Published in edited form in The Institutional Real Estate Letter Asia Pacific, Vol. 7, No. 7, July/August 2015, pp. 6 & 8, and in slightly edited format on LinkedIn, https://www.linkedin.com/pulse/search-value-australian-real-estate-michael-easson
The Australian economy is one of the strongest in the world, representing 2.52% of the global economy, with close to 25 consecutive years of economic growth.
What about investing in Australia today? This article’s focus is on the property sector where crosswinds test any pilot, though there are very good pockets of value for investors. Highlighted here is the general economic story, risks with particular sectors, and the on-going search for value.
If you believe that location, location, location matters, then Australia’s proximity to the burgeoning economies of China, India, Indonesia, and other Asian markets means in the long term that the country looks like a safe bet.
Australia’s real GDP growth, which is well ahead of the average of OECD countries and less volatile, has slowed in 2014 to around 2.3% annually, with inflation under 2%. These are ‘to die for’ figures for many European economies, but they highlight a weakening of Australia’s economic fundamentals.
General Fundamentals
The economic fundamentals driving Australia’s performance include strong population growth, a well-educated workforce, and relatively robust economic health.
On the latter, the OECD opined in April 2015 that: “Over the past decade, [in Australia] per capita income surpassed the average of the most advanced OECD countries, helped by high terms of trade and employment rates. However, productivity gains have been weak and the economy faces a period of adjustment in the wake of the mining boom.”
Australia’s population growth, compared to most advanced economies, is very strong. According to the Australian Bureau of Statistics (ABS), the preliminary estimated resident population (ERP) of Australia at 30 September 2014 was 23,581,000 people. In 2013, there was a 1.8% annual change – combining natural growth and immigration. Permanent migration under Australia’s Migration and Humanitarian Programmes rose by 7.7% in 2012-13 with 214,000 visas issued. Over the past decade, the mix of immigrants has changed to two-thirds skilled migrants, one-third family reunions – an exact reverse of the previous mix.
The weakening of the Australian dollar (trading at or over parity with the U.S. dollar two years ago) has seen a 25% correction, hovering around 75 to 80 U.S. cents over the past year. There are many reasons for this, mainly related to commodity prices falling.
The growth in private pension fund savings – superannuation – is an indicator of the health of the Australian economy. Total superannuation assets increased by 15.7% during the year to 30 June 2013 and currently it is close to $1.8 trillion. As a share of GDP, such savings leapt above 100% in 2013. Employers are required by legislation to pay a proportion of an employee’s salaries and wages (9.5% as of 1 July 2014) into a superannuation fund, and individuals are encouraged (tax incentivised) to put aside additional funds into superannuation.
Property Fundamentals
In May 2015, the Board of Australia’s Reserve Bank cut interest rates to a record low level of 2%. This figure highlights that the rock bottom lows seen five years ago in the US, the UK, Europe, Japan and elsewhere, were not replicated in Australia.
Indeed, the Australian property market has remained robust in the last five years, after a considerable dip in 2007-2009 when world factors hit hard.
The strength of the REIT sector today marks a significant turnaround since the GFC, which forced REITs to patch up their stricken balance sheets by undertaking painful recapitalisation, which initially slashed investor value.
In deleveraging by raising fresh equity, Australian REITS fixed up payout ratios, and their income streams have grown above inflation ever since. In stark contrast to the pre-GFC REITs, today up to three-quarters of REITs’ total returns are typically derived from rent paid by tenants, which are generally signed on long term leases. Low interest rates are supporting consumers and businesses – and drive up demand. A danger sign is that the current spread between REIT yields and 10-year government bond yields is wide.
Property trusts have delivered annualised returns of more than 14% over the past one, three and five-year periods, according to the S&P/ASX 200 A-REIT index. The market remains uncomfortable with gearing levels above 30% – well below the average ‘look through’ 50% level before the GFC.
There is an increasing flight to and search for value in the Australian market. Foreign capital continues to flood in – to commercial, retail, industrial, and residential markets.
The temperature in the kitchen is at 2005 levels. There is plenty of froth and irrational exuberance. Reacting to this, some sophisticated investors have developed software that incorporates historic and contemporary data to track risk and return, such as EG’s Property Risk Management Systems (PRISMS).
Because core property, office and retail, in particular, have been bid up, driving yields lower, there is a gradual shift to core plus strategies. Student accommodation; core plus office, mixed-use residential, transport related property investing, including industrial and office parks are seeing an increasing flow of funds.
The core office market has seen an influx of foreign investors, European, Asian, and North American over the last 6 years. But there is considerable pressure on yields as the flood of money seeks opportunities. The fault lines in the Australian economy complicate the story, particularly in some States where the downturn has been greatest – such as the capital cities of Perth and Brisbane.
Opportunities
Unique in the major global office markets, Australia’s incentives for tenants in premium office challenge international valuation methodologies.
Currently average incentives in the Sydney CBD are around 30%, which means that this discount is applied on head line rents for the whole of the lease term. Net effective rent, taking into account real IRR requirements of, say, 5% is really significantly lower than face rent. After leases expire, the incentive merry go-round starts again. Colliers suggest that incentives might ease in 2015, but only to 27%, historically still high.
The author currently occupies space in a Prime Office Tower in the CBD of Sydney, leased in mid-2014, where the incentive on the head line rent was over 40%, for 655sqm at $1035/psm, indexed at 3.75% fixed for 7 years.
Such incentives and the real value of core office real estate need careful consideration.
There is a steady stream of investment to core plus and secondary markets. This sector is often less volatile and less weighed down by incentives. Covenants with Top 200 ASX-listed companies and government tenants are attractive wherever located. The author is aware of sophisticated institutional property investors seeking fringe office investments with low weighted average lease expiry (WALE) that need refurbishment. Some commercial buildings need an upgrade in their green rating – the National Australian Built Environment Rating System or NABERS, which is similar to the US Green Building Council’s LEED Rating System. Generally, a rating of NABERS 4.5 stars or higher is required by government and many blue chip companies.
Other value-enhancing strategies focus on the rolling out of major new urban transport infrastructure projects across Australia. There has never been a bigger boom in new road and rail projects in Australia’s history. Road construction is being expedited as part of wider government plans, including federal-government incentives for the six States to sell assets and use the proceeds for new infrastructure (the Asset Recycling Initiative).
With residential, sophisticated investors in the residential sector see property as a network asset – value depends on what happens around it – and look for opportunities close to enhanced and new transport infrastructure. With real estate prices for equivalent properties in Shanghai reaching comparable levels to Sydney, more investment is to be expected from Chinese businesses, as well as ordinary citizens keen to invest in a western market in a similar time zone.
Mixed use and transport-oriented developments, close to new heavy and light rail, can be expected to roll out over the coming decade, along with new office parks situated closer to new road infrastructure.
In short, the Australian market remains strong. With its economy closely correlated to China’s, continued growth in Australia turns on what happens to the north. There is a close watch on value-opportunities beyond core – to core plus, value-add, and development. The next Chapter in Australia’s property market is now being written.
Below, the article as it appeared:
