Q3 2020 – Melbourne Office Market

  • Metropolitan office vacancy rate has risen to 10-year highs adversely impacted by subdued tenant demand coupled with a surge of completions;
  • Although sales volume in 2020 to date has already surpassed the 10-year average, more than half of the volume is attributed from four transactions;
  • The Melbourne CBD office vacancy increased to its highest level since 2017 with sub-lease vacancy projected to increase to 10-year highs by the end of the year.

With Melbourne still in lockdown as a result of a second wave of COVID cases, the impact of the pandemic won’t be realised until 2021. Vacancy rates have increased across all Melbourne’s office markets with many tenants having delayed relocation plans limiting leasing activity. As a result of the increased economic uncertainty, prime office yields have begun to rise from their historical lows of the start of 2020.

Sales Volume/Yields

Urban Property Australia has recorded $640 million of Melbourne metropolitan office sales in 2020 to date, already surpassing the 10-year annual average. Transactional volume of the metropolitan office market has been underpinned by ARA’s purchase of 200 Victoria Parade in East Melbourne for $330 million. Purchaser interest in the metropolitan office market has been solid in 2020 to date with the market accounting for 27% of all office sales in Melbourne, its highest share in 10 years.

Melbourne Office Investment Activity

While both prime and secondary metropolitan office yields remain at historical lows at 5.4% and 6.5% respectively, Urban Property expects that this will be the cyclical low of the yield compression cycle with yields having steadily compressed since 2013. Given the continued economic uncertainty resulting from COVID-19, we expect investors will have a greater focus on income security and tenant covenant and we expect prime and secondary yields to diverge in the medium term.

Supply

New supply for the Melbourne metropolitan office market is forecast to reach 10-year highs in 2020. Urban Property is currently tracking around 220,000sqm of new office space to be completed this year across the Melbourne metropolitan office market. In 2020 to date, more than 80,000sqm of new office stock has been delivered to the metropolitan office market, already surpassing the annual total of 21,800sqm completed in 2019. The vast majority of new supply projected to be completed in the metropolitan office market in 2020 is located in the City Fringe precinct. The City Fringe precinct is expected to account for 67% of total new supply in 2020 with 140,000sqm forecast to be completed in the year across 16 developments.

Looking ahead, UPA expects that new supply in the metropolitan office market will peak in 2020 for the medium term with developments requiring significant tenant pre-commitment prior to commencing construction in light of the COVID-19 uncertainty.

Tenant Demand

Job losses have been heaviest of all Australian states in Victoria with 160,000 jobs lost in the 12 months to August 2020. From an unemployment rate of 5.2% in March 2020, Victoria’s unemployment rate has now risen to 7.1% as at August 2020. Reflecting the softening business investment environment, job advertisements in Victoria fell by 45% over the year to August 2020, with 25,000 jobs being advertised compared to 46,000 jobs as at August 2019.

In 2020 to date, leasing activity across the Melbourne metropolitan office market was relatively subdued with total volume of leases significantly below the 10-year average. Net absorption in the Melbourne metropolitan office market was negative, having been impacted by a number of tenants relocating into other markets. Reflecting the focus of the new development (underpinned by pre-leases), the vast majority of metropolitan office leasing was located in the City Fringe office precinct.

Demand for metropolitan office space is likely to be adversely impacted as a result of COVID-19 in the short term. Given the economic uncertainty globally, leasing decisions for tenants are expected to be put on hold, coupled with some tenant’s experiencing significant financial hardship potentially leading to an overall reduction of tenants.

Office Net Absorption by Market

Vacancy/Rents

Predominately as a result of the recent completions, the vacancy rate of the Melbourne metropolitan office market has increased to 9.2% as at September 2020, its highest level in 10 years. Urban Property forecast that the vacancy rate of the metropolitan office market will continue to rise over 2020 and 2021 given the significant amount of uncommitted new stock scheduled for completion this year.

Reflecting the subdued tenant demand, prime rents have fallen across the Melbourne metropolitan office market for the first time in five years. Metropolitan office rents have been adversely impacted by an increase in incentives and a decrease in face rental levels. Despite the surge of new supply in the City Fringe precinct, the outer office precincts recorded larger declines in rents compared to the City Fringe sub-region. Looking ahead, Urban Property Australia forecasts that prime rents will remain steady over the remainder of 2020 as tenants seek quality space however secondary rents will ease due to the continued economic uncertainty and increase in unemployment as a result of the impact of the COVID-19 pandemic.

CBD, St Kilda Road & Southbank Office Markets

The Melbourne CBD office vacancy increased from 3.2% in January to 5.8% as at July 2020, its highest level since 2017. Despite the increase, vacancy remains below the 10-year average. COVID-19 has had a profound impact on the Melbourne CBD office leasing market with only 40,000sqm leased in the first half of 2020 compared to 230,000sqm leased in the proceeding six-month period. While sub-lease vacancy has increased over 2020, UPA projects that sub-lease vacancy will increase to 10-year highs by the end of the year. Similar to the metropolitan market, leasing incentives in the CBD have increased notably since the emergence of the pandemic in response to the softening of tenant demand. Urban Property Australia expects several mooted developments to be shelved given the pre-commitment hurdles and uncertain rental outlook.

Outside of the CBD, the vacancy rate of the St Kilda Road office market rose to 9.3%, impacted by tenants relocating to other markets and an increase in sub-lease vacancy. The Southbank office market also recorded an increase in vacancy, rising to 10.5%. Looking ahead, with the Anzac railway station as part of the Metro Tunnel project coming online in 2025, Urban Property Australia expects that tenant demand will remain solid for prime quality office stock along St Kilda Road given the enhanced transport access. Sales activity in both Southbank and St Kilda Road office markets has been muted in 2020 to date with only three offices having transacted. The sales volume of the St Kilda Road is currently on track the lowest annual sales level in 15 years. Reflecting the rising vacancy and unemployment levels, prime yields for the CBD, St Kilda Road and Southbank markets have all risen having fallen to historical lows at the beginning of 2020.

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