Commercial property returns set to fall

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AFTER nearly five years of “extraordinary” returns on undervalued assets, commercial and industrial property investors will need to prepare for tighter yields over the next half-decade as unsustainably low bond rates move upwards.

According to BIS Oxford Economics’ latest Australian Property Outlook report, authored by the firm’s head of property, Dr Frank Gelber, the period since the GFC-induced property downturn has been “unusual”: assets started undervalued, returns were driven by investment markets rather than leasing markets, bond rates were falling and an inflow of funds into asset markets led to firming yields and prices.

“Returns have been running with an incoming tide boosting total returns to property,” Gelber said leaving the market with extremely low yields and high prices.

He said there had been little contribution from rising rents, apart from the cyclical strength of the Sydney and Melbourne office markets.

BIS Oxford suggests that the best returns for investors with a five-year horizon are offered by office markets in Sydney, with a 9.2% internal rate of return (IRR), Melbourne at 7.7% and Canberra with 6.1%.

However, these are a clear step below the previous five-year period to 2018, which saw Sydney post returns of 17.8%, Melbourne 14.9% and Canberra 10%.

Large format retail property is also expected to offer attractive returns of around 7.9% over the next five years. While this would outperform traditional retail centres, it is also below the previous five-year period return of 16.7%.

Gelber said retail markets are most vulnerable to the shift in investor sentiment.

“While expected total returns to retail operations that successfully navigate the impending structural changes remain solid despite softening yields, some retail centres will struggle. The risk plays out as a property risk rather than a market risk.”

A report released last week by m3property suggested innovative retail landlords would still be able to capitalise on opportunities in the sector, which it said despite ongoing negative sentiment has a stronger risk and return profile than office and industrial assets over the next five years.

Average returns as part of the five-year outlook are of 7.5% for retail, ahead of 6.9% for office and near the 8.1% for industrial, while the risk factor for retail of 0.1% is more attractive than both the office and industrial sectors with 1.3% and 1.0% respectively.

Returns over the 12 months to June showed 9.3% for retail, 18.0% for office and 14.4% for industrial.

Gelber said recognition of lower expected returns has led to lower hurdle rates for investment.

“We can’t just put the money in cash. We have no choice but to allocate funds to the best available returns for given risk.

“Now we revert to leasing markets driving rents and hence capital growth and total returns. That brings the importance of demand and supply cycles back into play.”

He said bond rates are unsustainably low, both here and in the US.

“We’re already past the low point for bonds. As recovery in the US proceeds, bond rates will rise, unwinding much of the stimulus to asset yields of the period of falling bond rates.

“The tide will go out, with softening yields leading to a setback to prices and impeding returns,”

The strongest will be cyclical markets with the tightest leasing conditions driving rental growth, but which could lead to a subsequent cyclical downturn, while the weakest markets will be those cyclically exposed to soft leasing conditions.

“The Perth, Adelaide and Brisbane office markets will be vulnerable as investors come to realise how long it will take to absorb the oversupply of stock and the cost of re-leasing space in weak markets with high incentives. As investor interest dries up, softening yields will weaken prices and returns,”

Less cyclical industrial markets can expect solid rental growth, with total returns expected to be “solid rather than spectacular” and risk of oversupply is low.

“The yield softening will operate through buying and selling pressure. Markets with low expectation of capital gain will soften first as buying pressure dries up. Already, sentiment has turned against retail property, primarily for fear of growth in Internet shopping,” Gelber said.

He said different investors have different objectives and constraints.

“Some are strategic investors who rarely trade and need to be able to set and forget purchases and focus on maximising returns through leasing and value-adding strategies. Others are prepared to be tactical, allowing them to be more nimble in buying and selling properties, and hence crystallising returns near the peak of the cycle.

“Each of these strategies has allocation implications which need to be taken into account in constructing a property portfolio. Investment is becoming harder as the tailwind from falling bond rates turns into a headwind, and as the leasing and property cycles turn.”

Australian Property Journal