Mid year 2017 economic and property outlook update

Overview

The thrust of our January 2017 Economic and Property Outlook Report (Insight, Summer 2017) remains unchanged. We still see a phase of rising bond rates coming, and a corresponding softening of yields and asset prices. This will affect all asset markets, including property. The search for yield which has been prevalent over the last few years will transform into a search for income growth.

A focus on income growth means a continued focus on the Sydney office market. The strength of the Melbourne economy means that Melbourne offices can also be considered. There may also be some emerging regional tourism-related opportunities, but Brisbane, Perth and Adelaide will remain difficult environments for investors. Asset selection, as always, is of paramount importance.

Economic update

Patchy gross domestic product (GDP) growth has confirmed our view of continued slow economic growth, a weak labour market, soft household income and retail sales and contained inflation. The structural shift from mining regions towards non-mining business-related services and regions particularly Sydney and Melbourne continues.

In Brisbane, the full impact of the fall in mining investment was delayed by a shift of resources to building inner city apartments. The impending residential apartment downturn will have a negative impact on the economy. Perth also remains weak, with further negative impact expected, as the remaining gas project finishes.

Housing interest rates have already risen through rising bank margins, particularly for investment and interest-only loans. That, together with tightening loan to valuation ratios (LVRs) and equity pre-commitment requirements on developers, will take the heat out of the high-rise residential boom. It is much harder to get a project away now. Hence the widespread recognition of the impending downturn in residential property and building markets. The negative shock of this downturn will mean continued soft overall economic growth.

Two further US Federal Reserve rate rises have also confirmed that we are embarking on a phase of rising cash and bond rates. This is particularly important for property investment markets through the relationship between bond rates and yields (see our article “Making sense of commercial property yields” in Insight, Winter 2017). In Australia, cash rates will remain low for some time. However, bond rates have already started to rise and will continue to do so in step with the US.

Property markets update:

Office markets

The Sydney office market has gone from strength to strength, with tightening leasing markets driving effective rents, firming yields and further property price growth. With strong business growth forecast to come, we believe that the Sydney office market has further to run, and even at substantially higher prices, on a five-year horizon Sydney commercial property is (broadly speaking) undervalued in relation to forecast expected returns. These conditions point to the possibility of a 1980s-style boom.

The strength of the Victorian and Melbourne economies has resulted in upgraded growth forecasts, with a flow-on to the office market. The loss of the motor vehicle industry and parts of the power industry have had an impact, but the economy and employment have been good over the last year, suggesting continued strong, albeit lower (than Sydney), growth in Melbourne.

For 20 years, Melbourne has had a comparative advantage over Sydney. Readily available and cheap land for residential, industrial and office developments has contained rents and property values, making it a more cost-effective place to situate back-office functions for national operations. That will continue to boost the demand for office space and we have increased our forecasts of demand, rent and price growth in the Melbourne market.

Development phase

The Sydney and Melbourne office markets are entering a substantial development phase which will change the logic of office investment. Over the next ten years, 3.3 million square metres (sqm) of office space in Sydney and 2.3 million sqm in Melbourne will be built. Given that some of these developments will be refurbishments, net additions will be circa 2.4 million sqm in Sydney and 1.5 million sqm in Melbourne.

This development phase and net additions of this quantum will eventually have an impact, and five year forecast returns are much stronger than ten-year forecast returns for both Sydney and Melbourne. Repositioning and exit strategies will be needed to manage this cycle.

Canberra, Brisbane, Perth and Adelaide Office

The Canberra office market should see strong prospective returns over both short and long terms. Canberra’s oversupply is easing, particularly for better quality space in Civic. However, the risk to be considered is that Canberra remains a dominant tenant, two-tiered market.

Despite strong recent sales, it is early for countercyclical investment in the Brisbane, Perth or Adelaide office markets. They face a period of weakness before they absorb the excess stock created during the boom.

Other asset classes

Amongst other property classes, weak retail sales growth and the impending arrival of Amazon have heightened emerging concerns about the strength of retailers and centre returns for retail property. The property risks are heightened for weaker centres, but returns to strong centres should remain solid.

Stage of the Property cycle

Industrial property is still recovering from the GFC. Availability of land is keeping development highly competitive. Recent strong returns have been driven by firming yields, allowing a reduction of effective rents and some rises in land values. Rising bond rates and softening yields will reverse this, squeezing development feasibilities and leaving returns solid but not spectacular.

The current hotels development boom is focused primarily on business travel in capital cities. The boom will oversupply business travel markets and the use of investment apartments as serviced apartments may potentially worsen matters further (think Airbnb). As recreational tourism continues to recover over the next decade however, there will be a need for more tourist hotels and services in regional markets.

During the recent period of falling interest rates, investment returns were boosted through the impact of lower rates on yields and asset prices. This happened, not just for property, but for all asset classes including infrastructure, equity markets and, of course, bonds. Rising interest rates will unwind a lot of these gains, causing a softening of yields and prices across the board.

It is now evident that we are embarking on a phase of rising interest rates worldwide, driven initially by US Federal Reserve cash rates, underpinning higher bond rates. Indeed, expectations of further cash rate rises will cause bond rates to rise by more than cash rates. It’s not yet clear how quickly or how far bond rates will rise but the recognition that they will do so will encourage investors to switch from the search for yield to a search for income growth.

Asset returns over the next five years will generally be lower than the last five. That includes infrastructure, equities and bonds, as well as property. Currently, weight of money is still driving firming pressure on yields, even in low growth markets. This will eventually change and investors should begin to look for rental growth to drive values and total returns. In that respect, the Sydney and Melbourne office markets are the obvious candidates.

Research and Insights