There is no golden rule stating that property markets need to be synchronised; in reality they rarely are. A notable exception was the synchronised boom and bust of the 1980s and early 1990s. Since then, we have experienced rolling investment cycles which appear likely to continue for some time into the future.
Achieving outstanding property returns can look deceptively easy. How often have we seen newspaper headlines where some investor or developer has made squillions? What these articles omit is that the returns were the result of a lot of hard work over the preceding three to five years and that the returns were set up by a brave decision – usually contrary to conventional market wisdom – which incorrectly priced the asset.
Conventional wisdom is usually an extrapolation of current circumstances. But in a cyclical market such as property, such extrapolations rarely last more than a few years and sometimes are much shorter. The key is to understand, sector by sector, where we are in the cycle in order to understand the direction and the magnitude of the next cyclical swing.
At BIS Shrapnel we focus on the medium term; the next stage of the cycle. We look at the underlying logic of the different players in the market – investors, developers, tenants and financiers – to understand how they behave in given market circumstances. We use this information to trace the consequences of that behaviour and to understand how that leads to changes in market circumstances.
We focus on counting, and forecasting, demand and supply of property. Once we understand leasing market conditions, we have a pretty good handle on rents, and hence property yields and values. And that has been an extremely reliable medium-term tool for understanding sustainability and the direction and magnitude of cyclical swings.
State of Play
Recent hiccups in financial markets, resulting from the US sub-prime mortgage market fallout, have introduced uncertainty, causing many to question prospective returns in property markets. But those events will have little impact on the real side of the Australian economy and they will soon be forgotten.
Of far greater importance is the resurgent growth in investment in Australia which will underwrite continued strong growth through 2008. This will ensure strong demand in property markets; for office space, for consumer goods and for industrial space. On the negative side, however, the overvalued dollar is affecting demand for tourism facilities, with overseas tourists preferring better value-for-money destinations than Australia and more Australian tourists going overseas. Worse, strong economic growth in the face of skilled labour shortages will heighten demand-inflationary pressure and put pressure on interest rates, thereby affecting housing markets.
Commercialproperty, the new darling of the investment community, is performing strongly. Strong demand (particularly in the minerals boom cities of Brisbane and Perth), in the face of insufficient supply, is leading to tightening vacancy rates, rising rents, firming yields and rising property values. We’re now getting to the stage of strong increases in construction commencements, but that supply will only come on stream in two to three years time. The upswing has further to run.
Industrialpropertyhas performed strongly over the last few years, with demand boosted by investment in Australian industry sectors, and particularly in new warehousing. It will continue to perform well while the investment boom continues, but will be affected by a downturn in investment.
Retailpropertyis not performing to the stellar heights of the last 15 years when firming yields drove property returns, but the prospect of continued strong consumption expenditure and healthy retail margins is helping the income side of the equation. Retail property won’t do as well as commercial over the next few years, but is not as cyclical and should form a mainstay of a property portfolio over the long term.
Despite the dampening effect on demand from an overvalued dollar, hotels will perform strongly over the next three to four years as not enough are being built. Rising occupancy rates are leading to rising room rates – a double whammy on revenue per available room night – firming yields and rising property values. Despite the conventional wisdom that nobody makes money on hotels in Australia, there’s a boom coming.
On the Home Front
Residential property is the ugly duckling at present. Since the peak of the housing price “bubble” at the end of 2003, when housing prices fell or stalled and construction weakened, prices have drifted. Only Perth missed the downturn, but has turned down recently.
The problem is that not enough housing is being built in Australia, with construction well below the underlying demand and the deficiency of residential stock becoming more extreme year by year. We calculate an underlying demand of over 180,000 dwellings per annum compared with commencements this year below 150,000. The cumulative deficiency of stock will increase from 60,000 now to 100,000 in a year’s time.
Is it safe to come back into the housing market yet? Probably, but there’s no hurry. Rising interest rates and the threat of further rises are suppressing the upswing. Indeed, there’s a possibility that interest rates could do damage to prices. Meanwhile, investors find yields too low to be attractive without the prospect of capital growth, while tightening leasing markets are driving rent rises. Something has to give.
We are setting up the preconditions for a strong upswing once pent up demand is released. And, given the determination of some state governments to recoup infrastructure costs for new residential lots, it will take a significant rise in housing prices to bring enough lots and sites on stream to underwrite the required increase in construction. If you think affordability is bad now, just wait – it will be a lot worse in five years. The current delays to the upswing are like keeping a lid on a pressure cooker. Once released, the housing market will build momentum into what will become a boom.
As you may have noted, I am tactical rather than strategic in my approach to property investment. In a cyclical market, you have to be. The best returns are set up early when prices are undervalued, before the upswing really starts. The returns come from capital growth through the upswing, as yields are too low to be attractive by themselves. But staying in a market too long is risky. Although returns can be strong near the peak of the cycle, it is painful being caught in a downturn.
It’s easy to get caught up by the conventional wisdom. The best way through the convention is not necessarily the popular thing; and it requires a little research.
Dr. Frank Gelber is Director and Chief Economist of BIS Shrapnel.