Trends in Australian Real Estate

Emerging Trends in Australian Real Estate

18 October 2006

A survey of congress delegates revealed a relatively pessimistic view on property returns in the next year. Skills shortages in the economy were perceived as having the highest impact on property returns, followed by less disposable income and interest rate increases.

But David Rees, director of research at Mirvac, says these factors need to be placed in context. Firstly, he says skills shortages are a sign of a strong, growing economy and therefore shouldn't be problematic for the market. Secondly, with salaries going up and unemployment at 30-year lows, disposable income overall should remain stable.

However, Tim Stringer, head of wholesale property funds at Colonial First Estate, says skills shortages in the economy and particularly in the property industry are a key challenge due to the current environment of low cap rates and yield compression. "If you don't have the skills set within the organisations, then you're actually increasing the risk exposure to your investors."

Economic growth or bust?

Rees says there is a mixed view of the economy right now. He says the last number for headline growth of the Australian economy was 1.9 percent, hence the pessimism. And And recent media reports have revealed that people think the economy is going to get worse.

But, says Rees, "what happens in Australia, is that when you get sharp rising in commodity prices ... all sorts of weird things happen to the calculation of economic growth." He says the economy is actually growing pretty fast, at a rate of round 3.5-4 per cent.

Is it possible that things are going so well that people are building an insurance policy by being more pessimistic?

"I think when you're on the crest of the wave, you feel there is only one way to go" says Rees. "You would imagine convergence back to the long run average – you'd expect to see growth slow, you'd expect to see interest rates rise." It's not a disaster scenario, he says, it just means we're getting back to normality.

The underlying question is of course, after 15 years of strong economic growth, are we heading for a major correction?

Rees doesn't think so. "There's no logical coherence to that view," he says. "There's no reason why it can't continue."

In WA for example, when the boom finally slows, the downturn will just be a natural part of the cycle. "The government is financially sound. In the early 90s it had all sorts of ... financial difficulties. If the commodity cycle does slow this time, it'll be a much gentler landing."

"If you want to know ... where's the snag," says Rees, "it's probably not in Australia. Shocks typically come from offshore."

Stephen Ellis, CBRE's senior managing director, corporate, also believes the future looks bright. "I think that things are travelling pretty well, certainly from an investment point of view.

"There are a lot of infrastructure projects on the go and they all carry the economy forward. The momentum is there – I don't think anything is going to change that will bring the economy to a grinding halt." Even the ageing population, says Ellis, "is a speed hump on the horizon and is reflected in the diminishing skills workforce, higher prices and higher wages..."

Regarding the commodity boom, says Ellis, we're safe for another two years. "I think that China is going to continue to have a strong run, certainly up until the Olympics – they're not going to do anything to [stir the pot] ... so for the next two years it's going to be guns blazing. But after that, who knows."

Yield compression

With our stock of money increasing by 12-15 percent, and the actual stock of assets in Australia only growing 6-8 percent, we've been left with higher capital prices and yield compression.

Is this yield compression hiding bad deals? As Rees explains, when things are going well, like they are now, it's hard to distinguish between bad deals and good deals.

"I stick my neck out here by saying its hiding bad managers," says Tim Stringer. "Our clients are looking for active management; they're looking for ... depth of expertise. [Yield compression] has probably hidden bad managers ... because bad deals are only a result of bad managers."

But David Kier, Delfin Lend Lease CEO, says it's more due to the diversity in the marketplace. "I think diversity's being able to blend out what are some bad deals. Buying a shopping centre at 4.75-5 percent yields is being washed out by the same investors buying into a riskier proposition [such as] residential development with returns circa 12-18 percent."

But, says Ellis, "if people have bought a few years ago and we've had ... higher prices, is it such a bad deal?"

"I think that the time of the free lunch is over - managers are going to have to work their assets to get their returns," he says.

Rees adds, "The onus is now, more than ever, on the investor to decide."

Bad deals aside, are we likely to see yields go up again in the short to medium term?

Rees doesn't believe so. He says commercial property has consistently out-performed on a risk return basis in the past 20 years, and has finally dropped to where it should be. "Commercial property is a prime quality asset and it should be expensive ... I think a large proportion of the yield compression that we've seen globally is a valid and correct response to the quality of the assets."

Ellis also thinks yield compression will continue due to the huge demand. "It depends on the market of course, but in the ... office sector, it's going to compress further – 0.25-0.5 percent this year." He says the industrial sector also should firm over the next 12 months.

The winners and the losers

So, how to invest in the next year or so?

Breaking it down state by state, Ellis says Canberra and Adelaide will have a few problems in terms of the oversupply of stock relative to demand, although this will obviously provide some opportunities for tenants. "Vacancy rates are going to rise there and I think that it could be a little bit tougher ... over the forthcoming years."

The forecast is much brighter in Brisbane and Perth. "There are reports key money's coming back into the market, so obviously that's an indication that it's a landlords market. We're forecasting 20 percent plus growth in both those markets in the next 12 months."

In Sydney and Melbourne, while some forecasts have said these markets have turned, Ellis warns they may have got ahead of themselves. "Yes things are turning around, but there's still a lot of space to be taken up and there's not quite the demand that we've been led to believe."

Ellis says in Sydney, there may be some opportunities in the CBD. "The finance and legal sectors are booming so ... for the right stock in NSW, you could do pretty well."

In Melbourne, Keir believes the biggest problem will be an oversupply of stock. "One of the consequences of lower cap rates is lower returns, and I think were going to have to get used to higher average vacancy rates."

Overall though, Rees says that prime assets are close to, if not, fully priced. "So if you're looking to beat the market, you're going to have to do something quite innovative and I think you're probably going to have to go up the risk curve."

He suggests either finding assets that require investment and repositioning them, finding more innovative financial methods of managing those assets, or finding new sources of capital such as the resale market.

"It's not so much a matter of nominating the asset classes, I think it's more nominating the strategies that are going to generate the returns over the next few years."

Source: The Property Council

by Jackie Nevill