Secondary office markets continue to face headwinds

Secondary office markets continue to face headwinds

13 September 2019

Improvements in prime office vacancy rates have masked an underlying issue in many of Australia’s major CBD markets.

A new CBRE Viewpoint report highlights that the secondary office markets in the Perth, Brisbane, Adelaide, and Canberra CBDs are suffering from high levels of vacancy, and have recorded zero or negative net effective rental growth over recent years, with many buildings now rendered obsolete.

“The secondary markets in Sydney and Melbourne have performed well because of strong economic fundamentals, low vacancy rates and increased demand for office space in conjunction with strong white-collar employment growth,” said CBRE Senior Research analyst, Aiden Bresolin.

“However, in Perth, Brisbane, Adelaide, and Canberra, it is a different story. Some secondary buildings in these locations are now virtually untenable or have a high vacancy of 40%+ and require extensive refurbishment to be brought up to a modern standard.”

Secondary grade is a broad term for B, C, and D grade office buildings. Typically, these assets are characterised by smaller floorplates than their prime counterparts, lower energy efficiency and ageing design causing staff retention issues when combined with location and lack of amenities

Markets across Australia differ in the proportion of prime to secondary stock. For instance, Adelaide has the highest proportion of secondary stock to prime; however, in terms of total secondary stock, Canberra has over 1.2 million sqm, which is almost greater than Adelaide CBD’s total supply of office space.

In terms of historical trends, the spread between prime and secondary office vacancy has reached a near record high in both Perth and Canberra, indicating tough conditions in secondary markets. 

CBRE’s report highlights various “strategies that owners can adopt, including refurbishing secondary buildings or repositioning them to an alternative use such as residential apartments or hotel, although Mr Bresolin noted that the lull in residential markets had made the latter a less desirable option at present.

Doing nothing is another option, at least until a building’s underlying land value becomes high enough to warrant a refurbishment or repositioning program.

“B grade office stock remains popular amongst investors because these buildings have a lower price point, are higher yielding and often have value add potential through refurbishment, whereas  C and D grade assets present more of a challenge and higher risk, with attributes that make them difficult to modernise to meet the requirements of today’s tenants,” Mr Bresolin said.

“Redevelopment of these assets seems inevitable but can only occur when financially viable and the waiting game might be the best solution.”

Adelaide: The quiet achiever

Secondary assets play a large role in the Adelaide market due to the predominance of small to medium enterprises which are attracted to the size and lease budgets of an older building.

CBRE Senior Director, Office Leasing, Andrew Bahr noted that investor interest in the B grade market had remained buoyant, with interest from funds seeking to capitalise in Adelaide’s investment returns, which were amongst the highest in the country given the high-yielding nature of the market.

“Vacancy at an asset level allows for refurbishments to be conducted within a short time from purchase, adding immediate value and attracting and retaining tenants,” Mr Bahr said.

“However, there are C and D grade buildings in Adelaide that are simply untenable. Landlords not fully understanding the dynamics of the market, and the belief that finding a tenant first and then providing a tailored fitout is an option in an ‘impressions first’ market, are contributing factors to the decline in popularity of these buildings.”

Perth: Hedging your bets

A notoriously cyclical market, Perth has experienced the peaks and troughs synonymous with a resources-based economy. Secondary vacancy is at a near high of 26.7%, however improvements are expected in the medium term.

“In the six months to 1 July 2019, B grade vacancy rates fall by 3.3% which is the largest B grade vacancy fall since the second half of 2011 and a surprising result with the magnitude of the reduction,” said CBRE’s Senior Director, Office Leasing, Andrew Denny. “It is also only the second time in eight years that B grade vacancy has fallen.”

“In the past 18 months, owners of B grade building have started to undertake significant building refurbishments, including aggressive speculative fitout programs. However, most C-grade assets do not meet the requirements of tenants and are difficult to lease. Common issues in Perth include ownership by high net worth investors, who are under little pressure to upgrade or sell and can service debt at such low rates.”

Brisbane: On the rise

The vacancy spread between prime and secondary stock peaked in 2017 at a high of 10.9% and currently sits at 6.8%.  Secondary stock that has been upgraded to include end-of-trip facilities, lobby and speculative fitouts, along with lift and façade upgrades have better placed to attract tenants in a market that still has a high level of B-grade vacancy.

Larger tenants are leaving backfill space due to a flight to quality, made possible by high levels of prime vacancy over recent years. But these opportunities are diminishing as prime vacancy continues to trend downwards. Building upgrades are also occurring across the Brisbane market.

CBRE’s State Director, Office Leasing, Chris Butters, said; “A niche example now under construction is Brisbane’s Midtown Centre which will link to existing ‘C’ grade assets into one ‘A’ grade building once completed. The new tower will offer floor plates from 1,800sqm up to 2,500sqm with practical completion due for mid 2021. Midtown Centre will offer best in class amenity, services and workplace opportunities.”

Removal of stock due to infrastructure projects such as Queens Wharf has also occurred, particularly in Queensland Government owned buildings, Mr Butters noted.

Canberra: Government flight to quality

Canberra is host to a variety of government and institutional tenants requiring high quality fitouts and buildings to retain staff.

“The public sector accounts for around one-third of white-collar employment in Canberra and, with the trend for these public bodies to move into A grade space, vacancy in secondary stock is expected to remain high and possibly expand over time,” said CBRE’s State Director, Office Leasing, Zoe Ferrari.

“Canberra has never seen a secondary/prime vacancy spread as large as exists today (10.8%), which has occurred due to expansion of government tenants. Secondary buildings are ageing and losing appeal in the market as government requirements such as high NABERs ratings have contributed to a transition from secondary buildings to prime buildings. However, owners of secondary buildings who are proactively investing in refurbishments are continuing to experience solid tenant demand.”

Ms Ferrari added; “Many C grade assets have issues with noise, employee density, natural light, and lift and mechanical issues. With demand for this type of stock continuing to deteriorate, demolition and replacement would be the best strategy for optimum returns in the long run, albeit it’s not an easy strategy for owners to execute.”