The outlook for Australia’s property market: Damian Horton

GUEST OBSERVER

Commercial property sales hit a near record of approximately $28.4 billion in 2015 with 40 percent coming from offshore investors.

Sydney and Melbourne are among the top 10 destinations for international capital and with [gross or face] yields 3 percent higher than other gateway cities. These trends are so far continuing in 2016.

Given the long term nature of property it is important to look beyond the short term, so at Cromwell, we are focused on understanding how the market will look in five years and what trends will emerge across each of the sectors.

Our analysis shows that office markets are the most popular with international investors but other sectors such as hotels, retail, student accommodation and aged care are also increasingly sought after.

In all market sectors however, prices have generally run ahead of leasing fundamentals. The continued weakness of the economy means relatively subdued tenant demand for property in the short term albeit this demand should gradually improve as the economy begins to benefit from the pick-up in non-mining investment in a few years’ time.

Stronger growth in demand will then, to the extent that it leads to a tightening in leasing markets, underpin rises in rents and a further firming of prices. The timing and extent to which this happens will vary by market and geography.

A 5 year view sector by sector

Retail

Retail will show solid rather than spectacular income growth with differences between outcomes dependent on population, catchment growth and competition within each catchment.

Retailers still face significant challenges from internet shopping, a lower AUD and from aggressive competition. Even so, consumers have maintained expenditure growth and we believe that we are now largely through the weak period when increased vacancies in retail centres led to increased incentives and weak rental growth. 

Those vacancies are now drying up as demand for retail space improves.

Industrial

The industrial sector is basking in the glow of investor appetite after a long stint in the wilderness. Industrial demand is strengthening across the eastern seaboard capitals, underpinned by supply chain outsourcing and e-commerce.

Sydney is leading the pack, with the strongest demand in 15 years. The current growth drivers will remain in place, boosted as non-mining investment recovers but the rents will stay flat even though demand will be improving.

The market is still diminished by an ample supply of sites for development. There is plenty of zoned but not yet serviced land and aggressive development competition will keep a lid on growth in rents and prices.

The main issue is the impact of low interest rates on yields and hence rents. The firming of yields has improved development feasibilities, allowing developers to offer incentives which have spread to the re-leasing of existing properties. As a result, effective rents have fallen. Should interest rates rise, the development proposition would tighten and put upward pressure on effective rents. However that is still a way off.

Hotels

Hotels in capital cities catering to the business market were in extremely tight supply following the collapse in building post-GFC, particularly in cities servicing mining. That has now led to a building boom which when completed over the next few years would, if business was the only demand driver, oversupply those markets, city by city. However that will be offset in some cities by strong growth in tourism, both overseas and domestic. 

Hotels in tourist regions, where there has been very little building, will do extremely well as increased demand leads to tightening occupancy and rising room rates. We expect a boom in refurbishment and building of new hotels in tourist areas over the next 10 years. That will broaden to growth in the associated regional economies. 

Residential 

We are nearing the peak of the residential boom, but with marked differences between cities. Building is at record levels. Investor demand has driven the market, to some extent boosted by Chinese demand for bolthole properties, with owner occupiers relatively slow to follow.

Accordingly, the market has been driven by apartments with strong building in the inner-city.  Prices have risen strongly leading to concerns about affordability. This has turned into a classic cycle. The outcome will ultimately be driven by demand and supply in each market.

Office markets

Office markets fundamentals have come through an extremely difficult period dominated by weak tenant demand across the board as employment growth, and in particular business services employment (the primary driver of office demand), evaporated. 

Australia-wide, demand is now slowly recovering from that period of negative net absorption, albeit still affected in some cities by falling mining investment. There are marked differences between cities.

Regardless of these fundamentals, the Australian office market is experiencing cyclical high demand from investors, with record-low yields being accepted for CBD office assets. This is the preferred property sector for foreign capital, and will likely continue as the yield of Australian commercial assets aligns more closely with the global norm.

Summary

Overall, we believe the Australian economy will stay soft for the next two to three years as it works through the end of the mining investment boom. There will be a slow transition to more balanced growth, driven by industries benefiting from a lower AUD.

With Australian governments focusing on deficits and cost constraint, government investment is still falling overall. NSW is leading the way on using the cyclically strong investor demand to crystallise cash from asset sales to unlock future infrastructure investment. The next round of infrastructure investment will, however, take time to have an impact.

Inflation remains below target and until growth strengthens the RBA has a bias for rate cuts. The US, on the other hand, has begun raising rates and the reduced gap between the two monetary policies will likely see the AUD fall further.

There will be no recession in Australia but there will be a transitionary period. We expect it will be two to three years before non-mining business investment builds sufficient momentum and growth strengthens.

In the mean time, property fundamentals are not supporting the prices being paid for assets, and from our experience, a balancing of these two variables is inevitable.

Damian Horton is head of property, Cromwell Property Group and can be contacted here.