Head of Property Investment Strategy
The fall in broad inflation and interest rate expectations this year is beneficial for commercial property, effectively extending the favourable part of the economic cycle another year.
Lower short-term inflation and interest rate expectations, driven by continued below-average growth in the global and Australian economy has seen the “lower for longer” trajectory for interest rates extend further than was the outlook nine months ago.
This is highlighted in the AMP Capital’s Investment Strategy Team’s forecast for 10-year bonds highlighted in red (figure 1). The previous forecasts in September 2015 are in green.
Figure 1: Interest rate outlook falls further
Source: AMP Capital/RBA
Note: Fair Value Index derived from real policy interest rates (i.e. the cash rate less the RBA CPI target), real GDP growth and implied inflation expectations
Three possible positives
For commercial property, this outlook suggests three positive developments:
- There is scope for the current environment of double-digit returns to continue in 2016 and possibly into 2017 as more yield compression is possible.
- The period of adjustment for interest rates has extended another year, so the possible impact on property values is pushed out until 2019/2020.
- An extended cycle effectively means the sector has slipped from 11 o’clock on the cycle, back towards 10 o’clock. We believe recent developments mean the market has slipped, rather than being stuck at ten minutes to midnight. The latter view could be supported if Australia fell into recession, if there was a sharper than expected rise in bond yields, or if there was another calamitous global event that destabilised listed real estate markets.
How do we see these developments playing out over the next five to 10 years? We expect a number of developments:
- Retail: Over the next 10 years, we see the strongest rental growth from regional shopping centres that can expand to capture market share. These shopping centres must be in areas of strong population and income growth.
- Office: The next strongest growth outlook will come from Sydney and Melbourne office markets, in our view. We see both markets benefiting from a rise in tenant demand as economic fundamentals improve at a time of slowing construction.
The Sydney CBD is on track for undersupply in 2017/18, and we believe this market is going to record the strongest rental growth in the country over the next five years.
- Warehouses: Industrial assets in central metropolitan areas are seeing gentrification pressure, while growth in demand from e-commerce related business is expected to be resilient, outperforming greenfield industrial areas in terms of both rental and land values.
- Development: The lower for longer environment is allowing developers to be more competitive with pre-lease rents, holding back potential growth in market rents in the land rich greenfield suburbs in the industrial market.
- Downside risk: At the other end of the spectrum, there is still downside risk in Perth with weak economic fundamentals expected to persist into 2017. Weak conditions are expected in parts of the industrial market in Melbourne and Adelaide over the next 12-24 months as the effects of the car plant closures ripple through the supply and support chain.
Our portfolio construction is biased towards expanding high-growth retail malls, Sydney/Melbourne office markets, and introducing options such as the Brisbane CBD and Canberra office markets, which are lagging on the rental cycle but will start to improve progressively over the next two to three years. As a result, we are well placed to deliver a lift when it may be needed later in the decade.
For this reason AMP Capital has been proactive on improving the quality of its office, retail and industrial portfolios by selectively disposing assets that are not well positioned to deliver that growth in the medium term.
What are the risks?
What risks could upset the apple cart? Some of the major ones are an offshore event, global recession and geopolitical flare-ups.
Real estate-specific risks centre more around overdevelopment and overpricing. Most of these would have a medium-term impact which is why we favour core defensive assets such as regional shopping centres and prime CBD office towers.
The recent volatility in bond markets is a sign that interest rates are bottoming out. This could cause some instability in listed markets if there is a sharp repricing, but the absence of inflationary pressures and ongoing patchy global economic momentum suggests this could breed bouts of short-term volatility, rather than a large upset in the short term.
Another risk to Australia is the momentum in the Chinese economy. There is downside risk due to local debt issues and a slowdown in the Chinese economy would not be good for our export sectors.
Slower global economic momentum is also a risk because it could find its way to Australia, although our strong population growth, a relatively low Australian dollar and low interest rates would help offset some of the impact.
Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.