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The outlook for commercial property


Expect a fascinating three to four years in real estate given a raft of global economic and investment cross currents and challenges.

 

At the moment low interest rates are driving strong investor interest for commercial real estate assets due to the high yield on offer compared to bonds and term deposits. But as the economy slowly starts to build momentum over the latter years of the decade, interest rates and discount rates will slowly rise as growth and inflation returns to a more normalised setting.

Our analysis reveals there will not be a uniform impact when the interest rate curve shifts. At a sub-market and asset level, it will depend on where values are priced relative to the level of earnings growth for that market or asset and how accretive debt is to the yield at the point in time.

 

The sub-markets and assets that are best placed to cope with a rise in discount rates later in the decade are markets such as the Melbourne and Sydney CBD commercial property markets. Assets in these markets have the strongest rental growth prospects over the next five years. Other assets that are likely to be resilient are those seeing a rise in underlying land values, because of factors such as gentrification or stronger occupier demand.

Our analysis reveals there will not be a uniform impact when the interest rate curve shifts. At a sub-market and asset level, it will depend on where values are priced relative to the level of earnings growth for that market or asset and how accretive debt is to the yield at the point in time.

The sub-markets and assets that are best placed to cope with a rise in discount rates later in the decade are markets such as the Melbourne and Sydney CBD commercial property markets. Assets in these markets have the strongest rental growth prospects over the next five years. Other assets that are likely to be resilient are those seeing a rise in underlying land values, because of factors such as gentrification or stronger occupier demand.

However, in our view there is a high probability of a negative impact on values in the following instances:

As mentioned at the outset, the dynamics of the global economic environment and consequent challenges make for uncertain times for real estate and all asset classes. In the short term, the chase for yield is a positive trend but is pushing prices ahead of rental growth, which could cause a risk for low rental growth assets when interest rates rise.

Quantitative models confirm our observations the market is rising up the pricing cycle and now is the time to capitalise on the weight of money and position funds and assets for volatility and structural headwinds in the medium term. These are the following strategies we are enacting to manage this medium term risks.

  1. While the chase for yield is still in place we are selling second-tier assets. These assets include those where value-add can no longer be extracted, or those assets that will not comfortably ride the next part of the cycle because of either cyclical timing, or structural changes, such as industrial and second/ third tier discretionary sub-regional shopping centres.
  2. We are recycling this capital back into improving the experiential 24/7 appeal of core assets to ensure they can ride both this adjustment in pricing and long-term thematic changes ahead, for example our clients’ regional shopping centre portfolio.
  3. We are being circumspect on acquisitions and asset pricing at this point in the cycle. This means still maintaining a strategy of acquiring super prime assets or those that are going to benefit in the medium term from shifting themes such as gentrification and technology disruption, but disregarding those assets that are unlikely to be able to generate sufficient returns later in the decade.
  4. Portfolio construction models are clearly picking up the risk of capital rate adjustment and value loss/stagnation potential later in the decade. At the moment, the models are reducing exposure to industrial assets and are being more biased to high growth retail and office assets. Looking forward through the cycle, the optimal portfolio is progressively tilting towards high growth retail assets the lower cap rates, given this asset type’s proven defensive characteristics during periods of weakness. Our medium term portfolio construction bias is thus to high growth retail assets.

While SMSF investors generally don’t invest directly in commercial property assets, they do have the opportunity to gain exposure to this asset class by investing in managed funds and trusts. It’s therefore wise to understand the dynamics of the market to be able to make an informed investment decision.

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.
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