Commercial property values near recovery

While the surge in listed property trust yields led the rise in unlisted property yields last year, thanks to distribution cuts and a rebound in listed property trust valuations, they have now fallen back in line with unlisted yields. See the next chart. So whereas A-REITs were offering much better prospects than unlisted property at their low point in March this year, this is no longer the case and it is harder to distinguish between the two asset classes in terms of their return prospects, particularly on a five to 10 year outlook.

Secondly, Australian unlisted property offers an attractive yield premium over other assets. The next chart shows a composite of office, retail and industrial property yields versus an average of government bond, equity and housing yields. The gap between commercial property yields and other yields has blown out, suggesting yields on commercial property are relatively attractive.

In particular the back-up in commercial property yields over the last two years, at the same time that government bond yields have fallen, has ensured the property risk premium has remained high. The next chart assumes constant property rental and capital growth of 2.5% p.a. This has been added to the composite non-residential property yield and the 10-year bond yield has been subtracted to show a property risk premium.

The property risk premium is now relatively high and is likely to attract investors back into unlisted commercial property over time, particularly as bank and credit market lending spreads narrow further and the availability of finance for property improves in response to increased lender confidence in the property outlook.

Finally, the worst is probably over for property space supply and demand fundamentals and improvement is likely from next year. This is illustrated for office property where the supply of new space is likely to peak this year before declining in the years ahead. The improvement in economic confidence is also likely to lead to a continued improvement in office space absorption. This would suggest office vacancy rates are likely to start falling from next year – see the next chart – which in turn will be positive for rental growth. The office supply/demand situation is far better than was the case in the early 1990s when there was a massive supply of new office space just at the time the Australian economy had its worst post war recession.

Unlisted non-residential property values are at or close to the bottom. A gradual recovery is likely to get underway through next year in response to improved conditions in financial markets, the attractive longer term return premium unlisted property is offering over other assets and the improving demand/supply outlook for property space.

Shane Oliver is head of investment strategy and chief economist at AMP Capital Investors.