Chasing yield: outlook for commercial property
There has been a continual compression of capitalisation rates across Australia’s commercial property markets.
Australian commercial real estate is seeing high levels of sales activity, as investors chase yield in a lower growth, low interest rate world. According to JLL Research, $27 billion of major sales have transacted over the past 12 months. Capitalisation rates – the rate of return on an investment property based on the net operating income and its market value – are compressing. This is being led by the industrial sector where some sub-markets have already matched or exceeded their 2007 peaks. In this article, we explore where the property market is now and where we are headed in the next couple of years.
In a lower growth world, the chase for yield will likely continue for a little while longer
Figure 1: Property market yields (average prime)
Source: AMP Capital
Looking forward, our view is there is at least another 12-18 months left in the chase for yield (and capitalisation rate compression). This is because:
- The outlook for Australian economic growth is expected to be tepid in the short term (but not recessionary) which will continue to support investor preference for yield as the growth environment will remain sluggish. We expect Gross Domestic Product (GDP) growth of around 2-2.5%pa in the short term, with a gradual pick-up towards the end of the decade. At a global level, the International Monetary Fund (IMF) had also downgraded its global economic forecasts due to a weaker Chinese economy despite improvements in the US.
- Real estate looks attractively priced relative to other asset classes. Despite recent capitalisation rate compression, the spread in yields to bonds still close to historical wides.
- There is a possibility that interest rates may fall further if Australian or Chinese economic growth deteriorates. Core inflation is running towards the bottom end of the Research Bank of Australia’s 2-3% target range giving it room to decrease interest rates further to stimulate the economy.
- Australia’s higher running yields continue to attract foreign investors despite worries over the end of the mining boom and an overheated housing market in Sydney and Melbourne. The fall in the Australian dollar is also making Australian property more attractive for foreigners as they gain positively on the currency shift. That is, they can now get more ‘bang for their buck’ compared to 2-3 years ago; and
- Real estate debt is highly accretive to property income yield at the moment, thus there is the prospect that the leveraged buyer will also return, setting new price benchmarks.
What about capitalisation rates?
As highlighted in Figure 1, we expect capitalisation rates to fall further in 2016, with overall sector averages matching the 2007 peak. However popular assets and markets such as trophy assets, assets in markets with improving rental growth prospects and those with secure high yield (where leverage is most accretive) are likely to see capitalisation rates fall below their 2007 peaks, as we have seen in many overseas markets. The largest shifts are expected to occur in those sectors that have lagged in the compression cycle to date with improving fundamentals such as regional shopping centres and Sydney/Melbourne office (prime and secondary).
Capitalisation rates will stabilise or start to increase when the outlook for economic growth and inflation starts to improve, thawing ‘the chase for yield’ sentiment. At this stage, this looks likely around 2017. While there is still some capitalisation rate compression left in the market, property values are now sitting up around the 10-11 o’clock position on the cycle. This is a less attractive entry point for buying into real estate unless assets have strong rental growth prospects or some form of repositioning to alternative uses.
The movement in capitalisation rates to date has propelled the total return for the Australian commercial real estate market upwards into double digits and we expect this to continue until capitalisation rates bottom. Over the next three years we expect prime returns to average 9.5-10%p.a. across the sectors. Stronger returns are expected in the markets mentioned previously with greater prospects for capitalisation rate compression and improving rental growth prospects such as the non-resource state office markets and the high growth regional and sub-regional shopping centres.
4 things that could upset the applecart
- A recession: Not out of the realm of possibility but in our view a low probability as there is considerable momentum building in the NSW and Victorian economies which will counterbalance the effects of deteriorating fundamentals in resource linked sectors of the economy. Automatic stabilisers such as a fall in interest rates and the Australian dollar are also likely to be supportive for the non-mining economy.
- A sharp or sudden rise in interest rates in the United Sates (US): This causes volatility in bond markets which unsettles confidence and flows through to volatility in sharemarkets, reducing the capital available for alternative asset classes, commodities and emerging markets. China selling US treasury bonds to stabilise their financial situation is a risk that needs monitoring.
- A large fall in international real estate prices: International commercial real estate markets, particularly gateway cities, experienced steep capitalisation rate compression following 2009 with investors chasing secure cash flows and yield. Capitalisation rates are now well past their 2007 peaks. Australia has lagged the global repricing of yield (but is now catching up) but an ill-considered response to US interest rates and an overreaction in the bond market causing a larger than expected rise in bond yields could unsettle asset pricing (and sentiment for real estate);or
- An earlier-than-expected slowing of the chase for yield: This is possible from as early as mid-2016 if China and commodity prices stabilise, the US continues to strengthen, and the rise in US interest rates doesn’t cause too much downstream instability for investment markets.
About the author
About the author Michael Kingcott is the Head of Property Investment Strategy and Research at AMP Capital leading commercial property research and investment strategy.