The Sydney Office market and the UBS Evidence Lab - by Investa Property Group

ARTICLE BY MICHAEL COOK, GROUP EXECUTIVE, INVESTA PROPERTY GROUP

A short time ago UBS produced an interesting article drawing from its Evidence Lab titled “Forecasting Sydney and Melbourne Rents”. The general thrust of the piece was that the market may be overestimating the strength of the current office cycle and the implications for the Australian REITs with Office exposure.  

The Evidence Lab approach is admirable in its process, conducting surveys of industry participants, mining the internet, collecting observable data to build a model taking into consideration interest rates, employment growth, vacancy rates, GDP statistics and other measurable factors to try and predict office rentals, rental growth rates and incentives.

Investa adopts a similar approach and some industry veterans (yours truly included), have been analysing the data in a similar fashion for the last 30 years. 

Whenever anyone says, “but this time it’s different,” the usual response is either tacit skepticism or straight out disbelief (manifested by such colloquial requests to share what they are smoking or to provide a urine sample).

But this time it really is different. There are at least 10 reasons why the UBS Evidence Lab may be under estimating the scale of what is happening in Sydney. 

Each of these factors was relatively unforeseen and very difficult to predict or measure, which is precisely why this time it is different. These are not forecastable, cyclical factors.

In a post GFC environment, few owners or developers were prepared to launch into producing more office stock, so when Lend Lease launched Barangaroo, there were two clear effects, firstly, with nearly 300,000 of fringe office space entering the market, other developers were discouraged from competing (not like in Melbourne where, if one goes, they all go). 

Barangaroo scared off competing supply which allowed an opportunity for the post GFC office market to recover (1). 

But not fully – post GFC, the demand for office space has been anemic. Lend Lease has had to pull forward demand from 2019/20 to fill towers which were completed in 2015/16.

Both AMP and Lend Lease will experience the full legacy of this when they develop their towers on Circular Quay in 2020/21. Ok, so Barangaroo was a negative, but that’s the only one.


Very few of us in the property industry noticed the trend in the US of technology firms growing up, graduating from their suburban play pens with slides and ball pools to adult office buildings. In the USA, Amazon, Google, Salesforce and myriad others are crowding the major cities (2). In Sydney, the likes of Linked In, Apple, Salesforce, Amazon, Expedia and others have eschew Macquarie Park for Martin Place (and nearby). No-one predicted the “recentralisation” of the IT industry, or the explosive growth of the likes of Atlassian (3).

In addition, no-one would have predicted the emergence of a new industry, Fintech, and its need to be with or adjacent to its customer base, the big four banks. Both the Technology industry and the Banks have exhibited a voracious appetite for office space to feed “Fintech”. (4)

The residential development boom across both Melbourne and Sydney has led to traditional suburban office locations such as Chatswood, St Leonards, Strathfield, Epping, Ashfield, Burwood (Camberwell, Hawthorn, Box Hill) being over-run by residential development. 

With residential sales rates on a “per square metre” basis greatly exceeding that which can be achieved for office, no developer in their right mind would develop office ahead of residential. This furthered the phenomena of recentralisation of office space users, which shows no sign of stopping given the fundamentals of on going residential demand (5). 

At the same time all this was bouncing around in the background, the NSW government and to a lesser extent, the Victorian government have embarked upon a once in a generation infrastructure program. In NSW this measures more than $75 billion, and counting (6). The Sydney Light Rail Project and the Metro alone are accounting for a jobs growth boom that would have the resources states (Qld, WA and SA) drooling. 

No models would have forecast that  11 A & B grade buildings in Sydney would be demolished disgorging 60,000 square metres of office 
space users on to our streets (7). Especially during a period where every conceivable development site (except a couple) was being re-zoned to fulfil the exploding demand for hotel rooms, serviced apartments and CBD residential living (8). Across Sydney since 2014, more than 60 sites have been approved for Hotel or Serviced Apartment development. 

And this has only compounded the problem for UBS’ Evidence Lab. Whereas old office buildings were traditionally knocked down and replaced with new office buildings, now they are being replaced with expensive higher yielding apartments (9). This has forced development land prices to soar to new levels, making the feasibility for office development even more challenging, unless of course, we can justify higher rents (10).

But higher development land prices are just the beginning. The cost of development is going to be further impacted post 2018 when the infrastructure projects move into the development phase (11). Try getting a demolition contractor, a scaffolder or a form worker in 2019/20/21! 
We saw in Perth what happened to construction prices when the mining boom created a vacuum of resources in the construction industry. 

Construction price escalation rates could rival rental growth! 

And we haven’t even mentioned the We Work phenomena and the rise of “3rd spaces” (12) or the death of the home office. All factors few of us let alone the UBS Evidence Lab could predict.

During the depths of the GFC, we couldn’t see an end to the destruction of the real estate industry, but it recovered. 

Conversely, during a boom, it is difficult to predict when it will end. Sydney’s explosive 20% per annum rental growth over the last 2 years may not be sustainable, but calling an end to the cycle in 2019 may be a little premature. 

In calendar year 2018, there is only one small building being completed. In 2019, another single building. Then in 2020, another single building, then its just a few refurbished projects before Lend Lease completes its latest project in Circular Quay. This constrained supply cycle will persist until the completion of the Metro Over Station Developments in 2023/24, which means rental growth is likely to continue through the early 2020’s. And the more prolonged this rental cycle persists, the greater the pressure on incentives. 

Ordinarily, I would sit up and take notice of a UBS forecast, especially one using the rigour of the Evidence Lab, but this is not an ordinary cycle, this time it really is different.

MICHAEL COOK

Group Executive Investa Property Group October 25, 2017 

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