[#18]
Australia’s property markets
Just a few observations and comments to provide perspective and aid forming an informed view..
Asset returns are driven by how conditions unfold in relation to what is discounted. Our economy is in the early stages of transition, and the path forward depends on how central bankers play their hand. Markets are discounting one sharp round of tightening to bring inflation down, with stable growth and earnings. The outlook is tilted to the downside over the upcoming period with risk of an economic slowdown (RBA forecasts released earlier in August 2022 for GDP growth are slower than what population growth could be, suggesting a recession on a per capita basis), potential capital destruction (falling property values) in higher interest rate environment impacting transaction yields if rent growth is not high enough to offset rerate, and demand for property normalising closer to if not below long run averages.
Risk free rate as at 19 August 2022 (today):
- Australia Bond 10 year yield = 3.4%
Office CBD prime yields as at June 2022 are:
- Sydney = 4.4%
- Melbourne = 4.7%
- Brisbane = 5.6%
- Perth = 6.3%
Note, office CBD prime risk premiums between 2012 and 2019 averaged around 4% suggesting yields should be around 7.4% now.
Retail neighbourhood yields as at June 2022 are:
- Sydney = 5.6%
- Melbourne = 5.1%
- Brisbane = 6.8%
- Perth = 6.5%
Retail regional yields as at June 2022 are:
- Sydney = 5.0%
- Melbourne = 5.5%
- Brisbane = 5.0%
- Perth = 5.8%
Note, retail regional risk premiums between 2012 and 2019 averaged around 2-3% suggesting yields should be around 5.9% now.
Industrial prime yields as at June 2022 are:
- Sydney South = 3.3%
- Melbourne West = 3.6%
- Brisbane South = 4.5%
- Perth East = 4.8%
Note, industrial prime risk premiums between 2012 and 2019 averaged around 4-5% suggesting yields should be around 7.9% now.
Residential house yields as at mid-2022 are:
- Sydney = 2.2%
- Melbourne = 2.3%
- Brisbane = 3.4%
- Perth = 4.0%
Despite a rising interest rate environment, property valuations remain high based on close to record low yields. It would be reasonable to expect significant yield decompression to unfold as the market begins to price in higher nominal rates of return. If the broader interest rate environment is higher (this is a certainty now with the risk-free Commonwealth 10 year bond yield well above 3%), either property values will fall significantly as risk is repriced or commercial property would have to be considered less risky than it has historically or there be significant rental growth to offset higher required rates of return.
In terms of industrial property, demand has been primarily driven by 1) manufacturing exposed businesses expanding to service increased demand from large infrastructure and mining project construction (eg. steel fabricators) ; and 2) distribution logistics and warehousing businesses establishing premises to service growing e-commerce sector. The pipeline of construction work is not likely further increase by a large volume over the medium term and so additional space demanded by manufacturing businesses should ease. Simultaneously, as the saturation of businesses servicing the e-commerce sector increases with more distribution logistics and warehousing facilities commencing operation, there will be limited further need for additional facilities. Therefore, it would be reasonable to anticipate a significant reduction in new occupier activity for industrial space over the medium-term.
In terms of office space, many businesses are happy with employees working remotely partially (GDP per hour worked has increased so there goes the lost productivity argument) and while most office businesses have not foregone office space yet, they very well could once existing leases expire and they reassess their space requirement. From a businesses point of view, unless there is a benefit of working on site (such as client facing roles - consultants, lawyers, etc) then there is a financial benefit of not paying for a desk for an employee who could work remotely and more efficiently saving travel time at the very least. Also, the labour market has been very strong over the last 18 months although it would be reasonable to expect that growth to moderate over the upcoming period. As employment rises at a slower pace, there would be less additional demand for businesses to seek additional space for those extra workers to be productive. At the same time, there is a large pipeline of additional office space under construction (especially in Sydney and Perth). So in simple terms, supply of office space is expected to increase but demand could moderate (and so rental growth over the upcoming period could be subdue).
On the retail front, discretionary spending has been strong as households tap into accumulated savings and spend the extra money earned as more people are now employed in Australia than ever before.
In terms of residential property, housing is both an investment and consumption asset with demand for shelter inelastic (everyone needs a place to live wether they own or rent) and so the key variables are what people can and are willing to pay for housing (higher interest rates make serving a mortgage less affordable and households can borrow less and therefore pay less for purchases, but record employment levels also mean households earn more which they can spend on housing) as well as the relative demand (population growth, which is likely to accelerate as migration flows resume and skilled workers seek to capitalise on high paying employment opportunities in Australia) and supply (simply the amount of housing that exists, and we are currently building a large volume also).— DK.. just some thoughts, do your due diligence and decide your own actions.
