Office tower values are under pressure from rising interest rates and the shift to hybrid working, although Morningstar sees investing opportunities among the major listed property trusts.

office building

Morningstar says valuation concerns for ASX-listed REITs are overblown. 

The office sector is expected to be hit as the rising cost of debt impacts commercial property valuations, with Dexus' (DXS) sale of a Sydney CBD office building at a 17% discount to book value touted as a sign of things to come.

While pointing to near-term challenges for the office sector, Morningstar equity analyst Alex Prineas says the Dexus sale supports Morningstar's view that the major office real estate investment trusts (REITs) are undervalued.

While Morningstar expects further valuation falls for offices, it does not expect as much bad news as has been priced in by the market, according to Prineas.

Most office REITs - including Dexus, GPT Group (GPT) and Mirvac Group (MGR) - currently hold 4-star ratings from Morningstar, while Prineas says office-heavy fund manager Charter Hall Group (CHC) screens as particularly undervalued at 5-stars.

In an update on Thursday, Charter Hall said the total value of its properties has declined by $1.9 billion - or 2.8% - compared to six months ago, with the value of its office portfolio down 3.7%. Overall group property funds under management is now expected to be about $72 billion at June 30.

Opportunities in the major office REITs

Prineas has noted the major office REITs are trading at big discounts to their net tangible assets (NTA), recently saying the big office plays are where Morningstar sees the biggest opportunities.

Australia's largest office player Dexus, for example, is trading at a 32% discount to its NTA and a 25% discount to Morningstar's fair value estimate.

While the 44 Market Street tower Dexus is selling for $393 million is A-grade, Prineas notes it is not the company's best A-grade building. Half of Dexus' office portfolio is rated premium and 45% is A-grade.

He says the tower has high vacancy, short leases, and meaningful re-leasing risk given it is an older building sitting on the CBD fringe, where conditions are softer.

"We don't think Dexus' entire portfolio would trade at a similar discount," Prineas says.
Based on Morningstar's analysis, Prineas estimates asset prices would need to fall more than 40% to breach Dexus' gearing limit.

Prineas says Morningstar expects a gradual recovery in office rents as CBD activity continues to increase on the back of economic and population growth.

"While the expected modest recovery should eventually benefit all landlords, we prefer the portfolios of major REITs Charter Hall, Dexus, GPT and Mirvac partly because they have assets with leases signed at higher pre-pandemic rents, many of which are not due to expire amid the current trough in conditions."

Prineas also notes the major REITs have diversified portfolios, and their NTA does not include the intangible value of their funds management and development interests.

Prineas says commercial property faces headwinds, but Charter Hall's portfolio is well-placed and GPT's portfolio looks solid.

He argues Dexus' high-quality portfolio should see it perform better than most, and Mirvac's office and residential businesses should perform well once the current headwinds abate.

Morningstar has reaffirmed its fair value estimates for narrow-moat names Dexus ($10.80) and Charter Hall ($16.20), as well as for no-moat REITs GPT ($5.40) and Mirvac ($3.10).

Prime CBD assets support big office REITs

Prime assets, which dominate the major office REITs' portfolios, are expected to perform better than lower-quality buildings.

Amid a flight to quality as employers gravitate to the best buildings in the best locations, Prineas says the structural shift to hybrid working favours the premium and A-grade buildings in CBDs owned by the major office REITs.

"These assets are more typically suited to hybrid working due to their large floorplates, installation of modern technology, and locations that are more attractive for both employers and employees."

He makes a distinction between those assets and the lower-grade assets in the CBD fringe or secondary locations that are typically owned by smaller REITs or are privately owned.

"Once you get outside the core CBD, it's very specific to the asset, the location and other factors, but generally speaking, we think the impact of hybrid work will fall more heavily on B-grade and lower assets in suburban locations."

After analysing the latest Sydney train passenger data, Prineas says the recovery of activity in the city's CBD looks intact.

"This supports our view that rents for the major office REITs have bottomed and should see ongoing gradual recovery."

Prineas adds that while Melbourne has lagged the office recovery, Morningstar assumes the city will also gradually recover.

S&P Global Ratings analysts believe prime assets will help shield Australia's office REITs (A-REITs) from rising stress, as higher interest rates lead to rising financing costs and increasing capitalisation rates, and the shift to flexible working practices impact the sector.

"Office A-REITs face eroding cash flows, rising capitalisation rates, and higher asset-valuation risks," a recent S&P report says.

"S&P Global Ratings believes prime-grade assets will be better positioned than secondary-grade assets, given their strong tenants and ability to adjust to changing market conditions."

S&P concludes that more than two-thirds of the seven office-focused A-REITs it rates can sustain asset value declines of up to 10%, and the rest can sustain declines of up to 25%.

Valuations an issue for super funds

The valuations of an estimated $650 billion of unlisted assets, including commercial property, owned by superannuation funds are under scrutiny, particularly from the prudential regulator.

Industry super fund Hostplus is closing its standalone property and infrastructure funds, while expanding pre-mixed investment options for its 1.7 million super members.

Hostplus says it considered a range of factors, including the increasing complexity and cost of the standalone options, and how best to manage the asset mix and cash flows of its overall investments.

The $100 billion super fund is one of Australia's largest investors in unlisted property and infrastructure.

"We'll continue to invest in these assets, both in Australia and overseas, by blending them into our other pre-mixed options," Hostplus says.

The Australian Prudential Regulation Authority is focusing on super funds' unlisted asset valuations, now imposing binding requirements rather than just guidelines on valuation practices.

APRA's general manager of superannuation Katrina Ellis says the watchdog is focusing on the quality of the governance process around valuations and the frequency of valuations.

"That's because, ultimately, accurate valuations are vitally important for member equity. When members are transacting or not transacting, nobody wants stale valuations, so it's an area that we've put new requirements out for," she recently told a Senate estimates hearing.

Ellis says a big change has been to ensure super trustees actively monitor changes in volatility and markets to decide if an out-of-cycle valuation is required, rather than waiting for the next quarter.

AustralianSuper chief investment officer Mark Delaney, who admits the $280 billion super fund's investments in unlisted property have been "really disappointing", spoke about the importance of accurate valuations at the Morningstar Investment Conference in Sydney.

"If you've got a material percentage of your portfolio in private assets and they're not appropriately marked … say a smart member takes advantage of a lag in private market valuation, they'll transfer value from the existing pool of members to the one who switched, and we don't think that's the right thing to do.

"We go to a lot of effort to make sure that's not the case."

Delaney says AustralianSuper has an independent internal valuations team stress test the appraisal valuations for private market assets, to make sure value is not transferred between members.