William Buck New Zealand
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By CHRIS RYLANDS
RESEARCH MANAGER, WEALTH ADVISORY
In this update we will take a closer look at what has driven demand in the sector and how the current market compares to other historical points in the commercial property cycle. It is extremely difficult for anybody to call a turning point or top in a cycle. However, considering the current environment from a historical context can provide some guidance going forward.
Low global interest rates have caused many investors to consider alternative asset classes to satisfy their income needs. Commercial property has been a primary beneficiary of this theme due to its steady income profile. The sector also appears less volatile than other asset classes because it is unlisted and not subject to the same level of volatility as listed equities.
The Australian commercial property sector is particularly attractive to foreign investors as overseas interest rates are generally lower than Australia. This makes the yield on Australian commercial property quite attractive. Lower overseas interest rates generally allows an offshore buyer to borrow more at a lower cost and therefore pay more for the property.
Foreign investors have been the main driver of commercial property price appreciation in recent years. Fund Manager Folkestone concluded that foreign investors accounted for over 50% of Australian non-residential transactions during the 2015 calendar year.
Australia is also particularly attractive to foreign investors due to its stable political system and transparent capital markets. The fall in the Australian dollar has also made Australian commercial property comparatively cheaper for offshore investors.
A key measure to consider when valuing a commercial property is the capitalisation (“cap”) rate. In simple terms, the cap rate reflects the net income on the property divided by the value of the property. Therefore the cap rate reflects the net yield on property after the payment of all expenses. Below is a simple cap rate calculation on a property:
As demand for commercial property increases the price goes up, which in turn compresses the cap rate lower. The cap rate can fall even if rent or expenses remain the same. The compression in the cap rate is caused by a new buyer willing to pay above the previous property price to set a new valuation benchmark.
The following example shows the cap rate decreasing from 7.00% to 6.63% because a new buyer is willing to pay 10.00% more for the property.
A top in the cycle usually occurs when cap rates stop falling and then start to increase. This is caused by a new buyer who is unwilling to buy a property for sale because the yield is too low or the price is too high. Both these issues are essentially different sides of the same coin.
The chart below shows commercial real estate cap rates over the last 10 years compared to the Australian 10 year bond rate. The commercial property sector is generally broken up into three key sub-sectors: office, industrial and retail.
The chart above shows that the Australian commercial property market last peaked in 2008 immediately prior to the Global Financial Crisis. Around this time retail cap rates were ~6%, office ~6.25% and industrial ~7%. During and immediately after the GFC cap rates across the sector increased materially causing prices to fall. Any investor who purchased property at the top of the cycle experienced substantial capital losses, particularly if the property was highly geared.
Cap rates are currently resting at similar levels to the last market top in 2008. The major difference in the current environment is that interest rates are significantly lower, making the lower commercial property yields still appear attractive. However, if history is any guide, it does not appear to be an attractive time to buy when cap rates in the sector approach this level.
This current low interest rate environment could create the potential for further cap rate compression and price rises. Whilst the weight of offshore money could push yields even lower, the scope for further cap rate declines and associated prices increases appears limited.
In Part 2 of our look at the commercial property sector we will take a closer look at the risks of investing in the sector and examine the outlook for the sector in the coming years.