What is NTA?
Insight | 2 minute read
The key drivers for Australia continue to be the rise and fall of the mining production and investment cycle, tentative business investment for growth, the impact of the Australian dollar and the prospect of rising bond rates.
Overall for property markets, as interest rates rise, the search for yield will transform into a search for assets which will experience strong rental income growth.
Rebuilding the non-mining industries that suffered through the mining boom is taking time and involves significant industry and regional differences. The rebuild is slowly being led by dollar-exposed industries such as tourism and education services, with Australian GDP growth averaging only 2.5% over the last five years.
Going forward, a downturn in residential building will take over as the main factor constraining growth. Growth is expected to continue to average 2.5% over the next three years, with employment growth averaging 1.5%.
In Australia, despite experiencing a credit squeeze rather than a financial crisis and a downturn rather than recession, business confidence is still moderate. There has been a lot of action on the building and mining side of the investment equation, but businesses have not yet really started to invest for growth.
The signs are positive, but investment is tentative. Equipment investment remains soft, but computer-related investment in software, computer system design and related services are picking up.
The next stage is a shift from cost containment to growth. The missing elements are strengthening demand and profitability, and also the emergence of capacity constraints. Businesses are starting to invest, but primarily just to catch up on maintenance investment.
Non-mining demand and profits, while picking up, remain soft. Investment in increasing capacity and servicing growing demand are required to accelerate economic growth.
Given the impending negative impact of a residential downturn, growth will remain slow at least until non-mining business investment builds sufficient momentum to take over as a primary driver of growth.
A stronger world economy driving demand for mineral exports will keep the dollar at a level which constrains the competitiveness of many domestic industries. The rise in US interest rates relative to Australian rates could lead to some moderation, but an exchange rate higher than USD$0.70-$0.75 will slow the structural change required.
It has been a long, hard road for Western economies since the Global Financial Crisis (GFC). It is only now that investment is chiming in to accelerate growth worldwide.
Having been the primary driver of post-GFC growth, China’s growth is now slowing. However, despite all the doom and gloom stories, growth is likely to slow only moderately, particularly given that stronger world growth will boost Chinese exports. That augurs well for Australian commodities.
In the US, it was always going to take a decade to absorb the excess capacity created during the financial engineering boom which preceded the GFC. The US economy is already strong and now, a decade on, it’s looking as though business investment is starting to build momentum. US growth will strengthen further as investment kicks in.
The rise in US rates has started, with further rate rises expected in coming years. With a buffer between Australian and US cash rates, Australian rates need not directly follow US rate rises. Australian cash rates will stay at current levels for a while yet, before a strengthening Australian economy and the threat of rising inflation cause the RBA to raise rates. Australian bond rates, however, will track US rate rises.
Worldwide inflation has remained contained as growth has strengthened. This is not the new norm as wages will eventually pick up as labour constraints emerge. In Australia, the labour market is a lot weaker than the employment figures suggest. Given the relatively low growth, inflation will remain contained for some time yet.
Low interest rates worldwide have driven strong demand for assets, not just property, but also infrastructure and equities. Indeed, in the majority of markets, most of the capital growth experienced was driven by firming yields rather than any underlying income growth.
Though bond rates have started to rise, and while investor demand remains strong with the prospect of some further firming of yields, rising bond rates will eventually lead to a softening of yields and prices. This will create a headwind for investment markets. Expected returns will be lower. This will transform the search for yield into a search for income growth to drive future prices and returns.
There have been few surprises in the property markets in the last year. The exception is the shift in sentiment against retail property. Triggered by the concern about the entry of Amazon into the Australian market, this has caused a polarisation in attitudes towards the sector.
Industrial property has come into its own as an institutional investment class. It was a major beneficiary of the period of falling interest rates and firming yields. The GFC cleaned out industrial property, allowing returns to build from a low base.
However, it became apparent that new roads infrastructure had opened up large tracts of industrial land (often zoned but not serviced). Broadly speaking, as yields firmed, leasing competition from developers led to a fall in rents, even while firming of yields allowed residual land values from development to rise.
The problem is that softening yields will put pressure on development rents, as a means of offseting the impact of these softening yields and to maintain prices, as well as to to underwrite development feasibilities. Further, availability of land will limit capital growth. Recent strong historical returns are unlikely to continue. While returns remain solid, they are unlikely to meet current institutional benchmarks.
Investor sentiment has turned against the sector, largely triggered by the aforementioned entry of Amazon into the Australian market. To that, there is also the weakness of household income and expenditure, and hence, retail sales growth.
Moderate total shopping centre income growth has to be shared between current centres, moderately increasing supply and also the large inroads being made ‘into the pie’ by increasing levels of internet shopping. All of this will put pressure on centre incomes.
The key to performance is control over the catchment. The outlook for the strongly performing ‘super’ centres looks solid, but there is increasing risk. All centres are locked into a competitive refurbishment cycle to maintain their catchment. This increases costs and poorly performing centres will do badly.
Apart from the super centres, large format retail (e.g. Bunnings) have the best prospects in an asset class facing issues.
The office markets are cyclical and remain out of sync with each other.
Sydney remains the pick of the markets. It presents the best opportunities for investment and, more particularly, for development.
Demand has been moderate. But returns have been strong, underwritten by supply shortages driving rental growth. A gap in development post-Barangaroo, in addition to withdrawals of stock for residential development, the Metro rail and office redevelopment, mean that net additions to the volume of office space available to let has decreased.
The market will stay tight for another few years until sufficient stock comes on to satisfy demand. This environment provides an opportunity to upgrade and add value to properties, either through repositioning, refurbishment or redevelopment.
While not as tight on the supply side as Sydney, the strength of the Victorian economy is boosting demand for Melbourne commercial property.
Melbourne retains its comparative cost advantage over Sydney in the provision of back-office services for national operations. Accordingly, office employment and net absorption of office space will be stronger than Sydney in the medium term, underwriting a solid performance.
A long period of oversupply has finally come to an end in the Canberra market. Vacancy rates have tightened for commercial space in Civic. However, given government dominance of tenancy requirements, Canberra remains a two-tiered market with a dichotomy between occupied space and obsolete space not suitable for government or commercial tenants.
Perth, Brisbane and Adelaide all have vacancy rates over 15%, and it will take a few years to absorb the current oversupply. Individual investment opportunities will arise, but overall, the markets in all three will be difficult for some time.
Investors need to work hard to find good investment opportunities. In most cases, expected returns are around current hurdle rates. The Sydney and Melbourne office markets provide some ‘undervalued’ opportunities given expected future rental and income growth, particularly for value-add strategies. Their cyclicality, however, means that an exit strategy will be required.