Plenty of fuel still left in Sydney’s tank

BIS Shrapnel Chief Economist Frank Gelber (Photo: Ted McDonnell)
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SYDNEY’S commercial property market boom has not peaked. At least a 45% price growth remains on the cards, according to BIS Shrapnel Chief Economist Frank Gelber.

Speaking at the Australian Property Institute’s Sydney Property Market Outlook on Thursday, Gelber hinted that that figure might only be a conservative forecast.

He said that a lot of incentives in the market had started to evaporate, with face rents rising and investors aggressively pushing down yields, leading to dramatic price rises.

“So much so that a lot of our clients are saying, ‘can we still invest in Sydney commercial property, or is it overvalued?’” he said. “And so, our answer to that is, well, yes we can, and it’s not overvalued yet – if it keeps going much more, it could be,”

Gelber said that 12 months ago the internal rate of return was at around 14%. A lot of the capital growth had come through since, he said, and from June this year the internal rate of return over the next five years would be about 10% – still well above a lot of hurdle rates.

“I’m talking about these markets in terms of expected total returns, not in terms of valuations. So is it overvalued in relation to valuation? Yes it is, because prices are rising and yields are firming in this market. But is it overvalued in relation to expected returns? No, it still isn’t – there are still opportunities in this market,” he said.

“So yes, you can realise some profits in this market, you’ll make a pretty good return. But there’s more to come over the next few years, and we’re still looking at rises in prices of around 45% over the next five years. Now, that’s assuming a moderate cycle. Actually, the cycle could be a lot stronger than that, and normally is.

“We’re assuming that basically developers back off on new developments once they see that the market will be fully supplied. Typically, they don’t – they keep going. While however the market is reasonably tight, they keep developing, and so our four-year peak followed by a moderate downturn could very well turn into a six or seven-year boom, followed by a bust.”

“And we’ll need to play that one as we go through, and the way in which we do that is we count demand and supply as we go forward, looking at the quantum of development compared with the quantum of demand to know when we’re in blue sky territory.

“Sydney commercial’s still got further to go, there are still opportunities here, there’s a lot more development to be done, and a lot of that will be refurbishments of buildings that haven’t been touched for 25 years. Why? Because the financial feasibilities don’t work, but if you put up rents by 40% to 50% and the financial feasibilities do work. So that’s what we’ll be doing in the Sydney market.”

Gelber said Sydney’s industrial market presents a different environment, which isn’t as cyclical.

He said the market has fairly good supply, with fairly competitive developers keeping a lid on rents, with incentives coming into the market meaning yields have firmed and rents fallen in effective rent terms.

“How can that be? The reality is that the primary driving force since the GFC-induced downturn has been falling and then low interest rates, feeding in to firming yields and rising prices. And a lot of the capital growth we’ve seen not just in industrial but also in retail, and also in commercial has been associated with firming yields as investors have come in to take advantage, looking for yield.

“That’s about to change. We’re in the first stages of a phase of rising interest rates, which will feed into a softening of yields, and weaker prices. So the great days in that sense are over, and so the expected returns we have in a lot of these asset classes have not been as good as they have been in the past, and some people say, ‘you can’t invest then’.

“But we look at it differently. See, nothing’s going to do well. In the period of falling interest rates and firming yields, we saw strength not only in commercial property values or industrial property values and retail property values, but also in equities and particularly in bonds. And so as that reverses, yes it does reverse for property and equities and also for bonds.

“So a rise in interest rates is a fall in bond prices, and total returns to bonds will be absolutely bloody dismal over the next few years. So what do we do about that? Well, if you’re in the market basically looking to invest, you can’t just invest for an absolute return, you have to look at what the alternatives present and actually, none of the alternatives are going to be terrific.

Gelber said the market is at a stage where even moderate property returns are going to look “pretty good” compared with the alternatives in equity markets and fixed interest.

“The temptation is for markets to say, when bond rates rise we should raise our hurdle rates, but I think the opposite is true. Actually, when bond rates rise, and we see the negative impact on returns, I think that we’re going to be reducing our hurdle rates,” he said.

“In that sort environment, property will be pretty good so we’ll be building it and developing it and owning it, in an environment, yes, of lower returns, but still positive returns.

“And we still want yield – we don’t give up on yield in that sort of environment – but we need to build more to meet the moderate demand that will pick up further next decade and that will continue where down in the bottom of the cycle, or in non-cyclical areas, and so the property markets pretty much across the board will be doing fairly well over the next five years.” Gelber concluded.

Australian Property Journal