Commercial property

Commercial property values ​​will drop 10-30%

Essentially, commercial real estate is undergoing the same repricing that has already caused such carnage in stocks and bonds around the world.

But unlike listed real estate, the value of which has fallen about 20% from its highs at the end of 2021, the revaluation of commercial real estate is slow.

A repricing is in progress

Australian commercial property sales slowed significantly in the June quarter. James Alcock

The COVID boom has come to an end, not with a price crash, at least not yet, but in a pause.

“Everyone took a break to figure out what’s going on,” says real estate veteran Rick Butler. “There’s still huge interest, but a lot of people are looking for a buying opportunity.

“They wonder if some owners will be forced to supplement equity, as they were in the GFC. And they ask, ‘do I need a 10% chip?’ »

Australian commercial property sales slowed significantly in the June quarter, with transaction values ​​down 40% from the same quarter of 2021, according to global data and index provider MSCI.

The booming sector of the pandemic, logistics real estate, has actually slowed more than offices and retail. And the slowdown was most visible in the small segment of the market, with sales value in the $1-10 million range being half the level of a year ago.

Benjamin Martin-Henry, head of real assets research at MSCI, Pacific, warns that part of the drop in sales was a “normalization” of activity after last year’s extraordinary pandemic surge.

Nevertheless, a repricing is in progress. The difficult question is by how much.

Last month, Morgan Stanley equity analysts looked at the long-term relationship between the 10-year bond yield and the average return on assets held by Australian Real Estate Investment Trusts.

Like the graph below, from Cushman & As Wakefield shows, the spread between property yields and the 10-year bond rate has gradually closed since the GFC and, with the recent rise in bond yields, compressed to a new low.

In other words, the gap between a risk-free bond and commercial real estate with all its challenges seems out of whack.

Values ​​could drop 10-30pc

Matt Webb, director of industrial valuation firm m3property, told my colleague Larry Schlesinger that it was “hard to justify” buying an industrial property with a 3.5% yield, when the yield ten-year government bonds was 3.4%.

In simple math, restoring the classic spread between bonds and property yields – assuming the bond rate doesn’t fall – could imply a drop in values ​​of around 10-30%.

This is a very broad estimate. And it ignores some of the nuances of the bond yield versus property yield debate.

For purists, the key figure is not the nominal bond yield but the inflation-adjusted bond yield, which, as the chart shows, is still well below the average yield.

The graph also reminds us that the level of inflation will be a key determinant of the new real estate pricing.

In the 1970s and 1980s, real estate was seen as an attractive hedge against inflation because it reduced the real value of debt while increasing the value of income.

When the market recovers, assets that capture inflation in their rents, such as shopping malls or apartment buildings, could outperform those with low long-term fixed rent increases and revenue growth that may take a hit. delay.

Cushman & Wakefield Australia’s head of research, John Sears, says investors are concerned both about interest rates and the impact those rates will have on tenant demand.

Along these lines, Citi’s Australian real estate team recently noted that in “a challenging interest rate outlook over the next 24 months, we prefer defensive retail positions held by companies with a lower financial indebtedness and higher interest rate coverage”.

They argued that the two AREITs in this sector, Charter Hall Retail REIT and SCA Property Group, should be “better supported” in a tougher retail market.

“Cap rates are expected to rise, but some retail exposures are increasing NOI before this five-year downgrade effect,” Citi wrote.

“Impossible to be too negative on commercial real estate”

A head of research at CBRE, Sameer Chopra, sees a tug of war between higher bond yields and higher rents.

While bond yields have risen significantly over the past six months, rents have also risen, sharply in the case of industrial real estate and apartments, but also, to within one digit, in office real estate and shops.

At the same time, construction costs have risen, limiting new supply which, as the collapse of the early 1990s demonstrated, is an existential threat to commercial real estate.

Chopra argues that the scarcity factor – the fact that some properties trade very infrequently – must be taken into account in assessing the new price level.

“You can’t be too negative on commercial real estate right now because rates are going to come down,” he says.

Drew Bowie, managing director of MA Asset Management, acknowledges the risk of a slowdown in activity in the commercial real estate markets, particularly from short-term investors, who will fear that their capitalization rate will acquisition is well out of the market in a year. .

“However, we expect longer-term investors to continue to be attracted to good quality assets that will weather the cycles,” he said.