Rethinking The Australian Office

RETHINKING AUSTRALIAN OFFICES INVESTING IN

ASSETS TO UNLOCK FINANCIAL UPSIDE

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TABLE OF CONTENTS

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INTRODUCTION 01

DEMAND 02 FINDINGS 04

ANALYSIS 03

HOW CAN LANDLORDS POSITION THEIR ASSETS? 05

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DETERMINING THE FINANCIAL IMPACT OF IMPROVING OFFICE QUALITY KEY POINTS

A CW analysis of recent leasing transactions shows tenants have a clear bias towards higher quality

As they can’t physically move their buildings, to increase tenant demand landlords are limited to investing in the quality of their buildings .

But following a rapid escalation in construction costs and changing working habits, will these investments pay off?

buildings in central locations with higher amenity values.

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KEY INSIGHT Offices that increase

their quality from ‘market standard’ to ‘superior’ see a 5% decline in vacancy and a 7% increase in effective rents, increasing building income by 12%

In a large-scale study of the Sydney and Melbourne CBDs, Cushman & Wakefield quantifies the financial impact of these investments in Australian offices .

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INTRODUCTION 01

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IN THE MIDST OF THE BIGGEST STRUCTURAL CHANGE IN LABOUR MARKETS THIS CENTURY, OFFICE OWNERS MUST MAKE STRATEGIC DECISIONS AS TO HOW BEST POSITION THEIR ASSETS.

While data shows that tenant demand is skewed towards higher-quality properties, landlords have limited options. They can’t physically relocate their buildings to a more central location or build more transport connectivity around them. The main lever that landlords can pull is investing in upgrading the quality of their assets. But following a sharp climb in construction costs and tight financing conditions, is the return on this investment worth it for landlords?

This report quantifies the effects of an upgrade in building quality on its financial performance by analysing a dataset of 813 non-strata office buildings across the Sydney and Melbourne CBDs. After controlling for several factors including location, grade and amenity value amongst others, Cushman & Wakefield Research finds that increasing a building’s within-grade quality from standard to above average corresponds to a 5% decline in vacancy and a 7% increase in net effective rents.

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DEMAND 02

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DEMAND

PERHAPS MORE THAN ANY OTHER SEGMENT OF THE COMMERCIAL REAL ESTATE (CRE) UNIVERSE, THE OFFICE MARKET HAS UNDERGONE THE LARGEST STRUCTURAL CHANGE SINCE THE ONSET OF THE COVID-19 PANDEMIC. Mandatory lockdowns accelerated a shift of traditionally office-based workers to work from-home (WFH). Although there is evidence that a normalisation in working practices has been underway since 2022, the sudden adoption of WFH forced both employees and employers to become accustomed to new habits. Companies are continuing to adjust policies to find the optimal blend of in-office working and WFH. Benefits of in-person interactions that offices enable include team building, mentorship, and productivity-boosting network effects, amongst others. Against this backdrop, most employers have encouraged a return to in person working for at least a few days a week. Employers have been hesitant to directly mandate a return-to-office (RTO) policy amid a tight labour market that has increased employee bargaining power. Furthermore, analysis has shown that while mandated office attendance boosts the level of attendance, it detracts from employee wellbeing and productivity. As a result, employers have looked for ways to incentivize RTO without directly mandating it.

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FIGURE 1: SHARE OF EMPLOYEES* WORKING FROM HOME

COVID 19

100%

75%

73%

71%

60%

63%

90%

80%

70%

60%

50%

40%

30%

20%

10%

25%

27%

29%

40%

37%

0%

2015

2017

2019

2021

2023

Usually worked from home Did not usually work from home

* Share of employees with paid leave entitlements Source: Australian Bureau of Statistics, Cushman & Wakefield

FIGURE 2: SHARE OF OCCUPATIONS WORKING FROM HOME ON DAY OF CENSUS

40%

35%

30%

25%

20%

15%

10%

5%

0%

Managers

Professionals Technicians and Trades Workers

Community and Personal Service Workers

Clerical and Administrative Workers

Sales Workers Machinery Operators and Drivers

Labourers

Worked at home

Unweighted Average

Source: Australian Bureau of Statistics, Cushman & Wakefield

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Investing in a higher quality working space has been one way that employers can encourage employees back to the office. Perhaps unsurprisingly, even prior to the pandemic demand for prime office space outstripped that of lower grades, particularly once controlling for the relative stock of each in the market. Analysis of almost 250 Sydney CBD lease agreements over the past year confirms tenants’ preference to upgrade the quality of their office space.

Of the tenants that changed offices within the CBD, 45% moved into a higher grade while 40% stayed in the same grade of building. Of those tenants who relocated to a lower grade of building, 62% increased the amount of space leased and 38% moved into the city core. This could be a product of tenants attempting to keep costs as flat as possible by exchanging grade for space or location. Tenants that moved also showed a bias towards locations with more amenities, and speculative or refurbished fit outs.

FIGURE 3: AUSTRALIAN CBD NET ABSORPTION AS A % OF STOCK

14%

12%

10%

8%

6%

4%

2%

0%

-2%

-4%

-6%

2015

2016

2017

2018

2019

2020

2021

2022

2023

Premium A B

Source: Property Council of Australia, Cushman & Wakefield

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There has also been a significant push towards recentralisation. The average relocation was 400 metres. Sydney CBD is a little over 2.5 square kilometres, and as the tenant density maps below show movement was broadly towards the city core. Of the tenants who relocated and were previously in offices in the western and midtown precincts, one third moved into the city core.

FIGURE 4: CUSHMAN & WAKEFIELD AMENITY SCORE

60%

50%

40%

...and in to higher amenity spaces

30%

Tenants moving out of lower amenity spaces...

20%

10%

< 0.3

0.3 to 0.5

> 0.5

Prior lease

New lease

* Scores amenity value of buildings between 0 (lowest) and 1 (highest) Source: Cushman & Wakefield

FIGURE 5: POST TENANT RELOCATION FITOUTS

10% 15% 20% 25% 30% 35% 40% 45% 50%

0% 5%

Spec fitout

Refurbished

Existing

Source: Cushman & Wakefield

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FIGURE 6

Old locations

New locations

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ANALYSIS 03

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Of these five, the landlord can upgrade services and spaces to improve the quality of the asset, however quality is a somewhat subjective term. While building grade is often used, the quality of an asset can vary significantly within the same grade. To overcome this issue, a proxy measurement that mirrors building quality without directly measuring it is required. National Australian Built Environment Ratings System (NABERS) energy ratings provides a suitable alternative for a number of reasons: • It offers a numerical grading system (1 through 6) that covers a large sample of buildings; of the 813 non-strata buildings across the Sydney and Melbourne CBDs included in this study, 299 are NABERS rated. - 95% of Premium assets, 74% of Grade-A assets and 36% of B-grade assets are rated. - 98% of assets above 20,000 sqm, 66% of buildings between 10,000 and 20,0000 sqm, 35% of buildings between 5,000 and 10,000 sqm are rated. • NABERS ratings are also positively correlated with building grade and negatively correlated with the date of last refurbishment of the building (i.e., buildings that have been more recently refurbished tend to have higher NABERS ratings). These all point to NABERS being a good proxy for the quality of a building in this study, especially the correlation with the date of most recent refurbishment. • It increases with grade and size:

AS COMPANIES ADJUST TO A FLEXIBLE WORKING

ENVIRONMENT, THE QUALITY OF A WORKSPACE HAS BECOME A KEY DRIVER OF TENANT DEMAND. GENERALLY, THE QUALITY OF A BUILDING CAN BE NARROWED DOWN TO FIVE BROAD CATEGORIES:

1. SITE Proximity to public transport and central business districts.

2. STRUCTURE Efficient floorplates and modern core placements.

3. SERVICES State-of-the-art HVAC systems and energy-efficient lighting.

4. SPACES Flexible layouts that support various work styles.

5. SCENES Regular events and pop-up installations that engage tenants.

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FIGURE 7

40

35

30

25

20

15

10

Years since last refurb

5

0

3

3.5

4

4.5

5

5.5

6

NABERS Rating

Source: NABERS, Cushman & Wakefield

Landlords who refurbish their buildings typically not only enhance energy efficiency but also upgrade key features like the lobby, façade, and common areas, collectively improving the building’s overall quality and tenant appeal. Furthermore, a building that achieves a NABERS 5- or 6-star rating is considered ‘excellent’ or ‘market leading’, which allows analysis to focus on the effects of moving from a ‘market standard’ to ‘market leading’ rating, and thereby quantify the gains that a landlord potentially can achieve when investments are made to improve an asset to above average quality. Accordingly, the dataset comprises nearly 200 Grade-A and Grade-B buildings in the Sydney and Melbourne CBDs. Premium grade buildings were excluded as almost all are already NABERS 5 or above, thereby offering more limited scope to upgrade the asset. Grade-C and Grade-D buildings, as well as smaller Grade A-and-B buildings were not included as not only are they small in number, but the majority do not have a NABERS rating.

The top 20% of offices are likely to be fine, while the middle 60% of office buildings are likely to have to be repositioned and the bottom 20% risk becoming obsolete. THE TRIFURCATION OF OFFICES:

TOP 20%

MIDDLE 60%

BOTTOM 20%

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FINDINGS 04

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FINDINGS

IT IS RECOGNISED THAT THERE ARE SEVERAL FACTORS BEYOND THE QUALITY OF A BUILDING THAT CAN AFFECT ITS FINANCIAL PERFORMANCE. LOCATION, GRADE, PROXIMITY TO AMENITIES AND TRANSPORT HUBS ALL PLAY A ROLE.

The uplift in rents is due to higher face rents rather than tighter incentives. This shows that landlords are able to at least partially pass on the costs of investments in building through higher face rents to tenants. The benefits to investing in quality such as rental uplift and higher vacancy, were spread evenly between Sydney and Melbourne. Though in Sydney rents appear to be more sensitive to grade and in Melbourne amenity values, perhaps owing to a larger absolute rental premium of Grade-A over Grade-B in Sydney.

To isolate for the effects of a building’s quality on its financial performance, more than 300 permutations of models controlling for location (both Sydney vs Melbourne as well as submarket), building grade, amenity and connectivity value 1 as well as outliers were undertaken. The results show that a building’s quality has a substantial impact on its financial performance. Moving from average to superior building quality is associated with a 5% decline in a buildings’ vacancy and 7% increase in average net effective rents. This translates to a 12% increase in the net income of a building. Even if just modest improvements in building quality are undertaken 2 , this leads to a 2% decline in the vacancy rate and 3% uplift in effective rents.

How the benefits are distributed also show very interesting results.

The lower levels of buildings see greater rental uplift from an increase in building quality. This is true not only for relative uplift, ie the

Perhaps one of the most interesting aspects of the analysis is how benefits are transmitted.

INCREASE IN AVERAGE NET EFFECTIVE RENTS 7%

LOWER FLOORS SEE THE GREATEST FINANCIAL BENEFIT FROM INVESTMENTS IN BUILDING QUALITY

1 The Amenity and Connectivity Indices, created by Cushman and Wakefield, use leasing data for benchmarking. Scores are based on amenities (cafés, bars, restaurants, etc.) and transport stations within a 300-meter radius. 2 As measured by a one-unit increase in the NABERS rating of a building.

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Moving from average to superior building quality is associated with a 5% decline in a buildings’ vacancy and 7% increase

percentage increase on lower floors is greater than on higher floors, but also in terms of absolute value, ie the actual dollar increase on lower floors is greater than the absolute dollar increase on upper floors. The results also show that Grade-B buildings on average benefit more than Grade-A buildings from an investment in building quality. To some extent, this is in line with intuition. Higher floors should have more natural amenity value than lower floors: they would have better views, better natural lighting, etc. Meanwhile, by definition, Grade-A buildings should have more amenities than Grade-B buildings. As a result, the marginal impact of additional amenities would be less than an asset or location with fewer existing amenities, holding everything constant. This result does show that the positive impact on an investment in building quality is greatest on the areas of the building that can be the most difficult to lease.

in average net effective rents.

In short, investing in a building’s quality helps to strengthen a building’s weak points.

DECLINE IN VACANCY 5%

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HOW CAN LANDLORDS POSITION THEIR ASSETS? 05

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HOW CAN LANDLORDS POSITION THEIR ASSETS?

ALTHOUGH INVESTING IN THE QUALITY OF A BUILDING LEADS TO INCREASED INCOME, LANDLORDS MUST WEIGH THESE BENEFITS AGAINST THE COST OF THE INVESTMENT. In the first instance, building services engineers may be able to identify some “low-hanging fruit” when assessing a property, some improvements that landlords can make that are relatively quick and cost effective to implement and yield immediate upgrades. There are also some other logical improvements that landlords can make over the life cycle of their assets, such as replacing building infrastructure with more efficient items when they reach their end of life. However, more intensive changes will require more extensive planning. This is becoming increasingly important for landlords as the direction of public policy shifts towards legislation that mandates more energy efficient buildings. In the near-term, the City of Sydney has adopted new planning rules requiring development applications for commercial buildings (both new and redevelopment) to be net-zero by 2026.

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Slightly further afield, the Australian government is currently discussing policy that would require buildings to meet a minimum of 4-stars NABERS rating by 2030 and 5-stars by 2032. Currently only 30% of buildings in the Sydney and Melbourne CBDs clear the 4-star hurdle. This drops to 24% in Sydney and 17% in Melbourne respectively when the bar is lifted to 5-stars. In this context, it is critical for landlords to take a holistic view of their longer-term capex plans. Prioritising projects based on urgency and potential impact can help to ensure that the most critical upgrades are completed first. Furthermore, to ensure that upgrades are done in the most efficient manner, landlords must be able to overlay their plans for upgrading the environmental ratings of their buildings with their regular capex plans. For example, if a major upgrade or refurbishment is planned, why not also undertake environmental upgrades or quality improvements at the same time? The two are not mutually exclusive. This would allow minimising cost outlays on planning by economising spending on project managers and engineers. Concurrent execution of capex and environmental investments would also minimise the length of any disruptions to tenants.

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“...upgrading office buildings in Australia is not just about meeting regulatory

requirements; it is also about enhancing the financial performance of these assets.”

Ultimately, upgrading office buildings in Australia is not just about meeting regulatory requirements; it is also about enhancing the financial performance of these assets. With careful planning building owners can make their properties more energy efficient, reduce operating costs, improve tenant satisfaction and increase future occupier demand for their assets. Coupling this with a strategic approach will allow tenants to minimise costs and spread them throughout the capex cycle, all while maximising the benefits of additional income from higher effective rents and lower vacancies. Individual assets require a unique suite of solutions relevant to its own marketing strategy. To discuss what is appropriate for your assets please contact our market leading experts to assess and provide costings.

CONTACT OUR TEAM NOW

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AUTHORS:

SEAN ELLISON National Economics & Forecasting Manager sean.ellison@cushwake.com

LIN LEE Senior Strategic Research Analyst lin.lee@cushwake.com

CONTACTS:

DR. DOMINIC BROWN Head of International Research, Global Think Tank dominic.brown@cushwake.com MATTHEW CLIFFORD Head of Sustainability & ESG, Asia Pacific matthew.clifford@cushwake.com MARIA RUSSO-FAMA Director, PDS Sales, Strategy & Enablement, ANZ maria.russofama@cushwake.com TIM MOLCHANOFF National Director, Head of Office Leasing, ANZ tim.molchanoff@cushwake.com GORDON MARSDEN Head of Capital Markets, Asia Pacific gordon.marsden@cushwake.com

JOSH CULLEN International Director & Head of Capital Markets, ANZ josh.cullen@cushwake.com NINA SPAETH Director, Sustainability & ESG, Asia Pacific nina.spaeth@cuswake.com SHAUN KENAFAKE National Director, Building Consultancy shaun.kenafake@cushwake.com MICHAEL KEARINS Managing Director, Tenant Advisory Group, ANZ michael.kearins@cushwake.com

JAMES YOUNG Head of Investor Services, EMEA & APAC james.young@cushwake.com

ABOUT CUSHMAN & WAKEFIELD

Cushman & Wakefield (NYSE: CWK) is a leading global commercial real estate services firm for property owners and occupiers with approximately 52,000 employees in approximately 400 offices and 60 countries. In 2022, the firm reported revenue of $10.1 billion across its core services of property, facilities and project management, leasing, capital markets, and valuation and other services. It also receives numerous industry and business accolades for its award winning culture and commitment to Diversity, Equity and Inclusion (DEI), Environmental, Social and Governance (ESG) and more. For additional information, visit www.cushmanwakefield.com.