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Real appeal 3 - Spotlight on commercial real estate in Australia


This is the final installment of a three-part article series that explores investment opportunities in this environment. It explores opportunities for investors in commercial real estate.


 

The fall in inflation and interest rate expectations over 2016, and continued below average growth in the global and Australian economy prompts an investment thesis that below average economic growth will persist.

Low interest rates have been beneficial for Australian commercial real estate, effectively extending this asset’s class cycle for another year. As long as a recession is avoided, more yield compression is possible in commercial real estate.

From a total return perspective, Australian commercial real estate is expected to remain strong over the next three years, although the rate of growth is likely to decelerate from double digits, as captured in Figure 2.

The strongest return potential is expected from south-east CBD office markets across Sydney and Melbourne and high growth shopping centres that expand to capture market share. Solid returns are also likely in core plus markets such as secondary CBD offices in Sydney and Melbourne, and some suburban office markets that are lagging in the capitalisation rate compression cycle.

Figure 2: Robust outlook for total commercial real estate returns

Over the medium-term, high growth shopping centres (those in strong population growth areas that have been repositioned and expanded) are expected to be the star performers as they capture increased market share of retail spending, which flows through to growth in rents and strong occupancy rates.

The robust Sydney and Melbourne markets are expected to see increased construction later in the decade, which will take some of the rental momentum away as vacancy rates rise, but cities such as Brisbane will be improving, supporting returns in the sector. Figure 3 shows that over a 10-year horizon, there is very little difference in returns across all three sectors: office, retail and industrial.

Figure 3: Returns across office, retail and industrial are similar over a 10-year time horizon

Rental growth has lagged the rise in values, but this will start to redress

Australian commercial real estate values have risen sharply since 2012, but net income growth has lagged due to patchy economic growth, higher vacancies, and some structural adjustments, for example, in the retail sector. Many of those structural and cyclical adjustments are considered to be now bottoming, so the fundamentals for rental growth are likely to improve.

Sectoral performance and portfolio construction opportunities reflect variations in the underlying drivers and are highlighted below.

Retail

The retail sector has undergone a structural transformation associated with growing online competition. Occupancy cost ratios have adjusted in shopping centres and landlords are repositioning malls to combat the online threat.

Portfolios could benefit from a focus on dominant assets and convenience assets, preferably in population growth areas. Expand to capture market share and incorporate all the ‘retail of the future’ insights to manage structural headwinds.

Office

Sydney and Melbourne office markets are next strongest in terms of rental growth outlook, both benefiting from a rise in tenant demand as economic fundamentals improve at a time of slowing construction.

Sydney CBD is on track for undersupply in 2017/18. This market is going to record the strongest rental growth in the country over the next five years. Non-CBD markets are also expected to see above average rental growth in this window also. Melbourne too is heading in the same direction, but not as cyclical which compliments Sydney’s volatility in portfolio construction models. Brisbane is also starting to stabilise with a slow recovery in rents expected over the latter few years of the decade now that construction is slowing in that city.

AMP Capital’s optimisation models suggest a Sydney/Melbourne bias in the short term, supplemented by secure high yield. Models suggest a wider geographic allocation in the medium to long term as Sydney and Melbourne rise on the real estate cycle.

Industrial

Industrial assets in central metropolitan areas that are experiencing gentrification pressure and demand growth from e-commerce related business are also expected to be resilient, outperforming greenfield industrial areas in terms of both rental and land values.

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 to 24 months as the effects of the car plant closures ripple through the supply and support chain.

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.

Portfolios could benefit from investing in good core assets in prime locations close to intermodal hubs and transport interchanges, or more established areas facing gentrification pressures and growth in demand from e-commerce due to their central location.

In a world of low returns and lower interest rates, direct infrastructure and commercial real estate have emerged as compelling asset classes for investors seeking relatively low volatility returns uncorrelated with equities; and opportunities to access growth assets with consistent income streams.

The search for yield is a positive tailwind for commercial real estate, helping to lift prices. Rental growth has lagged price growth but is likely to improve from here.

In a world of low returns and lower interest rates, unlisted infrastructure has emerged as a compelling asset class for investors seeking relatively low volatility returns uncorrelated with equities; and opportunities to access growth assets with consistent income streams.

The lower for longer environment has extended the real estate cycle, and commercial real estate yields will remain relatively high versus most other asset classes. As bond yields appear to be bottoming out, this may moderate future valuation increases in real estate.

 

Funds related to this article: Wholesale Australian Property Fund

An income focused fund providing exposure to a diversified commercial property portfolio of high quality Australian office, retail and industrial properties often only available to institutional investors.

The Fund’s key aim is to provide investors with reliable income and long term capital growth.

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The commercial property opportunity for SMSFs

In today’s volatile markets, investors are considering more stable investment options.

By investing in commercial property you can have access to a diversified portfolio of high quality properties across the industrial, office and retail sectors.

Find out more about AMP Capital's commercial property offering, including benefits and risks.

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