This article is part of a series on potential secular changes on office real estate globally.
Working from home as the norm once seemed a remote possibility, globally and in the Asia-Pacific region. Not anymore.
The global pandemic has triggered adoption of working from home at an unprecedented pace. The shift is likely to reduce demand for office real estate over the next few years.
Globally, cash flows and asset valuations that give investors income stability in the office real estate sector could come under substantial pressure. However, in the Asia-Pacific region, the secular change to a new way of working could be less painful for landlords and REITs. The availability of funding, quality of tenants, and preference for in-person contact in the region, are all likely to ease the inevitable pressure.
We conducted a severe stress test on office landlords and REITs in Asia-Pacific gateway cities. It showed rating impact of at most one notch for half of our rated portfolio by 2023. However, this is an extreme scenario that is quite distant from our base case. Furthermore, despite the proliferation of working from home, any deterioration of business profiles would likely be gradual and manageable within the next one to two years. These players have so far demonstrated strong resilience. From now, whether they can maintain high occupancy with well-executed leasing strategies will be crucial.
|How Far Are We From Highly Stressed Scenario?|
|Actual City Data||Stress Test|
|As of end 2020||Year 1||Year 2||Year 3|
|Rent drop (y-y)||Vacancy||Spot rent drop (y-y)||Vacancy||Likelihood to happen||Accumulative Spot rent drop||Vacancy||Likelihood to happen||Accumulative Spot rent drop||Vacancy||Likelihood to happen|
|Hong Kong (Central)||-17%||7.3%||-20%||10%||Possible||-36%||18%||Unlikely||-49%||27%||Very Unlikely|
|New York (Manhanttan)§||-5.2%||12.2%|
Source: Vacancy-- Hong Kong, Sydney, Melbourne (Colliers); New York, San Francisco (CBRE); Tokyo (e-Miki), Singapore (URA). Rent-- Hong Kong, Sydney, Melbourne (Colliers); New York, San Francisco (CBRE); Tokyo (e-Miki); Singapore (URA). Note: For stress of U.S. gateway cities New York and San Francisco, please see our Feb. 11, 2021, article Remote Working In Testing U.S. Office Landlords' Credit Quality
Transition To A Tenant's Market
Working from home is set to trigger secular changes in economies and the way we do business. The speed and depth of impact on the office property landscape will vary regionally and globally. It may be too early to talk of a complete overhaul of our ways of working, but there are early signs.
Tenants such as multinational companies and financial institutions have swiftly adapted to changes brought about by the pandemic. Meanwhile, the preference for face-to-face contact in Asia gateway cities is likely to remain commonplace and delay total change. The previous income stability of the office sector, though, will no doubt waver.
When leases come up for renewal, we expect to see contract terms renegotiated. Leases are likely to be shorter, with optionality for extensions, given many tenants likely remain undecided future space needs. In the post-pandemic world, tenants will have greater bargaining power as the need for flexibility on office space grows.
Leases Less Locked-In
Reductions in weighted average lease expiry (WALE) profiles will increase rental income volatility in the next three to five years, in our view. Gateway cities with shorter WALE profiles such as Tokyo, Hong Kong, and Singapore (at about three to four years) will be more exposed to shorter dated leases than Sydney and Melbourne, where WALE profiles are above five years (see chart 2).
All is not lost. Although longer WALE profiles are associated with more stability, shorter WALE profiles could also have benefits. Higher-than-expected rates in a post-pandemic recovery are possible. For example, Hong Kong's rental rate skyrocketed by 56% a year after the global financial crisis and those with shorter WALE profiles were faster to capitalize on the uptrend.
Flight To Quality
Overall demand for office space will decline over the next three to five years as corporations reduce floorspace. However, we expect the operating performance of premium/grade A office buildings to stand out amid a flight to quality among tenants. Entities we rate focus on these high-quality assets and are therefore better protected.
Contrary to U.S. trends, the Asia-Pacific's more concentrated, urban markets will likely experience less pressure than suburban markets. This is because amid downsizing, tenants will likely prefer to relocate to smaller head offices in central business districts or representative offices in prime locations. As a result, we expect rental and asset value on secondary and older assets with less efficient floorplans to face more pressure. These lower quality assets usually have less attractive tenant amenities, lower prestige, and worse transport connectivity.
Valuation Loss For Rated Players Unlikely To Be Large
Office rental companies in the Asia-Pacific region we rate are only likely to gradually see valuation loss on their balance sheets. This would be the case even if rents continue to drop over the next one to two years. We also believe the magnitude of any losses will be mild. Valuation loss was manageable in 2020 at around 0%-5% for our rated office landlords and REITs in the Asia-Pacific region.
Cash collection rates for office landlords and REITs remain relatively high; they were over 95% during the peak of the pandemic in 2020. This was despite physical tenant occupancy of about 50% for several months. Office rental companies in the Asia-Pacific region are diverse and count blue-chip companies and multinationals among their tenants. Meanwhile, we expect property capitalization rates to be remain relatively stable in the coming one to two years amid a low interest rate environment.
Hong Kong, as one of the most volatile markets in the region, is demonstrative of the effect the pandemic has had on valuations. Offices there (rated and unrated; classes A, B, C as a whole) experienced 27% valuation loss during the global financial crisis. It rebounded by 38% in the 12 months that followed, and valuations more than tripled in the next decade. This provided positive support for funding and credit quality. In contrast, the loss was 17% last year for Hong Kong offices, against 4.2% for our rated office landlords and REITs.
Asia-Pacific Keeps Funding Simple
The capital structures of APAC office landlords and REITs tend to be quite simple, dominated by bank loans and debt capital market issuance because of their large fixed-asset bases. We believe that the well-banked status of these players will continue, because operations have been relatively unaffected and look likely to be on the mend. The general absence of commercial mortgage-backed securities also makes valuation adjustments less likely to hamper access to debt funding or have strong ripple effects in financial markets.
Banking relationships and access to medium-term notes was largely unchanged last year (see chart 3). Raising equity is also feasible for most office landlords and REITs as an alternative funding option. For example, Japanese REITs in general have records of frequently raising equity when acquisitions remain accretive to net asset value per share.
Even with about a third of our rated issuers being unlisted funds, we believe liquidity risk is well managed because of available headroom in committed undrawn facilities and cash reserves. Where open for new equity, these unlisted funds have a proven record of receiving support from unitholders, who tend to be long-term institutional investors. This ensures a sufficiently liquid secondary market to fulfil existing investor redemptions.
Cash Flows Will Show The True Picture
We expect the gap between face rent and effective rent to continue to widen amid heightened vacancy rates. Landlords and REITs will increase incentives, such as rent-free periods, to encourage tenants to enter longer term leases. This will impact cash flows and adversely impact credit quality.
Problems Only If Downturn Is Protracted
We tested the resilience of 11 office landlords and REITs (Table 2)from Asia-Pacific gateway cities against deep declines in rent and high vacancy rates.
|Rated Landlords and REITs Exposed To Prime Office Space In APAC Gateway Markets|
|Companies||Short name||Gateway city||Rating||Office exposure (by EBITDA)||Company Nature||Asset Size (Bil. US$)|
Hongkong Land Holdings Ltd.
|HKL||Hong Kong||A/Stable||65%||Listed company (landlord)||35.6|
IFC Development Ltd.
|IFC||Hong Kong||A/Stable||50%||Private company (landlord)||12.7|
Swire Pacific Ltd.
|Swire||Hong Kong||A-/Stable||33%||Listed company (conglomerates)||35.5|
Nippon Building Fund Inc.*
Japan Real Estate Investment Corp.
AMP Capital Wholesale Office Fund
|AWOF||Sydney & Melbourne||A-/Stable||100%||Unlisted fund||5.2|
|Dexus||Sydney & Melbourne||A-/Stable||85%||Listed REIT||12.3|
GPT Wholesale Office Fund
|GWOF||Sydney & Melbourne||A-/Stable||100%||Unlisted fund||6.4|
Investa Commercial Property Fund
|ICPF||Sydney & Melbourne||A-/Stable||100%||Unlisted fund||4.5|
Charter Hall Prime Office Fund
|CPOF||Sydney & Melbourne||BBB/Stable||100%||Unlisted fund||5.5|
CapitaLand Integrated Commercial Trust
|Asset value as of latest reporting date, includes properties held through other investments including unconsolidated assets. Asset value of Hong Kong-based operators excludes properties under development. *Not factored in substantial acquisition in Jan 2021. Ratings as of March 23, 2021.|
We see headroom for the rated office landlords and REITs to withstand a degree of earnings pressure from lower rents and higher vacancy rates. Under our severe scenario (Table 3), a third of these companies would face at most a one-notch downgrade in 2022, while about half could face downgrades in 2023 (Chart 4). We do not expect to see these severe conditions and they are significantly more severe than our base case. Therefore, the outlooks on the ratings of these companies are currently stable.
|Key Assumptions For Highly Stressed Scenario|
|Key assumptions in APAC region include:||Key assumptions in U.S. include:||Key differences|
|1) Only around 80% of leases (either from existing or new tenants) are renewed at expiration. The rest are left vacant due to a long-term decrease in demand every year for the next three years.||1) Only 50% of leases are renewed at expiration; assume no new tenant take up.||Significantly more APAC leases are renewed each year than in the U.S., given difference in lease structures.|
|2) Rent on expired lease to drop by 15% year on year, and spot rent to drop 15% every year over the next three years. In Hong Kong, we assume 20% falls every year for the next three years.||2) Lease renewals at rates that are 25% lower than effective rent (including higher lease concessions and tenant improvement).||Hong Kong was more volatile in past cycles.|
|3) An extra 3% occupancy lost every year where existing tenants surrender space before lease expiration.||Melbourne and Sydney properties take a 10% occupancy cut to capture less leases expiring the next year.|
|As a result, at the end of 2023:||As a result:|
|Cumulative occupancy declines to 75% (above 95% currently)||Cumulative occupancy declines of about 10% to the mid- to low-80% area (95% currently); and|
|Cumulative spot rent to drop by 40%-50% compared to current rent|
|A wide range of 20%-45% cumulative decline in same-property EBITDA.||10% decline in same-property net operating income in 2021, moderating to 5% decline annually from 2022-2024.|
|Note: For mixed-used operators, we only stressed the office portion while other earnings and vacancy assumptions are maintained at our most recent base-case assumptions. Rating impact would be more muted for these landlords given asset exposure diversification benefits.|
The success of leasing strategies and resilience of cash inflows will be the key indicators to monitor once recovery from the pandemic truly sets in. The Asia-Pacific region is ahead of the curve in terms of returning to office given better control of the pandemic (see appendix 1 and 2).
The ability of landlords and REITs to maintain occupancy and the cost of incentives to achieve this could demonstrate whether their competitiveness and market standing remain intact. Hurdles to achieving this could include the upcoming supply in these gateway cities, which is quite substantial (see appendix 3). Asset quality so far has not been materially impaired, but valuations would likely fall noticeably if weakening signs emerged.
|Return To Office Rate Suggests The Level Of Embrace of Work From Home|
|Hong Kong||The adoption of WFH in Hong Kong has not been uniform. Over the course of 2020, multinationals and larger firms have been more supportive in encouraging WFH, with IT platforms more readily available. Smaller companies have been more reluctant to embrace WFH. Factors such as high residential density and the proximity and convenience of commuting to office premises work against prolonged WFH arrangements.|
|Tokyo||The first state of emergency order from April to May 2020 brought a new way of life to office workers. Despite the lack of travel restrictions, many global corporations headquartered in central Tokyo limited their employees' office access, targeting 70%-90% of employees working from home; some companies have even made it permanent. The number of people using subway lines during the morning rush hour consistently recorded a 30% decline year-on-year from June to November 2020.|
|Singapore||We expect significant headwinds because of WFH being widely adopted as well as uncertainty over the easing of office capacity restrictions--capped at 75% since April 5, 2021. Protracted WFH arrangements will make tenants rethink their leasing strategy, including greater use of hot-desking, relocation to multiple office locations away from city center, and preference for shorter or more flexible lease contracts.|
|Melbourne and Sydney||Over the course of the pandemic, employees have adapted to WFH arrangements with many in the larger CBDs of Melbourne and Sydney not yet returning to the office. As restrictions ease, the respective state governments are encouraging companies and their employees to return to the office. Companies are progressing return to office initiatives at different rates noting employees have already largely adapted to WFH working from home during the course of the pandemic with some expressing WFH preference on a continued basis.|
|WFH--Working from home.|
|Planned Supply Will Add To The Burden|
|Supply And Vacancy Trend||Supply Pressure in 3 - 5 years|
|Around 1.3 million sq ft of new office supply over the next four years, equivalent to 5% of the existing stock in Central. There was nearly no supply in past five years.||Two Taikoo Place, located in at Quarry Bay, will add another one 1 million sq ft of new supply during 2022-2023 to cater for to growing relocation demand from Central, adding pressure to Central's vacancy||While multinationals have begun cutting headcount and reducing floorspace, some spaces will be taken up by Chinese financial institutions.||Hong Kong’s largest secondary office hub, Kowloon East, was badly impacted due to weaker tenant profiles (financial institution back offices and SMEs)||Five pieces of commercial land parcels in Kai Tak, adjacent to the Kowloon East hub, were proposed to be rezoned residential by the government recently. We believe this demonstrates government’s awareness of non-Central office demand weakening and to ease supply pressure|
|New supply in central Tokyo during 2023, 1.5 million square meters (~16 million sq sf) of new floorspace will be added to the market, the third largest increment after the Global Financial Crisis, representing about 3% of the city’s stock.||Some tenants could consider satellite offices outside Tokyo as they strategically optimize their business resources given IT enhancements|
|Vacancy rate is expected to rise to mid-teens over the next three years, from 9.6% during the fourth quarter 2020 .||The URA forecasted new office supply of 664,000 square meters (7.1 million sq ft) between 2021 and 2024.||However, these will be partly offset by the redevelopment of older office buildings, considering various initiatives and incentives by the government to rejuvenate the downtown area.|
|Melbourne and Sydney||Manageable|
|Sizeable space completions between 2021 and 2022 in both Melbourne (148,470 sqm/1.6 million sq ft ) and Sydney (273,300 sqm/2.9 million sq ft) are likely to constrain rent levels.||Given some of this new stock is pre-committed (Melbourne in particular), we expect a higher than normal subletting of existing space and older stock to come onto the market, putting pressure on vacancy rates and rental levels.||Against the backdrop of rising vacancy rates, landlords who compete with subleasing tenants could be prepared to be more flexible with both rental incentives and lease terms to secure and retain tenants.||Office incentive levels have risen in excess of 30% of face rents in these cities and are being factored in the declines to net effective rents in our forecasts. Landlords are prepared to be flexible to accommodate tenant leasing term requirements.|
- Remote Working Is Testing U.S. Office Landlords' Credit Quality, Feb. 11, 2021
- Australian And New Zealand Retail REITs: Pandemic Leaves Lasting Pain, Jan. 10, 2021
- Hong Kong's Tight Property Supply Becomes An Advantage, Nov. 23, 2020
- China Commercial Property: Incumbent Advantages Today Suggest Credit Strength Tomorrow, Nov. 3, 2020
- For Australasian REITs, COVID-19 Could Strike A Longer And Deeper Blow, April 28, 2020
- Will Asia's REITs Keep Their Angel Wings? April 27, 2020
This report does not constitute a rating action.
|Primary Credit Analyst:||Esther Liu, Hong Kong + 852 2533 3556;|
|Secondary Contacts:||Christopher Yip, Hong Kong + 852 2533 3593;|
|Aldrin Ang, CFA, Melbourne + 61396312006;|
|Simon Wong, Singapore (65) 6239-6336;|
|Ryohei Yoshida, Tokyo + 81 3 4550 8660;|
|Research Assistant:||Harshil Doshi, Mumbai|
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