Office is not dead (and why this could be "one of the deals of the cycle")

To steal a line from Mark Twain, “the reports of the death of the office are greatly exaggerated”.

At least, that’s the view of Elanor Investors Group’s co-head of real estate, David Burgess. How has he arrived at this view? He’s done the work.

“This was something we had to look deep and hard at - the future of office and what it means, especially with the impact COVID has had on the way we live," said Burgess.

"The conclusion we've come to is that this is another office cycle. 
"Over the last 40-50 years, based on the research we've done, there have been four or five cycles. More specifically, over the last 30 years there's been two downturns and this is the third."

Burgess's key point is that these true, countercyclical opportunities are rare: "So, you have to get comfortable that this is not a spike and not a major structural issue".

The other two downturns Burgess referenced are the recession in the early 90s (the one we had to have), and the GFC. He added that in the 90s recession, there was significant oversupply in the market from the late 80s, which saw markets such as Perth and Sydney enduring 30% vacancy rates. 

As for the GFC, Burgess said that “liquidity just shut down and pricing reversed quite aggressively."

The time to act is now

It’s one thing to do the research, formulate an opinion, and have a plan. It’s another thing altogether to execute it when the whips are cracking.

In talking about the other downturns, Burgess noted that “they're the two times in my career that I'd seen genuine countercyclical deep value buying opportunities, and this is the third time I’ve seen it ”.

Having seen this movie before, Burgess was keen to take advantage of the opportunity, so as not to be competing with everyone else when things start to look brighter.

“Most investors are fearful at this time and are just waiting, and will miss the opportunity now and then start competing with everyone else at the backend," he said.

The market will come out of this and will start looking better, and people will start looking again and then be in a competitive position”.

Preparation plus opportunity equals success

For anyone unfamiliar, Elanor Investors Group (ASX: ENN) is a real estate fund manager that invests across various sub-sectors, including commercial office, healthcare, hotels, industrial, and retail property.

The philosophy is a bottom-up, asset-by-asset approach, looking at the intricacies of each property, understanding the risks around cashflows, and looking at the sustainability of the income. “If you get your income right, that helps sort out a lot of the sustainability of capital value going forward," said Burgess.

As noted above, the Elanor team does a lot of research into the property market before deciding to buy or sell, but there is another factor to consider: Are there any suitable properties to buy, at the right price?

You can be a willing buyer, but if people aren’t willing to sell, there isn’t much you can do. Asked about this conundrum, Burgess emphasised that at the bottom of the cycle, there aren't often a lot of opportunities, as owners would rather hold on through the trough.

That said, Elanor has been in this game for a while and is a trusted counterparty – that is, the firm can raise capital and complete deals once it has committed. That fact, coupled with a well-developed network established over years of building relationships, means that occasionally, the stars align and suitable properties become available. 

What are you looking for in an investment?

Before getting to the specifics, it’s important to understand some of the broad characteristics Elanor looks for when searching for opportunities.

In terms of the properties themselves, Elanor is focused on high-quality buildings in good locations, with good floor plates that meet all the tenant requirements. Increasingly, ESG is becoming important, so things like carbon neutrality are a factor.

As for the financial side of things, the key consideration is the sustainability of income and how Elanor can underwrite the investment. As Burgess said:

"Is there upside or downside risk and how do we price that risk for the rents that are being adopted? If you get that right, then you'll find that you have good prospects of asymmetrical returns where there is more of the upside, and very little downside."

The other element Elanor considers in the current environment is the fact that some buildings can be purchased below replacement cost. “So then you're not only getting good builds for them, but you're actually buying it at rates which you can't build it at”, said Burgess.

He added that there are extremely elevated construction costs across Australia at the moment, hence why buildings can be purchased below replacement costs. For what it’s worth, Burgess doesn’t see any immediate evidence that those costs will come down, but this situation isn’t normal and likely won’t last forever.

The diamond in the trough

In terms of stars aligning, 55 Elizabeth Street, Brisbane, is the incarnation of that alignment for Burgess and Elanor.

He and his team did the work, made a call, and found a property that ticked all the boxes and was available at the right price.

Elanor quite easily raised $100 million recently - the capital raise was oversubscribed from wholesale and sophisticated investors - to purchase the building, and whilst Burgess pointed out that he and his team always walk investors through the pitfalls and possibilities of every opportunity, in this case, the opportunity was compelling.

“The building is only 10 years old, it was priced at $8,000 per square metre, it has very high-quality fit outs, good floor plates, and is in a location where there is major infrastructure being developed just 150 metres away at Queens Wharf," said Burgess.

He added that the building is in the government precinct, and the building is occupied by a Commonwealth government tenant who has almost five years remaining on the lease. Furthermore, the building was acquired at a 10% unleveraged yield.

“Putting all those factors together - the quality of the building, the location and infrastructure support that's going in around the area, the headline yield, and the quality of the covenants – that’s why there was really good support for the investment”.

The final cherry on top, however, was the discount that Burgess estimates Elanor received on the purchase price – “at a 50% discount, it becomes compelling value”.

Where to from here?

It would be remiss to sit down with a property investor at this time of year and not ask for their outlook into 2024.

In framing his response, Burgess highlighted the stabilisation in interest rates as an important factor, noting that 2023 was difficult as rates continued to rise from 2022.

He is hoping that, if the end of the cycle is near or has already arrived, that will “buy us a bit more stability in the forthcoming year in property markets… and the pricing of assets becomes a bit more clear”.

Be prepared

This wire opened with Burgess’s thoughts about office still being well and truly alive, albeit perhaps forever altered by COVID. So, whatever the outcome next year, Burgess won’t be departing from the process that he and the Elanor team have established.

The foundation of that process is deep research, which gives the team the confidence to act, even though it may be uncomfortable to do so.

"Everyone's fearful at the moment, asking whether the commercial office is dead, but I think time will tell that will be proven wrong. It's a lot to get your head around and then do the work, and understand what's going on. Then, it's just about trying to originate and find the right opportunity," said Burgess. 

He added that it is important to be on the front foot in these cycles and be ready with the capital so that you can execute on an opportunity should it arise.

“We certainly did not want to miss the opportunity in this cycle and we’ve been able to acquire 55 Elizabeth Street," Burgess said.

"We'll probably look back on that and say that's one of the 

deals of the cycle”.