Economic state of play and outlook
Australia’s economy continues its slow re-balancing process, away from the resources sector towards more broad-based economic growth.
Green shoots are tentatively emerging. In particular, recent business confidence and capex surveys are positive for non-mining business investment. Public investment is supportive, with a number of major transport and infrastructure projects, as well as the NBN rollout currently underway.
However, consumer spending is subdued and is likely to remain so for some time. Residential building – which has been a strong driver of growth in recent years – is starting to fall and will be a drag on growth for the next few years.
Critical to the competitiveness of industry is the low exchange rate of the Australian dollar, which is stubbornly stuck around US$0.75, at which point it provides only lacklustre support to export industries and overall economic competitiveness.
On balance, GDP growth is expected to remain below 3% for the next couple of years, with a low probability of RBA cash rate rises before the second half of 2019. It will be the early 2020s before we expect a synchronisation of investment cycles to underpin stronger economic growth.
Australian property is not a uniform investment class
Australia’s commercial property sectors and markets have seen major swings in occupier demand over the past decade, driven by the mining investment boom and bust, as well as the GFC. Soft economic growth in the near term suggests the difference in performance between sectors and regions will continue.
At the same time, investment returns from property over the last five years have been strong – buoyed by a tailwind from falling interest rates and strong demand from offshore investors that have combined to drive yields to record (or near record) lows.
Whilst we expect some further modest near-term firming in yields, a new phase of rising interest rates, even if only gradual, will see yields and prices begin to soften. Asset returns will generally be lower over the next five years, but still favourable when compared to alternative investment options.
Emphasis is increasingly turning to leasing conditions and rental growth as the primary driver of property prices and total returns.
Australia’s major office markets are at different stages of the office cycle, with CBD vacancy rates at 30 June 2018 ranging from lows of 4.6% in Sydney CBD to 19.8% in Perth.
Sydney and Melbourne have strong underlying tenant demand and offer the best prospects for net absorption and tightening vacancy rates over coming years. As a result, they are both now entering a substantial development phase, opening up opportunities for new projects, refurbishment and repositioning.
Both markets will provide good returns over a five-year period, but returns will moderate once new stock comes on-line and begins to change market dynamics.
In Canberra, the A-grade market is tightening rapidly, but high vacancies amongst secondary stock will subdue the overall market recovery. Canberra offers solid prospective returns on both a five and ten-year basis, but this is a two-tiered market with a single dominant tenant and all the associated risks that this brings.
Cities dominated by resources, notably Perth and Brisbane, are likely to improve as the downturn in resources investment continues to run its course.
However, they face a long period of slow incremental improvements to absorb excess stock, and the risk is that more stock hitting the market could delay the recovery, especially in Brisbane.
Despite the variation between markets, investor demand for offices across Australia’s capital cities has been strong, thereby driving a tightening of yields across the board that, in some cities, is at odds with prevailing conditions.
Looking ahead, as interest rates rise, we expect a greater divergence in yields between cities as investors start to discriminate more between markets with strong and weak prospective returns.
In the retail sector, there are concerns about the strength of retail centre income growth and total returns for regional, sub-regional and neighbourhood centres. Weak retail sales growth, the poor trading performance of some retailers, the arrival of Amazon and growth of the online sector generally, mean even large centres run by experienced managers face ongoing challenges.
Industrial property markets are experiencing strong occupier and investor demand, but availability of land is keeping development highly competitive. Recent strong returns have been driven by firming yields, allowing a reduction of effective rents and some rise in land values.
Rising bond rates will reverse all of this, squeezing development feasibilities and leaving returns solid but not spectacular. Industrial property will have trouble meeting some investors’ hurdle rates.
Retail and industrial sectors are experiencing less cyclicality than office markets and returns, particularly from retail, are more stable. For office, Sydney and Melbourne remain the focus on a five-year total returns time horizon. However, with global capital still highly active, new opportunities remain expensive and owners with existing portfolios remain in a favourable position.