Recent economic news has some predicting the Australian economy is undergoing massive change. Daryl Wilson looks at the arguments and the potential impacts on property investors.
Among the day-to-day economic minutiae of fiscal deficits and surpluses, unemployment, currency and balance of trade updates, a larger story about the future of Australia and our position in the global economic pecking order is beginning to emerge. The changes for property investors may be profound.
Since the start of the global financial crisis in 2007 the Australian economy has experienced a number of significant changes, particularly in relation to government bond yields and the cost of debt.
The question many economists and investors are now asking is whether those changes are part of the normal boom-bust cycle – or evidence that the entire economy has shifted to new ground.
With the European sovereign debt crisis continuing to take precedence in the news, investors could be forgiven for thinking the rates paid by borrowers are at all-time highs.
In fact the opposite is true in highly-developed economies. In July, the yield on the benchmark 10-year US Treasury notes fell to a record low of 1.38 per cent compared to its average of 3.73 per cent over the past decade.
On August 30, the 10-year US Treasury note yield still stood at just 1.62 per cent. If that is not low enough, the return on bonds issued by a number of European governments is now negative in absolute terms – meaning investors are buying bonds for less money than they will receive back over the life of the bond.
They are effectively paying governments including Germany, Switzerland and Denmark to take their money because of the perceived risks associated with placing that money in other investments.
The situation is not quite so extreme in Australia, but 10-year government bonds are still at record lows of around 3 per cent.
From 1969 until 2012, Australian Government 10-year bond yields averaged 7.76 per cent, reaching an all-time high of 16.4 per cent in May of 1982 and a record low of 2.71 per cent in July of 2012.
This collapse in the so-called "risk-free" interest rate has been more pronounced in Australia than anywhere else in the world and the primary reason why international money continues to flow into the country at record levels, driving up the currency (which in turn creates its own problems and opportunities).
The international view of Australia as an investment haven and the expectation that the vast offshore investment inflows will stay invested beyond the short term is the key factor driving the argument that the economy is experiencing a fundamental change.
By leaping up the rankings of global economies, it is reasonable to expect the much lower bond rates experienced recently to continue as we are bracketed with other economic (G8) powerhouses.
If bond yields of 3 per cent (less than half the average over the last 40 years) becomes the new norm it will have major repercussions for the property industry – and provide a world of new opportunities for investors.
The opportunity arises because over the long term all other assets, including commercial and industrial property, are priced in relation to the risk-free (bond) rate.
If government bond yields stay at current levels then the prices of other assets will rise until they also offer historically low returns.
The rationale for this is that investors are able to pay more for assets and still make an acceptable yield/return because they can borrow money cheaply.
A fall of just 1 per cent in the capitalisation rate of a property, from 8 per cent to 7 per cent, leads to a 14 per cent increase in value, even if the underlying income doesn’t change.
This offers the prospect of substantial capital gains for property investors in the medium term.
The potential impact of this over a longer period is the construction of significant new supply of stock (ie, new buildings) in the market, with developers and investors all chasing the premiums currently available.
However this process will take two to three years from when new construction starts before this new building wave comes on stream. In the meantime, with limited vacancy rates in most office markets, office property rents can rise significantly and very quickly if tenant demand increases.
BIS Shrapnel forecasts average rental growth of over 50 per cent in all key office markets in the next five years.
Daryl Wilson is the director of Cromwell Property Group.
