The corporate news cycle of late abounds with commentary around the market correction predicted for the commercial property sector, with clear hints signalling that widespread value writedowns may be just around the corner. While there is no silver bullet to counter these threats, there are a number of measures at owners’ disposal to enhance resilience and protect net operating income (NOI). Counteragents to the indisputably worrying forces of successive interest rate rises, banking crises abroad, leveraging, and a lack of transactions obfuscating accurate market valuation. In this article, we explore two actionable means to address the negative factors at play in the current Australian commercial property climate, namely embracing the sustainability challenge and re-prioritising tenant satisfaction.
What can be done?
If property values take a hit and marked-to-market losses are realised, the question becomes: How do property owners prepare? And what is within scope for owners to minimise the damage? While there are factors that will always remain beyond owners’ control, like higher implied cap rates from valuers, macroeconomic disruptions and geopolitical turmoil; there are strategies that remain within their grasp. To hammer home the extent of the threat, Barrenjoey analyst Ben Brayshaw forecasts “book values to be written back on average by around 20 per cent across office portfolios and cap rates to expand by 100-125 basis points”.
Commercial property owners that fail to properly consider sustainability will lose marketability to tenants. NOI, a key driver of property value, is inextricably linked with tenant and leasing metrics. Improving green credentials is one tried-and-tested method for lifting these metrics, with commercial tenants increasingly looking to align their accommodation strategy with their ESG commitments, as explained by Matt Werner, CBRE’s Global President of Client Care:
“Reducing emissions is at the forefront for our clients, and they see ESG goals impacting all aspects of real estate decision making. That can include providing spaces that improve employee health and well-being, reducing resource use in building operations, or investing in renewables or efficiency. We anticipate the most highly sought-after real estate will help companies in achieving their stated environmental and social goals.”
Charter Hall chief executive David Harrison pointed to the bifurcation between greener, more modern stock and older buildings, suggesting that owners with second tier stock face the toughest times,
“...rather than these very broad 10-20 per cent devaluation forecasts, it will be very different by market, and it will be very different by building. If you’ve got an older building with high vacancy, you’re going to have a shallow buyer market and therefore if you really need to sell, then there might be some pricing challenges.”
This sentiment is backed by the numbers, with a new global survey from CBRE finding 84% of tenants are specifically looking for energy-reducing features, while nearly 50% of respondents would either demand a lower rental rate or reject a leasing deal altogether if the property did not meet their strict sustainability criteria. In the context of the NABERS framework, there is evidence from CBRE of higher occupancy for NABERS 5.5 and 6 Star rated buildings, with a 4% gap to 4.5 Star rated and 11% gap to offices with a rating of 4 Stars or less.
CBRE’s 2023 Asia Pacific Real Estate Market Outlook lists the flight to high-quality green buildings as a trend to watch, “As companies come under pressure to comply with ESG regulations and set ambitious net-zero targets with 2030 as a common goal, they will exhibit stronger demand for green buildings and green leases. New Grade A office supply in Asia Pacific fell to a five-year low in 2022 but will rebound this year, providing occupiers with opportunities to relocate to newer and ESG-compliant buildings.” This underscores the real threat to buildings that fail to prioritise sustainability.
By nature, strategies that enhance a building’s green credentials also increase efficiency and reduce running costs, meaning they too have the potential to boost NOI and, by extension, property value. Certified sustainable buildings save resources (energy, water, heat etc.) while reducing both wastage and maintenance expenses, which collectively flows into tightened outgoings. According to The World Green Building Council, the cost uplift of sustainable built assets is far lower than the market expects. It estimates operational costs for sustainable assets are over 13% lower for new construction and 9% for retrofitted building projects. Add to this the rising cost of carbon offsets, tightening regulatory pressures, an energy crisis; and the potential for sustainability initiatives to maximise property value become abundantly clear.
Maintain laser focus on tenants
Commercial tenant demand and leasing activity remains promisingly stable, as JLL’s Head of Strategic Research Annabel McFarlane explains, “Though economic uncertainty is impacting some decision making—while unemployment remains low and business conditions remain strong, we expect solid demand from tenants”. While this is encouraging, the focus on retaining existing tenants becomes business-critical as a tool to defend NOI and protect asset value. Losing a tenant and incurring the cost of space turnover, including lost rents, make-ready costs, and broker commissions, can significantly reduce NOI and magnify the inherent risks to future cash flows. The solution: meet and exceed tenant expectations so as to maximise satisfaction.
While a building’s investment thesis, from core through to opportunistic, will dictate the level of involvement required to establish a stable cash flow, maximising tenant satisfaction remains the one constant non-negotiable. How well you can maintain happy tenants will drive such key metrics as occupancy, projected rental rate growth, and WALE (by NLA or GRI). Kingley Surveys, a provider of real estate research and performance benchmarking, recently quantified the correlation between tenant satisfaction and renewals. According to the findings, tenants are 18% less likely to leave with a 1-point increase in satisfaction, while their intention to renew increased by 8%. Meanwhile, a 1-point increase in satisfaction resulted in a 7% decrease in vacancy.
This aligns to generally accepted theories of behavioural economics whereby the greater the customer satisfaction, the more likely a customer is to repurchase a product. So, how can property owners promote tenant satisfaction and, by extension, protect NOI? The first and most foundational step is getting the simple things right; fulfilling building user’s basic expectations before moving on to other, more advanced needs. This means presenting a comfortable fit-for-purpose environment by maintaining air quality, ventilation, thermal comfort, ideal temperature and relative humidity conditions, and keeping tenant disruption to a minimum by reducing plant and equipment downtime. These require a case-by-case determination, as ideal conditions will vary according to geography, season, foot traffic, and property type.
A major reset may well be on the cards, with commercial property values predicted to tumble by as much as 15 to 20 percent as implied cap rates finally bring stubbornly low recorded cap rates closer to reality. Adopting a mentality of action rather than denial will put property investors in as prepared a state as possible, with a number of measures at their disposal to protect NOI and valuation. At the heart of the solution? Resilience, as ultimately ‘resilient infrastructure and resilient people drive resilient portfolios’.
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