Divestment: Durham Street case study

At PMG, we believe that careful stewardship and smart strategy enable us to bolster our property portfolio and continue to deliver regular cash returns to our investors and the potential for growth in value over time.

An important part of this strategy for us, at the appropriate time, is to position our funds to take advantage of strong opportunities that arise; to be proactive, not passive.

An evolving market

The commercial property sector has seen a general softening of yields across all markets throughout 2023, to differing degrees across regions, sectors, and even individual properties. We believe this movement has been driven primarily by the ‘higher for longer’ interest rate environment, and the impact that has on supply of, and demand for, commercial property.

Despite this, we have seen sustained demand for some types of commercial real estate, specifically high-quality industrial, large-format retail and office property that is well-located.

Office sector snapshot

With employers recognising the importance of the office environment to enhance culture and retain talent, we are seeing a continued demand for high-quality office spaces. This is reflected in increased occupancy and rent per square metre for prime offerings across New Zealand’s main centres over the first half of 2023*.

One of the most notable changes in the post-COVID era is the widespread adoption of hybrid work models. Many organisations have realised that employees can be productive while working remotely, however still acknowledging the value of in-person collaboration, and thus are embracing flexible work arrangements.

According to JLL’s 2023 Office Sentiment Survey, while 16% of occupiers say they are considering reducing their space, this is balanced by 14% saying they are looking to increase their space. This is testament to the changing needs of businesses and how they use their office spaces.

While we believe there is a promising outlook for the office sector, there’s also a noted flight to quality, which points to definite preferences for high-quality, well-located modern office spaces that enable greater flexibility, sustainability, collaboration, and hybrid working options*.

At PMG, this flight to quality has been evident in lease renewals and considerations, as tenants have shown a preference for sustainable, modern facilities that support the wellbeing, work-life balance, and productivity of their employees.

Adapting to the flight to quality

In the PMG Direct Office Fund, we have responded to this flight to quality over time by increasing our focus on not only quality locations, but quality office stock that can attract and retaining stronger tenants over the long term, driving rental growth and the potential for growth in value over time.

Recently, as themes in the office sector have been emerging, PMG has taken a proactive approach to adjusting the Fund's asset allocation. Recently, this has meant focusing on acquiring higher quality assets and selling the Fund’s assets expected to fall below our long-term quality expectations at appropriate points in their investment lifecycle. This enables us to lift the quality of the property portfolio and place the Fund in a position to further grow and diversify in future.

The Tauranga CBD has faced significant challenges over the past 10 years. In part, this is due to the development of large shopping malls located on the fringe of the city which has driven people away from the centre of town. This shift has changed the retail landscape significantly and has resulted in less attractive amenities available in the town centre. This shift has flowed through to the office sector resulting in higher vacancy across the B and C grade stock and a bifurcation of the market toward a handful of new buildings where better amenity is provided.

About the property

The changes in the landscape of Tauranga CBD impacted PMG's 127 and 143 Durham Street properties, which were both older buildings. In line with this, we made the decision to sell the two properties. The sale price, at $1,000,000 above independent valuation enabled the Fund to realise a return of more than 50% on the total cost of ownership, in under seven years. After factoring in regular income over time from the properties, the effective gross return generated for investors was 13.1% per annum**. The divestment decision was well-timed and prudent in the current economic climate - reducing the Fund’s loan-to-value ratio and interest costs while improving distributable income.

The transaction also provides the Fund with the capacity to take advantage of quality emerging acquisition opportunities that can increase diversification, income, and potential value for investors.

127 and 143 Durham Street were PMG’s first-ever properties. In 2019, following a growing shortage of quality office space in Tauranga, PMG proactively embarked on an office upgrade of the long-standing property to retain and attract high-quality tenants. Spanning 983 sqm with seven tenancies over three levels, including PMG’s Tauranga head office, the rolling fit-out project also kicked off at the same time as Tauranga City Council’s Street beautification project.

The two-year upgrade was planned to improve the property’s productivity for investors while supporting the development of high-quality office space in the CBD, to attract and retain quality tenants, achieve longer lease terms, and greater levels of rental income. It also meant PMG could support the regeneration of the CBD.

Through the project, PMG implemented several new innovations to help create a professional and modern workplace. The entire fit-out at each tenancy was made by working closely with our tenants to meet their requirements.

We installed modern, efficient air conditioning to create a comfortable work environment regardless of how spaces were used, providing flexibility and efficiency for tenants. We also significantly improved the fire rating between tenancies and common areas and replaced all lighting to energy-efficient LED lights.

The project also allowed us to implement environmentally friendly rubbish and recycling services for tenants including worm farms.

The improvements also led to a 4-star NABERSNZ rating for PMG’s head office tenancy.

Positioned for the future

The recent sale of the 127 and 143 Durham Street properties is a testament to PMG's active approach to managing our funds and properties.

As a result of the sale of the Durham Street properties, the Fund’s borrowings are more conservatively positioned amid a period of heightened interest rates and lower property valuations. This not only offers the capacity to support property acquisitions in future but also provides headroom to key banking covenants.

While our funds acquire all properties strategically with the intent to hold them long-term, we believe that strategic disposal of properties forms part of good portfolio management to enable us to maintain a robust portfolio through different market cycles, supporting the provision of regular returns to our investors, with the potential for long-term growth in value.

* JLL Q3 2023 Office Vertical Vacancy Review and JLL Office Sentiment Survey 2023

** Stated before tax, unlevered (before the impact of gearing), and before any variable fund overheads

Disclaimer: The information in this blog is of a general nature and was current on 27 October 2023. It is not intended to be regulated financial advice for the purpose of the Financial Markets Conduct Act 2013 and does not take your individual circumstances and financial situation into account. PMG does not provide financial advice. Please seek advice from a licenced financial advice provider before making any investment decisions.