A negative narrative could create a contrarian investment opportunity

2023 was full of mini-storylines within a much more volatile market. One of those mini-storylines was the fear that commercial real estate valuations would fall through the floor due to higher interest rates and the effect that has on asset revaluation. This was especially true in the US where valuations on office buildings have fallen by as much as 30% in some cases. 

But this hasn't been the case in Australia - even if the same pessimistic narrative has permeated into the system. 

Colin Mackay of Cromwell Property Group thinks he knows why:

"That evolves from two main things - one is a misunderstanding as to the extent of space impacts that work-from-home will result in," Mackay said. 

"The other thing is an under-appreciation of how elevated construction costs are right now."

But just because vacancies have risen and valuations are changing does not mean that all commercial property needs to be tarred with the same brush. In this episode of The Pitch, Mackay will present a commercial property investment idea that one could characterise as a contrarian call.

EDITED TRANSCRIPT

Hans Lee: Investors have cooled on office properties – are there still opportunities in the space?

Mackay: We're seeing opportunities across the office space. I think the key driver of that is the re-pricing that we've been seeing, particularly in the second half of this year. Unlike other sectors in commercial property, where valuations have been a bit stubborn, we have seen offices re-price. That means that it's starting to offer quite attractive yields.

Lee: Is there a specific part of the market you view more favourably right now?

Mackay: We think fringe markets are offering some good opportunities. So when I say that, it's the edge of the CBD. They are still central locations and they still benefit from transport amenities and tenant agglomeration. But it's generally a little bit harder to bring new supply into that market. We see good demand drivers there as well. The physical characteristics of the buildings in these kinds of markets tend to be more aligned to smaller occupiers. This is a segment of the occupier market where we see better growth fundamentals.

Lee: How and why has the narrative changed since the pandemic, and how do you plan to take advantage of the opportunity?

Mackay: I think the narrative has certainly become deeply pessimistic and I think that may have evolved from two main things. 

One is a bit of a misunderstanding as to the extent of space impacts that work-from-home will result in. Even if we're working in the office three days a week, and that's a reduction compared to the five days pre-COVID, you're not going to see the same extent as that in terms of space impacts because you need to account for fluctuations in office occupancy.

Lee: You’ve said in the past that “Opportunities exist where sentiment is not aligned with fundamentals” - why is that important and can you give an example of what that looks like?

Mackay: All offices are being tarred with the same brush, so to speak. While, yes, headline vacancy is quite elevated, you've got more than half of CBD assets that are 95%+ occupied, so they're not seeing an impact. 

If you take a market like Surry Hills in Sydney, vacancy is at 7%. That's less than one percentage point higher than the long-term average. But it's being priced as if it has the same supply-demand fundamentals as the broader market, and that's just simply not the case. 

That's where we see sentiment operating at that broader industry level, and that's moved far beyond the underlying fundamentals of specific assets or specific markets that have different underlying characteristics.

Lee: When you identify and ultimately invest in an opportunity, what are some of the things Cromwell does to improve the property, to generate a better return for inventors?

Mackay: A lot of that comes down to the underlying bricks and mortar. There is a whole spectrum of things, and it can be something quicker and easier like improving the look and feel of an asset, and how it presents. It can be something a bit more substantial, like incorporating end-of-trip facilities and third spaces. It could be ESG initiatives like improving waste, water, and energy consumption.

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