What are we to make of the current setback to non-residential property markets? Can they recover from a major external shock or is that shock just the catalyst for what would have been a market downturn anyway? Does it mark the end of the boom and the beginning of a long bear market? Or is it just a setback in the upswing? Are all the non-residential markets the same or should we take a different approach in dif­ferent markets?

Let’s take a step-by-step approach to what’s happening to property markets.

The external shocks have three elements.

Firstly, the collapse of the US subprime loans market, commercial mortgage-backed securities and interbank lending in the United States is having an impact on world financial markets and affecting the ability to fund property investment and development.

Secondly, the setback to sharemarket prices in the US and throughout the world has particularly affected finance and property markets.

And thirdly, the sharp US downturn/reces­sion is threatening economic conditions in other countries, particularly Europe.

In dealing with these, I’ll focus on the impact on property markets. Let’s start with the last item first.

Australia’s problem is not growth but inflation.

Australia will, to a large extent, be insulated from the impact of weakening world growth initi­ated in the US.

Strong business investment, led by mining investment, is driving strong growth. GDP growth is currently around 4 per cent and running above the capacity- and labour-constrained speed limit of 3 to 3.5 per cent. Employment growth is currently 2.8 per cent compared with a non-inflationary rate of around 2 per cent.

The resultant inflationary pressure is putting pressure on interest rates. The collateral damage is continued suppression of recovery in the under­building and understocked housing markets leading to strongly rising rents. Strong employment and wages growth continue to drive strong household disposable income. It is still too early to tell whether the last dose of interest-rate rises has done enough to contain demand. We think inflation will prove more intransigent, requiring more interest rate rises by the end of the year.

The economy will slow through the course of the year as interest rates impact on consumption expenditure, but growth will soften towards a sus­tainable rate rather than enter a major downturn.

The shock to financial markets has affected the ability to finance property investment and development in Australia, with a major impact on listed property trust (LPT) prices.

The US-initiated credit squeeze is affecting Australia’s ability to finance domestic lending. Australia needs to borrow offshore to finance the current account deficit. In recent years, banks have become the main conduit for satisfying this borrowing requirement. While traditional sources have dried up, the interest-rate differential and the strength of the economy have cushioned Australia from much of the effect of the credit squeeze so far.

Further, some corporates are now borrowing directly overseas, reducing the borrowing require­ment through the banking system. But the financial system remains nervous and cautious. We still don’t know how bad the credit squeeze will be or how long it will take to ease. Meanwhile, competi­tion between banks for Australian funds is raising market rates above normal margins with RBA-determined cash rates. Non-bank lenders are being squeezed for funds and some have left the market, while bank lenders are tightening credit risk criteria and becoming more selective about clients. The emphasis has shifted from book growth to credit security. And interest rates for all property clients have risen.

The fall in sharemarkets around the world, including Australia, has particularly affected financial equities and LPTs.

The initial shock to Australian LPT prices came from an inability to refinance an overseas portfolio – the Centro shock seems so long ago now – but quickly spread through the whole sector. The fall in equity prices cut off the ability to raise new equity funds and put pressure on LPTs to reduce gearing by selling assets. And LPTs own a major chunk of the Australian property market nowadays.

The property investment market has shifted from a seller’s to a buyer’s market.

The volume of property for sale will lead to a blow-out in yields. This process has already begun. But the reluctance of buyers waiting for the market to finish falling has led to a mismatch between buyer and seller expectations and a very low volume of sales. And it’ll take a long time for valuers to confirm. The problem is that we don’t really know how bad the yield blow-out will be. There is no real precedent for an episode of this type and mag­nitude. The BIS-Shrapnel forecast is that prime yields for commercial industrial and retail property will soften by half to 1 per cent this calendar year. Secondary properties will soften by more.

The anomaly is that leasing markets will remain strong.

The strong economy, strong demand and con­strained supply will continue to underwrite rising rents, cushioning the impact of softening yields on prices. While there may be a slight pause in forward leasing demand because of the current uncertainty in the economy, that will evaporate in the face of continued strength.

The strength of leasing markets means that, after the setback this year, property prices will rebound next year.

Our experience over many cycles is that leasing market conditions drive property market condi­tions. The investment market setback is being driven by a financial market shock. Once the credit squeeze is over and the backlog of properties for sale is absorbed, property sales markets will rebound to levels determined by the underlying leasing market conditions.

But, medium term, we’re coming towards the end of the cycle.

In many markets the cycle will turn within the next five years. Even with sustained demand, and even with some setback to development associated with tighter credit conditions, we’re on the thresh­old of the period of overbuilding. The question is: by how much? What will be the extent of oversup­ply? And how long will it take to absorb? And that means we need to think long, not short, carefully working our strategy towards the shape we want in five years’ time.

Five years from now the cycles will have turned.

The Melbourne, Brisbane, Perth, Adelaide and Canberra commercial markets will have turned down. Only Sydney commercial will remain strong because it will have missed the excesses of the cur­rent commercial boom.

The industrial market boom will have ended with no more firming yields to come to the rescue and an end to the phase of demand associated with strong business investment.

Retail property will remain reasonably solid, although here too there will be no further firming of yields to drive prices.

The residential cycle, currently waiting in the wings, will take over as the primary driver of growth.

The current financial-market-driven setback and the impact on confidence in lending provide an extraordinary opportunity to take a position in markets. But we should avoid short-term gain, rid­ing out the end of the current cycle, and use this as an opportunity to position into the next cycle.

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