Ultimately, the hybrid work environment is here to stay and it’s unlikely we’ll have people back in the office permanently five days a week, and it costs money to maintain buildings.”

But he also noted that REITs had proven to be a highly durable asset class, adding that “this is an opportune time to appreciate that durability”.