Australia's office sector appears to be turning a corner. The decline in office property values is stabilizing. If this trend takes hold over the next 12 months, it could facilitate asset sales and allow both debt and equity investors to identify new opportunities. We believe a return in steady capital investment is key not only for reinforcing credit ratings but also for diversifying funding sources and addressing future needs.

A return of capital flows would also help office landlords to repair their capital structures. Some rated office issuers have divested portfolio assets to strengthen their credit metrics. For some, rental income will play a diminished role in overall earnings as they look to reduce capital needs by growing funds management. This could add volatility to the earnings mix.

Transaction Spike Will Help Price Discovery

Valuations eased in the fourth quarter of 2024 for the office-exposed issuers we rate. The return of office property transactions in the second half of 2024 has started to give valuers a much clearer view of pricing.

Rated entities have generated A$2 billion of sales since June 2024, with a further A$1.4 billion under heads of agreement or being actively marketed. We believe rated landlords that seek to sustain their scale and competitive position will offset asset sales with new developments or acquisitions.

Chart 1

Under current settings, it is cheaper to buy than it is to build. Inflationary pressures and supply-chain constraints have substantially increased construction costs over the past three years. New developments are struggling to achieve economic rents, with many failing to proceed beyond feasibility studies. Rents are well below the level required to justify greenfield projects; this increases market interest in existing office assets.

As a result, new supply has been pushed out toward the end of this decade. These dynamics support transaction liquidity of existing assets, which we expect will continue to pick up for existing prime-grade assets located in core central business districts.

Funding Diversity To Improve Debt Maturities

The stabilization of commercial property valuations is likely to improve funding conditions and capital flows. This will lower bond spreads and ease access to longer-term funding. The decline in valuations puts a brake on debt capital market issuance. In its place, the office-exposed issuers we rate increasingly relied on bank debt.

Domestic banks may have been reducing their exposure to the wider commercial real estate market, but they have nevertheless remained the key source of funding for our portfolio of office-exposed issuers. Over the past two years, issuers have leveraged their relative creditworthiness and strong banking relationships to almost exclusively refinance and seek new bank funding.

Chart 2

A lack of funding diversity reduces average debt maturity and increases lender concentration risks. Competition has kept credit spreads aggressive, and issuers have been able to access bank debt on relatively longer-dated tenors. We have frequently seen issuers access seven-year tenors, and occasional instances of up to 10 years.

Despite longer-dated bank debt, weighted average debt maturities continue to erode across the portfolio of issuers we rate. We see this as issuers roll off debt capital market instruments that offer longer-dated repayment periods. As a result, the weighted average debt maturity profile of some issuers has started to approach our key tolerance level of three years.

Chart 3

At the tail-end of the pandemic, it became increasingly expensive for office-exposed REITs to access debt capital markets. Consequently, issuers relied more on bank funding. Uncertainty stemming from the work-from-home trend and wider sector outlook resulted in spreads for office-exposed issuers increasing 60 basis points (bps)-120bps over 2022 and 2023. Interest rate rises, higher vacancy rates, and valuation declines exacerbated this. Compared with the wider Australian corporate sector or other non-office-exposed REITs, office issuers traded at higher credit spreads.

Chart 4

More interest rate cuts should help further stabilize asset valuations and lead to tighter bond spreads. Bond spreads have begun to narrow in the past year and are trading close to 2022 levels. This coincides with a period when office landlords were last actively conducting debt capital market issuances.

If spreads continue to tighten, office landlords are likely to target and issue into the debt capital markets. This should help issuers diversify their funding sources and extend the repayment periods for their debts.

Equity raisings could soon be within reach for the wholesale office funds. Elevated interest rates and depressed valuations, which restricted debt capital market issuance, have also constrained the ability of unlisted issuers to raise equity. Declines in valuation across certain core precincts in Sydney are likely to extend to other capitals such as Brisbane and Perth. This should restore confidence for debt and equity investors to progressively return in the second half of 2025.

Valuations: Are We There Yet?

Chart 5

Office valuations in December 2024 indicate that pressures are starting to moderate. The revaluations coincided with the Reserve Bank of Australia cutting the cash rate to 4.1% from 4.35% in February 2025. Valuations of key and highly sought-after office assets in certain core CBD precincts have stabilized, and we don't expect further valuation movements to be materially negative over the next six to 12 months.

Valuations are asset-specific and vary across commercial properties. Demand for key assets in core CBD precincts remains strong, driving high occupancy rates, growth in face rent (or asking rent), and competitive incentive rates. This contrasts with lower occupancy and weaker demand underpinning secondary assets, subject to further negative revaluations.

Table 1

Expanding Funds Management: Risk Vs Reward

The evolution of some A-REIT business models presents new risks. GPT Group and Dexus, two office-exposed property groups listed on the Australian stock exchange, have each announced strategies centered around the expansion of their funds management businesses. As funds management earnings grow and earnings profiles evolve, we expect rental investment income to decrease as a proportion of total earnings.

In general, we consider earnings not derived from property rental income as less predictable and inherently more volatile. This is due in part to the performance aspect of the fee income, which introduces the influence of the valuation cycle to earnings. There is also risk of loss of fund mandates due to underperformance.

We expect the transition toward an expanded funds management business to occur gradually this decade. The growth in funds management is unlikely to be centered around the office sector but will instead bring added diversity through exposure to other real estate and infrastructure asset classes.

Redemptions May Squeeze Cash Flow, Reputation

Investor withdrawals will remain a risk for private wholesale funds. Liquidity redemption windows enable unitholders to cash out their investments. However, if too many investors withdraw at once, it can strain the fund's cash flow (liquidity risk) and harm its reputation (reputational risk).

In August 2023, we revised the outlook on Mirvac Wholesale Office Fund to negative outlook due in part to outstanding unitholder redemption requests. GPT Wholesale Office Fund could face similar redemption pressures when a liquidity window opens in 2026. So too could Investa Commercial Property Fund in 2027.

GPT Wholesale Shopping Centre Fund has obtained unitholder approval and replaced its previous liquidity redemption window with a more open-ended redemption structure. The new structure continues to allow unitholders to redeem capital while allowing the fund to minimize material liquidity event risk. We expect other issuers facing similar liquidity events to allow sufficient time to actively manage redemption requests through appropriate capital resourcing.

Return To Office, Return To Confidence?

The return-to-office trend and the stabilization of office asset values have alleviated pressure on most of our rated office-exposed issuers. With market signals pointing toward returning confidence in the sector, we expect issuers to restore funding diversity and tenors over the next 12-24 months.

Without these actions, issuers won't have the credit metric buffer to weather another freeze in capital flows in the same way they have over the past three years.

Editor: Lex Hall

Related Research

• Australian Prime Property Fund Commercial, March 24, 2025
• Dexus Divestments To Deliver Deleveraging, Feb. 18, 2025
• GPT Group's Diversity Supports Investments And Strategy, Feb. 17, 2025
• GPT Wholesale Office Fund, Nov. 6, 2024
• Dexus Wholesale Property Fund, Nov. 5, 2024
• Mirvac Wholesale Office Fund, Aug. 13, 2024
• Australia's Office Funds Look To Asset Sales To Protect Ratings, July 28, 2024
• Investa Commercial Property Fund, June 19, 2024

Appendix

Table 2