Commercial property values near recovery

Since peaking in late 2007, unlisted commercial property prices have fallen by around 20% as a result of the fallout from the global financial crisis. However, commercial property values appear to be at, or close to, a bottom, as upward pressure on yields is fading and demand/supply fundamentals are improving.

Just as sharemarkets led commercial property returns on the way down they will likely do so on the way up, so we expect property values to start improving next year.

The plunge in commercial property values
The past 18 months have seen sharp falls in commercial property values. Since peaking in late 2007, commercial property values have fallen by around 20% on average – with 25 to 30% falls in office and industrial property and 10 to 15% falls in retail property. The driver of this slump has been the global financial crisis and the associated economic fallout. Specifically:

* The credit crunch increased the cost and reduced the availability of debt used to fund property purchases and holdings. This put pressure on existing owners to sell and led to reduced investor demand;
* Some diversified investors such as superannuation funds were put under pressure to sell unlisted property as their exposure rose in response to falls in sharemarkets; and
* An increase in the supply of property space and reduced demand as the economy slowed put downward pressure on effective rents.

The result was downward pressure on unlisted commercial property values as investors demanded higher yields in order to invest. From their lows in late 2007, average commercial property yields have increased by around 1.4 percentage points (with each 0.25% rise in yield translating to a 4% loss in value).

Values may be bottoming
However, there is now good reason to believe property values may be at or close to their low. As can be seen in the next chart, the rise in property yields appears to be slowing. This reflects a range of factors, in particular:
* Selling pressure is abating as the demand from lenders to reduce gearing is diminishing. This reflects improving credit markets, narrowing borrowing spreads and listed property trusts raising $19 billion in equity capital since the start of last year. Listed property trusts that were potential sellers last year are now potential buyers.

* Similarly, the pressure on diversified investors such as superannuation funds to rebalance and reduce their property exposures, which had become inflated by the slump in sharemarkets, has reduced as property values have fallen and sharemarkets have rallied.
* Property demand seems to be improving as investors seek to take advantage of higher property yields.
* Demand for property space seems to be improving as supply is constrained. While demand for industrial space is still soft, the net absorption of office space moved into positive territory in the September quarter consistent with signs of economic recovery.

These considerations suggest that property valuations are likely to bottom in the current quarter.

Expect a recovery to commence next year
There are several reasons to expect a recovery in property values in 2010. Just as last year’s collapse in listed equities and property trusts led the slump in direct asset valuations, the rebound in listed assets points to a recovery in unlisted asset valuations through next year.

Thanks to their higher gearing and greater liquidity, Australian listed property trusts (A-REITs) dramatically overshot direct property on the upside during the 2004 to 2007 period and thus overshot on the way down during the bust. Contributing to this was their greater exposure to the US and Europe where the economic and property slump has been much deeper. In recent years they have been leading direct property by a year or so and are now pointing back up. See the next chart.