The big rumour on the market at the moment is of a possible deal between the acquisitive Stockland and GPT, once the latter frees itself from the clutches of the strained investment bank, Babcock and Brown.
If it happened it would be pitched as a ‘merger’ not a takeover to try and avoid either group overpaying for the other in a market that is very suspicious of leveraged investments.
It would be portrayed as an industry consolidating move at a time when confidence is needed in commercial and retail areas.
The credit crunch is pushing up yields on unlisted office, retail and industrial property.
But the downside in Australian unlisted commercial property values is likely to be limited by relatively good demand/supply fundamentals and more conservative pricing than has been evident overseas.
But, expect unlisted commercial property returns to slow substantially.
The AMP’s Chief Strategist and Economist, Dr Shane Oliver says shares, including LPTs, are likely to provide better returns over the next year or so.
Last year saw direct (or unlisted) commercial property funds – office, retail & industrial – return around 21%.
By contrast Australian listed property trusts (LPTs) lost 8.4%, their worst calendar return ever.
In fact, from their high in February last year to their low last month, LPTs fell 41% in value in response to the impact of the global credit crunch.
The big issue is to what degree the fall in LPTs presages falling commercial property values.
Anyone who thinks unlisted property values can’t fall doesn’t remember the early 1990s when they fell for three years in the aftermath of a building boom and recession – see chart above.
Reasons for concern
Returns from directly held office, retail and industrial property in Australia accelerated over the last few years on the back of strong growth in rents (reflecting tightening underlying supply and demand conditions) and investors being prepared to buy buildings on lower yields (i.e. the ratio of annual rents to property values).
The global credit crunch and worries about a US led economic downturn suggest that unlisted commercial property yields are now on the rise:
• The credit crunch has increased the cost – and cut the availability – of debt used to fund property purchases.
This hasn’t been helped by rising cash and bond yields;
• Pressures to reduce gearing levels are leading to forced property sales (such as Centro, Allco, MFS);
• Moves by industry super funds to cut direct property weights inflated by falls in shares could add to selling; &
• Economic conditions are likely to deteriorate leading to lower demand for property space causing weaker rents.
Indications for the March quarter are that unlisted property yields rose about 0.25%. (At current yields each 0.25% rise in yields means a 4% fall in values if rents are unchanged.)
But reasons not to expect a re-run of the early 1990s
Several factors suggest investors should not be too worried. Firstly, the fall in unlisted property yields in recent years was largely justified by the fall in inflation from the 1980s which had pushed down interest rates and income yields for bonds, shares, LPTs and housing.
The previous chart shows a composite of office, retail & industrial yields versus an average of bond, equity and housing yields. In the 1980s the two lines were close, but a large gap arose which only in recent years started to close.
Secondly, while Australian bond yields rose in the last two years, directly held non-residential property still offers a satisfactory risk premium over bonds. The next chart assumes constant property rental and capital growth of 2.5% pa. This has been added to the composite nonresidential property yield and the 10-year bond yield has been subtracted to show a property risk premium.
While the excess return expected from commercial property over bonds has declined, it is far more attractive than prior to the early 1990s slump in property values.
Secondly, while there is some evidence that LPTs lead direct property, LPTs are very volatile. As evident in the next chart, movements in LPT distribution yields have been far more extreme than the yields on offer for unlisted commercial property.
This has seen LPT share prices trade wildly around the value of their underlying buildings. In fact, LPT’s 5.1% yields a year ago saw them trading at a greater than 20% premium to the underlying value of the properties they represent.
It’s also likely that currently reported distribution yields for LPTs of around 7.5% based on historic distributions will exaggerate actual yields as some trusts have cancelled or cut distributions to reduce debt.
So while the rise in LPT yields suggests upwards pressure on unlisted commercial property yields, their recent rise is likely to exaggerate the actual pressure.
The low rental yields on residential property suggest that it is particularly vulnerable – but that is a separate story.
Third, space demand/supply fundamentals are good versus the early 1990s. For example, the supply of new office space
