Will ASX office REITs ever recover to their pre-COVID-19 heights? Or are they facing a slow, painful death?

Spare a thought for ASX office REITs. Prior to the pandemic, you might have thought they were amongst the safest investments on the ASX.

After all, they were in many instances backed by long-term leases that were only going in one direction – no prizes for guessing it. And while they cost a lot of money to build, record low interest rates and tenant demand meant that many could pay for themselves. How times and perceptions have changed.

ASX office REITs (and private investors) downgrading left, right and centre

The pandemic decimated the office market, and number of major fund managers with investments in office towers have downgraded their holdings. Overall, office values have dropped 22% from their peaks. Office cap rates, which measure a buyers’ required return, are 125 basis points higher than the past two years. For those unaware, the higher the cap rate and required return, the lower the price.

You may not be invested in an ASX office REIT, but your superfund (particularly if it is one of the larger ones such as AustralianSuper) may well be invested in this space – existing developments, new developments or even both.

Why is the sector faring so badly?

Well there’s two reasons. First, the rise of remote working that means businesses will need less space going forward.

Don’t be fooled by desperate PR and IR officials from ASX office REITs trying to convince you that their tenants will need the same amount of space, only it’ll be used differently.

Tenants will use the space differently, but they will need less of it.

And for each percentage rise in people returning to the office month by month, every Australian capital city has visitation numbers well below pre-COVID levels.

Granted, you might see pre-COVID levels on individual days – like Tuesday, the new Monday, as well as Thursday, the new Friday. But the cumulative figures are nothing to write home about.

Second, high interest rates which mean it will cost more to construct office towers. And the rise of remote working means it is even more of a risk to build new office towers, lacking certainty that you’ll get high-quality tenants willing to pay top-dollar rents.

If values of property fall, a REIT’s gearing gets higher and higher. A general rule of thumb is anything above 30% is unacceptable.

Eventually, the owners may have no other choice but to sell it. This is a reality that occurred during the GFC in the USA as well as in Australia. Yes, even though Australia did not fare as badly, the drying up of credit led to a number of deaths because the REITs had no spare cash. And dependant on how long it was hold for, someone will be recording a loss.

A decade and a half on, what’s unfurling now may not be as rapid as then, but is occurring nonetheless. And we haven’t even mentioned the construction supply chain crisis that is killing construction firms left, right and centre across Australia.

Will the market ever recover?

It remains to be seen and may be contingent not just on people returning to the office but interest rates reducing (as well as to what extent). Now, there are some signs that people are coming back, judging by patronage on the new Sydney Metro, and new office mandates left right and centre, ranging from the NSW Government to Amazon. It seems a fait accompli that the next direction interest rates will be heading is downward, but just when and how many cuts is uncertain. One rate cut would be exciting for sentiment, but would have a modest impact at best considering the RBA’s cash rate increased from 0.1% to 4.35%.

Should I avoid the sector altogether?

Yes, we think investors should avoid the sector. Not REITs altogether, but avoid all ASX REITs.

You may disagree with us, but if you must, we would implore investor to stick with diversified REITs – avoid those that have all their eggs in the office basket. Investors should also take a close look at their REITs’ debt and gearing levels.

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