Is there life after the recent near death experience for commercial property in Australia?
The Reserve Bank pointed out in its latest Financial Stability report yesterday that commercial property remains a concern for the banks with high levels of non-performing loans.
The central bank commented "Conditions in the commercial property sector have broadly stabilised over 2010, with the declines in prices and rents seen in most sectors since 2008 appearing to have run their course."
And the AMP’s chief economist, Dr Shane Oliver says returns are starting to improve as prices rise after a 20% slump through 2008 and 2009.
Over the two years to December last year Australian commercial property values fell by around 20% as the global financial crisis pushed up the cost and availability of debt, the slump in listed asset values in 2008 contributed to property selling to reduce unlisted property weights in superannuation funds and an increase in the supply of property put downwards pressure on rents.
As a result, from their low point in late 2007 average commercial property yields, or capitalisation rates, rose by around 1.4 percentage points (with each 0.25 percentage point rise corresponding to about a 4% capital loss).
This year though the pressure on yields has reversed resulting in modest capital growth for investors.
Selling pressure has abated as borrowing rates have fallen and Australian real estate investment trusts (A-REITs) have recapitalised.
The pressure on superannuation funds to rebalance away from property has faded and some have sought to take advantage of higher yields.
And finally the demand/supply outlook for commercial property has improved along with the economic outlook.
Expect the modest recovery to continue
There is good reason to expect the recovery in commercial property values to continue.
Firstly, the rebound in Australian real estate investment trusts, which tend to lead direct property values, suggests there is more to go in the recovery in the latter. See the next chart.
In fact, thanks to distribution cuts and the rebound in AREIT values, unlisted commercial property now offers more attractive yields than A-REITs.
Secondly, the yields available on Australian unlisted commercial property are now attractive compared to many other assets.
The next chart shows a composite of office, retail and industrial property yields versus an average of government bond, equity and housing yields.
The gap between commercial property yields and other yields remains wide suggesting yields on commercial property are relatively attractive.
This is particularly noticeable compared to residential rental property, as can be seen in the next chart.
In the 1980s the rental yield on housing and commercial property was similar, but today commercial property has a rental yield which is far higher.
In fact over the last few years the average commercial property yield has risen to around 7.2% whereas the gross rental yield on housing has actually fallen to 3.4%.
With Australian residential property over-valued on most measures, this suggests that office, retail or industrial property is far more attractive for investors than housing as it is less dependent on capital growth going forward and less at risk of a correction.
The relatively high level of commercial property yields at the same time that government bond yields have fallen, has ensured that 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 to give a guide to potential total returns and the 10-year bond yield has been subtracted to show a property risk premium.
The property risk premium remains relatively high and is likely to attract investors back into unlisted commercial property over time, particularly as bank and credit market lending spreads narrow further and the availability of finance for property improves in response to increased lender confidence in the property outlook.
Finally, the worst is probably over for property space supply and demand fundamentals and a gradual improvement is likely.
New CBD office supply is in the process of peaking and this combined with an increase in space absorption on the back of the improving economy suggests that CBD office vacancy rates have likely peaked and will trend down over the next few years.
This is very different to the early 1990s, as shown in the next chart.
The retail property construction cycle has been relatively subdued although constrained retail sales going forward in response to more cautious consumer attitudes towards debt and higher interest rates will likely ensure only modest growth in retail capital values. Industrial property supply is one area where growth is likely over the next few yea
