The current commercial property cycle is now over eight years old. This means the risk of a reversal or extended period of consolidation continues to grow. The Reserve Bank of Australia (RBA) voiced concerns earlier this year that many commercial property values appeared unsustainable over the medium to long term. However, values are likely to remain supported in the near term as investors continue to demand income in an environment of historically low interest rates.
Caution is now required at this point in the cycle despite the cushion provided by low interest rates. Reviewing the chart below from Part 1 confirms that the bulk of the capital gains are now in the past and the “easy money” has been made. Commercial property yields are now approaching the lows (property values approaching the highs) reached immediately prior to the Global Financial Crisis.
An added reason for caution is the sector’s illiquidity. As discussed in Part 2 of our update, selling a commercial property generally takes three to six months and may take longer in a market downturn. The lack of liquidity in the property markets means an investor is unable to readily react to changing market conditions by selling a property.
This also means that the property may have to be held through a market downturn and even sold if there is a breach of banking loan covenants. This locks in a loss at the worst possible time. The loss will be magnified to the extent that there is gearing on the property.
What could make the market turn?
- A sustained rise in United States (US) bond yields. The yield on long duration income producing assets like property and infrastructure are generally compared to the global cost of money: the US 10 year bond yield. When the yield on the US 10 year bond increases, other income producing assets become less attractive. We have seen domestic listed property, infrastructure and utilities stocks suffer sharp declines over the last quarter as global bond yields increased. The chart below shows the performance of the Australian Real Estate Investment Trusts so far this year.
- Debt will also become relatively more expensive if the US 10 year bond yield increases. Australian banks often seek funding in international markets and higher borrowing costs will need to be passed on to domestic borrowers. Higher inflation expectations could cause global bond yields to jump higher. The yield on the US 10 year bond went from 1.78% – 2.14% post-election on the basis that Trump’s fiscal stimulus would cause US inflation to rise.
- Slower economic growth. Australian economic growth is largely hostage to international events. A slowdown in the global economy, particularly in China, would have ramifications for domestic economic growth and trade. This would reduce demand by businesses for commercial space. Trump’s victory is likely to increase political tension between the US and China, which could have unintended consequences for domestic growth.
- A fall in international real estate. A change in the value of global real estate can cause investors to reassess the value of domestic property. “Brexit” was an example where listed real estate in the United Kingdom (“UK”) was repriced to reflect changes in the UK economy. The repricing in the sector also caused a revaluation of global listed real estate outside the UK, even though the actual properties had little or no links to the region.
Asset Allocation and Portfolio Construction
Commercial property can play an important role in an investment portfolio. It can provide regular income and lower overall portfolio volatility given the asset class is unlisted. Depending on a client’s risk profile, an allocation of 10 – 15% can add value through an investment cycle. However, given current valuations, illiquidity and the potential for higher bond yields we are progressively existing the sector rather than adding additional exposure to client portfolios at this time.