Time to Catch the Falling Knife?
Over the past 12-18 months, the office market has been dominated by discussions of flight-to-quality, price discovery, and bifurcation. However, we are now witnessing a shift towards a new, perhaps more precarious phase often described as "catching a falling knife". In recent months, office values have seen significant write-downs, and the previously wide gap between buyers and sellers is beginning to narrow. This change has prompted investors to cautiously re-enter the transaction market once again as evidenced by the rumoured divestments of 255 George Street in Sydney, 367 Collins Street in Melbourne, and 240 Queen Street in Brisbane. It also raises several questions:
Examining the Past to Predict the Future?
During the GFC, it took two years, from Q2 2008 to Q1 2010, for prime and secondary office values to hit their lowest points, dropping by 16.0% and 20.2%, respectively according to the Property Council of Australia/MSCI Annual Property Index. However, unlike the sudden market shock causing the GFC, the current decline in office values results from a gradual adjustment due to several factors:
These factors have led to a more staggered impact on office markets. Notably, secondary office values began to decline six months prior to prime offices, which only started to decrease in Q4'22. Secondary offices have now experienced seven quarters of negative capital growth, with losses reaching 17.0%. On the other hand, prime offices have faced five quarters of negative capital growth, with values dropping by 11.8%, which is slightly less severe than the 14.0% loss after five quarters during the GFC. Importantly for both segments, however, peak losses may have already been reached so does this mean the office market is nearing the bottom of its current dip and upside is on the horizon?
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Pricing metrics allude to impending troughing
It's no secret that transaction metrics lead valuations. Indeed, pricing evidence is a crucial component of an asset's valuation, so prices are a leading indicator of what's to come for asset valuations. Examining office disposals across key office markets in Australia, it's evident that price falls are tapering off. Most major office markets saw transaction cap rate expansion peak in mid-2023 before slowly subsiding, and in the case of Perth, bottoming out. Sydney for example, saw office yields increase 68bps between Q2’22 and Q2’23, before seeing expansion taper off to 14bps in Q3’23 and just 6bps in Q4’23. A reversal of this trend, whilst possible, seems unlikely, indicating that markets are close to reaching the bottom of the current downturn.
How Have Office Markets Bounced Back Previously
Recovering from the GFC was a long journey, taking nearly eight years for prime offices and an additional 1.5 years for secondary offices to recoup losses seen during the GFC. Yet, for investors who acquired offices at the low point of the GFC and sold them seven years later – the average hold period for offices – the average value uplift was 29% for prime and 23% for secondary offices. This demonstrates that strategic timing can lead to substantial returns in the office market.
The dilemma of whether to invest now or wait for clearer signs of market bottoming is a classic risk-reward trade-off. Investing now could mean securing quality assets before the market fully bottoms, likely at lower prices due to reduced competition. Conversely, the risk of further declines means there's a possibility of not maximising the investment's potential value. The decision ultimately depends on an investor's risk tolerance, investment horizon, and confidence in their market analysis.
Whilst past market cycles can provide valuable insights, each cycle has its unique drivers and characteristics. The prevailing uncertainty about the role of offices in the workplace of the future might offer opportunities for those willing to accept the risks associated with catching a falling knife.
Disclaimer: The views and opinions expressed herein are solely my own and do not reflect the views of any institution or entity with which I may be affiliated. The information provided and any analysis performed is for informational purposes only and should not be considered as financial advice, investment recommendation, or an endorsement of any particular strategy or investment. All content is provided "as is" without any warranties of any kind. I make no representations as to the accuracy, completeness, suitability, or validity of any information presented and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. All information is provided on an as-is basis. Individuals should conduct their own research and consult with a professional financial advisor before making any investment decisions.