Countdown to lift-off

Strong returns from commercial property are coming. Frank Gelber says now is the time to lay the foundations.

I’m not looking for anything spectacular in the commercial property markets this year.

That comes later. This is the time to get set.

This year will be solid rather than spectacular. This is when we return to the basics of property. This is the time when we rebuild rental incomes, with price rises conservative, largely underwritten by rent increases.

There won’t be any rate-fuelled inflow of funds driving down yields. Investors are still cautious following the financial engineering boom and the GFC-induced downturn. They were burned by the fall in property prices – particularly those who geared into the market. And, of course, most investment vehicles were themselves geared. The more conservative vehicles have survived, somewhat chastened by the experience but still in reasonable shape.

The banks and the super funds are sitting on their hands. Looking resolutely into the rear vision mirror, they think that property is risky. And those that don’t are afraid to take a position away from the pack. They are keeping a firm hold on the purse strings. Many are still trying to reduce their exposure to property. Fear still rules.

But the horse has bolted. And they’re shutting the stable door, making sure it can’t get back in again.

To me, the risk associated with direct property investment is low, not high. I want to increase my exposure, not reduce it – though I may be a little careful about the investment vehicles that I choose to do it through.

Others, particularly in the property investment management area, are of a similar view. But they are constrained by their ability to convince investors. There is a huge anomaly – read opportunity – in this market.

Certainly, there are major differences between the outlooks for different sectors and for different vehicles. So let me run through a potted summary of my attitude to the commercial property markets. We can talk about investment vehicles another time.

Broadly speaking, we’re faced with a near-term mild oversupply after demand weakened in the downturn. But we stopped building as the tightening of credit in the GFC curtailed development across the board. Funding is only now beginning to return but, faced with prices below replacement cost in most commercial markets, development will be slow to recover. Given the lead times between development and completion of buildings, it’s only a question of time before available supply is absorbed and we enter a period of tight supply.

Short-term, the outlook for property will depend on demand. And that in turn will depend on the economy.

The rebound in the Australian economy following the GFC-induced downturn has stalled.

Households remain cautious, building up their savings. Housing has stalled. Retail sales are still weak. With governments around Australia focused on reducing their budget deficits, strong government expenditure will wind back. The question is whether private investment will come through in time to fill the gap left by weakening government spending.

On the positive side, the strength of minerals prices has locked in the next round of investment – mining will be a primary driver of the economy over the next five years. Later on, that means strong demand for labour, the emergence of labour shortages, wage inflationary pressure, strong rises in interest rates and probably a strong dollar through the middle of the decade. There will be winners and losers, and we need to understand how they will affect the different property markets. But that comes later. We are just at the beginning of that phase.

Over the next year, strong household incomes and balance sheets will underwrite improving consumption expenditure. Housing will take time to regain strength. Mining investment will kick start private investment. But the missing link is an improvement in non-minerals-related profitability.

Our forecasts at BIS Shrapnel are for an economy picking up momentum through the course of this calendar year.

Accordingly, property demand will be solid but not spectacular, picking up as the year proceeds. And that will feed through to property incomes.

This is not a time when we should expect strong capital growth, with investor demand driving down yields. Much of the fall in prices following the GFC was a correction in yields following the overvaluation in 2007 when yields were too high. We should not expect yields to bounce back. That comes later when investors return in force.

Retail property was less affected by the GFC-induced downturn. Certainly, there was a correction in yields following the previous overvaluation, with regional and sub-regional centre prices falling by between 10 and 20 per cent. But retail property incomes remained solid, with some constraint on rents in the downturn but with relatively few insolvencies and property vacancies. Retail sales weakened but, with the strong Australian dollar, margins remained high. Now, retailers are concerned about the weakness of retail sales growth and about competition from Internet shopping.

Generally, the purchasing power of larger retailers cushioned them compared with smaller retailers. And larger, better quality centres gained at the expense of smaller properties. But, by and large, retailer incomes, and hence retail property incomes in the larger centres, remain reasonably strong. Our forecast at BIS Shrapnel is for solid but not spectacular total returns with regional and sub-regional centres averaging around 10 to 11 per cent per annum over the next five years.

Industrial property markets were hit hard by the downturn with prices falling by between 20 and 30 per cent and yields softening by between 1 and 2 per cent. Most of that was a correction in yields following the overvaluation of the boom. Accordingly, we don’t expect any strong rebound in prices arising from investor demand.

For developers, the real pressure was on land prices, which fell dramatically. Even so, industrial property prices remain below re-placement cost. As funding returns and demand re-emerges, we expect rising rents to underpin rises in property prices underwriting internal rates of return in the low teens over the next five years.

Office markets were hit hard by the downturn with prices falling by between 20 and 40 per cent. Some markets panicked, offering extraordinary incentives to secure tenants. But we are past the trough and into the upswing. Demand has started to pick up. Net absorption has increased but, with most businesses still nervous about taking on new lease commitments, there is still a latent demand for additional space. Meanwhile, development was slaughtered during the GFC period. Prices are now probably 20 to 25 per cent below replacement cost lev- els. With little new supply, it won’t take long to absorb excess stock.

Given the long lead times in office developments, this market will overshoot, building momentum into what will become a boom in five years’ time. And I’m using the word “boom” carefully. Our forecasts for the major capital city markets (apart from Canberra which is oversupplied) show internal rates of return of between 16 and 20 per cent over the next five years. That’s extraordinary.

While some risks still remain in the vehicles for holding commercial property, the property risk itself is low, not high. In the boom we were overgeared, overvalued and on the way to being overstocked. The downturn in prices and building took most of the risk out of the market.

Most of the office, industrial and retail markets are, on our forecasts, showing quite extraordinary prospective returns. It won’t happen quickly. It will be slow at first, building momentum only when stock shortages drive up rents and prices and attract investors.

A large part of the reason for the strength of the outlook is that the flight of lenders and investors caused an unwarranted overreaction on the supply side, setting us up for emerging property shortages over the next two to three years and hence for an upswing, building momentum into a boom. I’ve never seen it like this.

To me, there are extraordinary low risk/high return opportunities for medium-term investors. A 15 per cent internal rate of return for this risk is extremely attractive. There may be better returns over the next five years, but I don’t know now what they are. If you do, let me know.

But I do know about commercial property. This is the time to get set, to position for strong returns in two to five years’ time.

Dr Frank Gelber is director and chief economist of BIS Shrapnel.