As the financial crisis came to a head over the last four months, the severity of the credit squeeze escalated damage to the real side of economies around the world, including Australia. Economic forecasts from the RBA, Treasury, the OECD, the IMF and BIS Shrapnel, amongst others, have all been revised downwards.
And that has changed the timing and magnitude of the cycle in Australian office markets. It has weakened demand and brought forward the property downturn before excessive construction had a chance to cause significant oversupply. In that sense, the financial crisis has done us a favour.
Was it only last year that Australian GDP growth was 4 per cent – well above the speed limit determined by capacity and skilled labour constraints, with the consequent demand-inflationary pressure leading the RBA to tighten monetary policy in an attempt to reduce demand. They raised interest rates by a full percentage point in the lead-up to April this year, with the consequent collapse in consumer and business confidence affecting consumption expenditure, business spending and housing investment.
Meanwhile, in retrospect, the financial crisis was relatively moderate in the first half of 2008. While the sharemarket fell dramatically, credit remained reasonably available at a reasonable price, albeit subject to tighter credit criteria. The credit squeeze did not eventuate to the extent that banks feared. While the current account deficit meant Australia had an overseas borrowing requirement, many Australian companies borrowed directly offshore. Incidentally, those who borrowed in the “carry trade” – that is, in foreign currencies – have paid a heavy price.
As the financial crisis came to a head in the last three months, both the cost and availability of credit tightened significantly while the sharemarket collapsed around our ears.
That had a profound impact on the listed property trusts (LPTs) that now own most of the institutional grade property. The fall in their equity prices and pressure from their bankers put them under extreme pressure to reduce gearing. The banks went into risk avoidance mode and tightened credit criteria, including tougher pre-commitment requirements to secure funding of interest payments and lower loan-to-value ratios (LVRs) to protect them against falls in property values. Investors at the time were reluctant to commit further equity, penalising the share prices of companies who tried to raise it. And at the same time, some of the LPTs who had switched from project finance to balance sheet funding threatened to trigger their loan covenants.
The pressure to sell assets has intensified. With few buyers and many sellers, yields have begun to soften and will soften further before this is over. Meanwhile, valuations are lagging the process with few sales on which to base valuations. Most of the properties on the market will not be sold. But, given the pressure on some LPTs to sell assets, those that are sold will be at reduced prices.
Now, with little alternative, we’re starting to see some equity funding, albeit at much lower share prices. The irony is that, while investors don’t like it, that funding reduces the risk, both for the LPT and the investors themselves.
Many of the LPTs have development businesses attached and require project funding. And the banks are squeezing credit, particularly for non-residential property. They will roll over funding or fund development projects that meet their tighter criteria, but often with the proviso that the LPT reduces overall gearing.
Project finance has become a whole lot tougher. Not only do projects need to gain greater pre-commitment, but more equity is required; higher yields mean that they would require a higher level of rents for financial feasibility and, in any case, there is no take-out for the end product. In some cases, the scale of project has been reduced. Many projects have been delayed, deferred, shelved or just plain cancelled. Projects already commenced are being completed, but this situation has made a huge dent in the next round of projects.
Just in case this sounds like a tale of doom, there is a positive side.
BIS Shrapnel’s pre-financial crisis forecasts were for a boom and bust in office markets. Had the cycle been allowed to run its course, had construction continued to increase, most office markets would have been substantially oversupplied and turned down sharply within five years. The exception was the “basket case” Sydney market where weak demand and insipid development meant that Sydney missed the upturn. The strength of the cycle, particularly in Brisbane and Perth but also in Melbourne, meant substantial oversupply, requiring a long period of stagnation to absorb the excess capacity created during the boom. We were headed for a classic cycle.
For a while, I thought that a relatively mild financial crisis with little impact on demand would allow a quick rebound in office markets. That setback/quick rebound scenario would merely have delayed the cycle with a similar boom/bust outcome, again missing Sydney but nipping the Melbourne cycle in the bud. Recent events make that unlikely.
As it is, the heightening of the financial crisis and the credit squeeze over the last three months have caused a sharper setback to investment and have adversely affected the real side of the economy. Effectively, it has caused a premature downturn in the property cycle before it had a chance to gain momentum. It means a much more moderate cycle with limited damage and the current weakness in effect underwriting a solid recovery three or four years hence.
The recent escalation of the financial crisis has damaged the real economy. While I suspect that the worst of the credit squeeze has passed, damage to the banking system means that there is still a recession to come in the US, the UK, Japan and parts of Europe. While Australia is experiencing effects through trade and the overseas borrowing requirements, banks remain financially sound and the economy is largely sheltered. While some are bearish, my feeling is that Australia will not go into recession. Unemployment will rise but there will not be the wholesale loss of jobs and financial difficulties for households that I regard as a recession. Once households realise that their jobs are safe, they will start to spend again. The lower dollar will boost the tradables sectors. Growth will be lower, but it needed to be.
For office markets, the impact is on the demand side, with weaker growth, employment, office employment, demand for and net absorption of office space. No longer is this a pure investment market phenomenon affecting yields but not rents. Lower demand means a moderate rise in vacancy rates in most markets leading to some, though limited, rises in incentives and falls in rents. Property values will fall, but not by enough to trigger significant losses by banks. This is a moderate softening in property markets, which will take two to three years to absorb.
On the supply side, the setback to the current round of projects will run into softening leasing markets – enough to prevent a quick rebound in office markets and office development. That will delay the upswing until vacancy rates come down and rents again rise. It will take between three or four years, depending on the market.
Interestingly, we’re witnessing a similar phenomenon in the minerals sector where falls in commodity prices are undercutting financial feasibility of more marginal projects and financial constraints are causing the cancellation of some projects. Here, however, I am much more concerned about the next round of projects and the impact on minerals investment and, given that they’ve geared up for high levels of investment, the cities that service that investment.
What I am describing in the office markets is the financial crisis causing a weakening of demand, a softening in leasing markets, forced sales in investment markets and a moderate downturn in property values.
The worst cycles come from the supply side. This is nothing like the oversupply-induced downturns in some overseas markets. In Australia, it is nothing like the 1989 boom/bust.
In a sense, the financial crisis has done us a favour by nipping the upswing in the bud before we had a chance to substantially oversupply office markets. Had the cycle run its course, we would have.
As it is, we’re beginning a premature and moderate downturn, more like a setback to the upswing, with a weakening in leasing and investment markets, and with the correction to supply underwriting a quick tightening in leasing markets and a resumption of the upswing three or four years hence.
