FYI | May 29 2007
By Chris Shaw
Residential property may not have fully recovered from its downturn of a couple of years ago but strong underlying conditions and the weight of money flowing in has meant recent years have been very good for the commercial property sector.
The flipside is yields have fallen to historically low levels, so a report led by ANZ Banking Group head of financial system analysis Paul Braddick has attempted to assess whether the commercial property market is in any danger of experiencing a pricing bubble.
Looking at the market in recent years the bank notes capital returns have improved significantly from levels of around 3% in the late 1990s and early parts of this decade to around 10% now for the retail and office sectors and about 5% for industrial property, though limited rental growth meant yields have firmed during the same period.
It is important to put this in perspective though, as the gains in recent years have followed a period of significant underperformance and so represent some element of catch-up in the office and industrial markets in particular. There may yet be more to come, as in real terms the bank estimates average office prices for example remain 37% below levels from 1984, compared to a 128% increase in real house prices in the same period.
The report points out the trend in recent years has been driven by increased investor interest, tighter property market fundamentals and a structural fall in the risk-free interest rate, all of which are expected to continue to be supportive in the near-term.
This fall in the risk-free rate suggests to the bank the firming of yields in recent years has not been excessive, particularly when viewed in the context of a falling in yields across all asset classes thanks to a fall in global risk aversion levels. On its numbers the risk-free rate has fallen 230 basis points relative to its 1990s average while both retail and office yields have fallen by less, suggesting risk premiums in the sector have actually risen relative to historical averages.
Add in the fact the labour market has been very strong in Australia in recent years and the likelihood of both economic growth and consumer spending accelerating in coming years leads the bank to suggest commercial property market conditions will tighten further, so additional yield compression seems likely.
As a result, rather than a bubble the bank sees an ongoing strong market with the medium-term showing potential for further valuation gains thanks to tight supply and increasing demand. Longer-term questions remain though as the bank sees potential for the strong returns that have been achieved in recent years bringing additional interest to the market, resulting in additional supply and then a reversal in market values.
Assessing each sector specifically the report points out fundamentals in the office market have improved significantly in recent years as vacancy rates have come down and should fall further given strong employment conditions.
This tightening has driven prices up by more than 10% in the past year, the largest price increase for 20 years, with further gains in both prices and rents considered likely over the next year or two. While such strength may prompt an increase in developments the bank suggests this is unlikely to impact prior to 2010 at the earliest.
Similarly in the retail market the fundamentals look solid for the next couple of years in the bank’s view as building activity in the sector is likely to slow and so limit new supply. One area where growth is likely is regional and sub-regional areas thanks to increased residential construction in growth corridors. The bank expects rents to move a little higher in the medium-term, but this should be covered by stronger retail profits thanks to ongoing high levels of consumer spending.
It is the same story in the industrial sector where the bank sees the strong underlying economic conditions as proving supportive, though it notes the strength of the currency is likely to see a more pronounced shift away from properties suitable for manufacturing to those suitable for warehouses and distribution.
Total returns remain solid as yields are better than in the office and retail sectors and in the bank’s view rents are likely to trend higher in coming years, at which time additional supply currently in the pipeline should come to market and result in a stabilisation phase for property prices in the sector.