Capitalising on the recovery
While near zero interest rates are prompting investors to hunt for alternative places for their money, many investors have already flocked to residential real estate, but commercial real estate shouldn’t be overlooked.
It’s a new era for commercial real estate in Australia – bolstered by cheap debt, structural changes and an under allocation to real assets- the outlook appears promising.
The success of the vaccination program and the way Australia handled the COVID-19 pandemic itself is a siren call for global property investors as Australia has reaffirmed its reputation as a stable safe-harbour for capital – with more growth still to come.
So, what are the other drivers for the strong outlook? And what risks remain on the horizon?
REASONS FOR OPTIMISM
The first driver is interest rates. Record low rates and accommodative central bank policy are here to stay for the foreseeable future.
It goes almost without saying that low rates are strongly supportive of capital-intensive assets like real estate, but there are a few mechanisms underlying this: low rates make raising capital cheap for investors, they reduce the available yield on cash and fixed income investments and make real estate look more attractive, and they underpin business and consumer activity.
Bond yields over the next two to three years are likely to remain at the lower end of their long-term average, while commercial real estate can yield 4% to 5% – that 200 to 300 basis spread over the risk-free rate offers a healthy risk premium.
The second reason for optimism is the opportunities to come from the COVID-19 pandemic. Market dislocations always produce winners and losers and we believe the COVID-19 cycle has left some commercial real estate sectors, notably retail, looking mispriced.
Technology disruption is a third driving force of the coming recovery, with demand buoyed by long term themes like e-commerce, remote working, health and wellness.
Fourth, investment volumes are forecast to rebound sharply in 2021/22 from the lull of 2020. Investors have cash to spare after fresh equity raisings and given the low cost of debt, real estate is an increasingly attractive vehicle for that investment.
And finally, the high vaccination rate is underpinning a strong outlook for the Australian economy.
There are many reasons economic growth matters for commercial real estate, but chief among them is the low unemployment rate. The labour market is tight and consumers who feel positive about their job prospects are more likely to spend.
Next year is shaping as a very strong period for spending, especially on travel, entertainment and food and beverage as people emerge from closed borders and lockdowns.
INFLATION PROTECTION
The outlook is not risk free. Inflation looms as the biggest potential threat and capital markets are clearly signalling they are concerned.
But we believe commercial real estate is well placed to ride out a bout of inflation. Most rental agreements are tied to inflation and carry an in-built hedge. Inflation also typically accompanies strong economic conditions – low unemployment and higher wages – all factors that benefit real estate directly.
The threat of interest rate rises on the back of inflation movements will increase, but while rates will obviously rise at some point, they will remain at historical lows. History shows commercial real estate values are not impaired by interest rates until the cash rate reaches at least 4%, which approaches commercial real estate’s average yield of 4.5%.
So, which sectors offer the best returns as the Australian economy emerges from COVID-19?
OFFICE
There’s little doubt that the office market has borne the brunt of COVID-19, but there are already early signs of recovery. Office downturns are usually short and, in the past, have been followed by strong rebounds.
While the work from home phenomenon is here to stay, it is easy to overstate its impact on office demand. The white-collar sector – a key driver of office demand – is growing at 2.4% per annum.
More people in jobs means more demand for office space and these fundamentals of growth and low unemployment look like balancing greater remote working.
In any case, not all businesses will keep flexible working from home policies. Many client-facing roles will migrate back to offices as quickly as they can. Some companies are realising that remote work does not suit many young peoples’ career development.
As businesses manage their post-COVID workplaces, with many prioritising getting people back into the office, the focus on green star ratings, amenity and the offering of a healthy, safe environment will drive demand at the premium end.
Supply is also a factor, with JLL Research estimating additional new supply from 2021 to 2025 already reduced by over 50% compared to the pre-COVID forecast.
Our real estate research team anticipate vacancies at the prime end of the market will decline to very low levels. In our opinion, deep liquid markets in Sydney and Melbourne will outperform. This will place further upward pressure on values. Secondary stock unable to adapt to the technological, sustainability and wellness requirements of this new era of tenants will struggle.
RETAIL
The story of retail is the story of household income and population growth – the combination of government stimulus and lockdown-reduced spending means the household savings rate hit a record high of 22% during 2020. Data from 2021 shows a decline in the savings ratio yet it remains historically high. Considering the most recent lockdowns in NSW and Victoria, we anticipate the rate will push back up again in Q3 results. Australians have some ~$90 billion more socked away in bank accounts.
In our view, we expect this cash will underpin a very strong 2022 for retailers. Resumed population growth pressure will also boost the sector and an expected uptick in wages should put even more money in people’s pockets.
Still, there are headwinds.
The re-opening of borders will also see many spend their savings on international travel. And the rapid growth in online shopping will continue to take sales away from shopping centres.
But the industry has some tricks up its sleeve.
Retail is adapting away from purely shopping-focused to mixed-use alternatives, incorporating a greater emphasis on entertainment, leisure and other personal services. The pandemic has reminded us that the importance of local community, medical, health, fitness and many other personal services, are an important part of our wellbeing. Retail formats are adapting to the competition of e-commerce by focusing on these aspects of the retail offering, but only some centres are suitable.
Shopping centres are adopting whole new income streams – adding logistics, office space and even apartments to diversify.
Many shopping centres are on vast tracts of well-located, desirably zoned land and can unlock considerable value. The shopping centre of the future will be more akin to an airport, with multiple income streams and a sharper focus on placemaking, wellness, inclusion, and a wide offering of services.
LOGISTICS
We expect logistics to be the strongest performing commercial sector over the next three years, forecast to deliver investors an average return of more than 9% over the medium term.
These are not the logistics and industrial assets of old. Blue-collar workers and heavy manufacturing have given way to high-tech, sophisticated pieces of supply chain infrastructure.
A logistics asset today could be a refrigerated food storage centre for a supermarket, a data centre for an internet company, an urban farm supplying the restaurant industry or even an energy generation facility.
The COVID-driven boom in e-commerce has seen online sales rise to 12% of all retail sales, below markets like the UK and US, but growing more quickly. AMP Capital researchers forecast online share to reach about 25% by 2030.
This is fuelling record demand across all major markets in e-commerce, logistics, fulfilment and distribution.
Logistics and industrial are the number one asset class being acquired by Asia Pacific investors, surpassing office and retail for the first time, partly because most fund managers are materially under-exposed to the sector.
PORTFOLIO CONSTRUCTION
Given the likely trends, we believe a few opportunities stand out for investors:
Logistics will deliver the strongest total returns of all the commercial sectors, driven by strong global investor demand, rising rents and limited supply;
In the retail sector, neighbourhood centres offering convenience-based retail services are set for strong, stable returns over the next decade, whilst super regionals may look favourably priced compared to their more expensive office and logistics counterparts; and
Office markets are diverging. Premium offices in Sydney and Melbourne will do well as people return to offices and supply is limited. Perth will enter a sustained cycle of recovery. But secondary markets and fringe buildings will struggle unless they have the amenity and services on offer to attract the next generation of tenants adapting to new ways of working.
So, as we emerge from what has been a difficult time for all, with the investment community firmly focused on inflation, growth, interest rates and the continuing focus on environmental, social and governance (ESG) based solutions to our built environment, investors should be ready to capitalise on the recovery ahead.
Luke Dixon is head of real estate research at AMP Capital.
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