Is this the end of the property upswing?

Many equate risk with yield. On that view, the current blow-out in Australian property yields would be viewed as denoting increased risk.

That’s not the way I see it. On the contrary, the softening of prices has reduced risk and presents an opportunity to take a position in assets not available – at least, not at these prices – for years. We know why yields are blowing out. It’s in reaction to the financial crisis and the subsequent credit squeeze, together with the impact on the prices of listed property trusts (LPTs), which are now called real estate investment trusts (REITs).

The discrediting of the securitisation logic that dominated the analysts’ assessment of LPTs until recently has now given way to their call to reduce gearing. And that, together with tightening credit conditions from banks and the decimation of nonbank lending into commercial property, has placed a lot of property on the market, both officially and unofficially.

We think that prime yields will soften by half to one per cent through this year. Most say they will only sell secondary property. But through the long upswing marked by firming yields, the differential between prime and secondary yields has compressed. Now, that will reverse, with investors becoming more concerned with asset quality, so that secondary yields, market by market, will blow out by more than prime yields. Selling secondary properties will involve more of a hit to prices – something that LPTs will not be keen to report.

No – we’ll see a lot of good properties sold before this is over, of a quality not readily available for years. The logic of securitisation was to look for investments that “washed their faces” with yields greater than borrowing costs and positive cash flows – to take secure cash flows and gear them up, to improve return on equity. The analysts weren’t interested in capital gain and they weren’t interested in old-fashioned property investment fundamentals. LPTs had to hide sensible property investments for fear of being marked down in the market for outmoded thinking.

I remember saying at the time that when the market turned those same analysts would turn around and hang the LPTs that had followed their advice. And that’s precisely what they’re doing now. Meanwhile, the inflow of funds reduced yields and, with strong market conditions increasing rents as well, the combination of gearing and capital growth made for a heady mixture.

Pretty soon yields fell below interest costs so that capital growth became essential for returns, contrary to the initial logic of securitisation. But the securitisers were doing fine, taking a fee on the way in and a fee on the way through, with plenty of funds available for investment. They complained that the Australian market wasn’t big enough to satisfy the need for investment property and looked for alternative investments and overseas markets.

Well, it’s big enough now. And it’s the overseas markets that are providing the biggest headaches. But what of the Australian property markets? Australian property markets will turn out to be amongst the least affected of the Western world markets. But in the sharemarket decline, Australian LPTs have been just as badly hit, if not worse. Hence the perceived need to sell assets and the blow-out in yields.

We may not have seen the worst of the impact on LPT prices. Their ability to attract new funds has been curtailed so they cannot continue to pay out capital growth as dividends. As we work our way through the series of dividend reductions that will effectively limit dividends to net rental income, market uncertainty could continue to suppress prices. Markets are short-sighted and fickle.

The news is bad. The trend (“your friend”) is down. Prices are weak. But, to me, the market has overreacted. Gearing may be a problem for some, but many LPTs are quite sensibly geared. And the underlying assets are sound. There may be some setback to net asset backing, but damage for most LPTs will be limited. To me, LPTs are good value now.

I want to be in position when the market recovers. It’s just a matter of when. This has been mainly an investment market phenomenon, not a leasing market phenomenon. The Australian economy remains much stronger than other Western economies, with limited impact from the financial shock, and with the effect of rising interest rates on consumption expenditure offset by the continued strength of investment, both government and private. Growth will slow – a little.

Our problem is inflation, not growth. That means continued strength of demand in the face of limited increases in supply, firm vacancy rates and upward pressure on rents. Leasing markets will, after the current uncertainty, remain strong. In many markets, the impact of softening yields on prices will be offset by rises in rents. Indeed, the latest BIS Shrapnel forecasts show a pause in growth for most markets, rather than the decline many commentators expect.

And we expect a rebound next year! We interpret this whole episode as the shock resulting from the impact of a substantial financial crisis on investment markets, upsetting the normal relationship between the investment and leasing markets. Once that shock has receded, the investment market will return to levels consistent with conditions in the leasing market. That’s not to say that the long upswing will last forever. There will be a downturn – but this isn’t it. It’s just a setback to the upswing.

Indeed, to the extent that it has delayed new development, it makes the upswing longer, and probably stronger. To me, this year is the time to be aggressive about investment. And to the LPTs themselves, they need to be as brave as possible without jeopardising their relationship with their investors and bankers. This cycle still has a way to go.