Life is returning slowly to Australian property; not housing, which is doing very well, but the big end stuff, the CBD towers, industrial sites, tourism and other assets in listed property trusts.
But what of the other part of the sector, the unlisted property where many investors have been ‘trapped’ for the best part of two years as managers froze redemptions, values plunged and sales were few and far between.
The AMP’s chief strategist and economist, Dr Shane Oliver sees some glimmers of light appearing for this area.
The past 18 months have seen sharp falls in commercial property values.
Since peaking in late 2007, commercial property values have fallen by around 20% on average – with 25 to 30% falls in office and industrial property and 10 to 15% falls in retail property.
The driver of this slump has been the global financial crisis and the associated economic fallout.
Specifically:
- The credit crunch increased the cost and reduced the availability of debt used to fund property purchases and holdings.
This put pressure on existing owners to sell and led to reduced investor demand;
- Some diversified investors such as superannuation funds were put under pressure to sell unlisted property as their exposure rose in response to falls in share markets; and
- An increase in the supply of property space and reduced demand as the economy slowed put downward pressure on effective rents.
The result was downward pressure on unlisted commercial property values as investors demanded higher yields in order to invest.
From their lows in late 2007, average commercial property yields have increased by around 1.4 percentage points (with each 0.25% rise in yield translating to a 4% loss in value).
Values may be bottoming
However, there is now good reason to believe property values may be at or close to their low.
As can be seen in the next chart, the rise in property yields appears to be slowing.
This reflects a range of factors, in particular:
Selling pressure is abating as the demand from lenders to reduce gearing is diminishing.
This reflects improving credit markets, narrowing borrowing spreads and listed property trusts raising $19bn in equity capital since the start of last year.
Listed property trusts that were potential sellers last year are now potential buyers.
Similarly, the pressure on diversified investors such as superannuation funds to rebalance and reduce their property exposures, which had become inflated by the slump in share markets, has reduced as property values have fallen and share markets have rallied.
- Property demand seems to be improving as investors seek to take advantage of higher property yields.
- Demand for property space seems to be improving as supply is constrained. While demand for industrial space is still soft, the net absorption of office space moved into positive territory in the September quarter consistent with signs of economic recovery.
These considerations suggest that property valuations are likely to bottom in the current quarter.
Expect a recovery to commence next year
There are several reasons to expect a recovery in property values in 2010.
Just as last year’s collapse in listed equities and property trusts led the slump in direct asset valuations, the rebound in listed assets points to a recovery in unlisted asset valuations through next year.
Thanks to their higher gearing and greater liquidity, Australian listed property trusts (A-REITs) dramatically overshot direct property on the upside during the 2004 to 2007 period and thus overshot on the way down during the bust.
Contributing to this was their greater exposure to the US and Europe where the economic and property slump has been much deeper.
In recent years they have been leading direct property by a year or so and are now pointing back up. See the next chart.
While the surge in listed property trust yields led the rise in unlisted property yields last year, thanks to distribution cuts and a rebound in listed property trust valuations, they have now fallen back in line with unlisted yields. See the next chart.
So whereas A-REITs were offering much better prospects than unlisted property at their low point in March this year, this is no longer the case and it is harder to distinguish between the two asset classes in terms of their return prospects, particularly on a five to ten year outlook.
Secondly, Australian unlisted property offers an attractive yield premium over other assets.
The next chart shows a composite of office, retail & industrial property yields versus an average of government bond, equity and housing yields.
The gap between commercial property yields and other yields has blown out; suggesting yields on commercial property are relatively attractive.
In particular the back-up in commercial property yields over the last two years, at the same time that government bond yields have fallen, has ensured the property risk premium has remained high.
The next chart assumes constant property rental and capital growth of 2.5% p.a.
This has been added to the composite non-residential property yield and the 10-year bond yield has been subtracted to show a property risk premium.
