In essence, commercial property is undergoing the same re-pricing that has already caused such carnage in stocks and bonds around the globe.
But unlike listed property, which has dropped around 20 per cent in value from its late 2021 highs, the repricing of commercial real estate happens in slow motion.
A repricing is on the way
The COVID boom has come to an end, not with a collapse in price, at least not yet, but in a stand-off hiatus.
“Everybody has taken a pause to work out what is going on,” says property veteran Rick Butler. “There is still enormous interest but a lot of people are looking for a buy-side opportunity.
“They are wondering if some owners will be forced to top up equity, as they were in the GFC. And they are asking: ‘do I need a 10 per cent chip?’”
Sales of Australian commercial real estate slowed dramatically in the June quarter, with the value of transactions down 40 per cent compared to the same quarter of 2021, according to global data and index provider, MSCI.
The boom sector of the pandemic, logistics real estate, actually slowed more than office and retail. And the slowdown was most noticeable at the smaller end of the market with the value of sales in the $1 million to $10 million bracket was half the level of a year ago.
MSCI Head of Real Asset Research, Pacific, Benjamin Martin-Henry cautions that part of the fall in sales was a “normalisation” of activity after the extraordinary pandemic surge last year.
Nevertheless, a repricing is on the way. The hard question is by how much.
Last month, Morgan Stanley’s equity analysts looked at the long-term relationship between the 10-year bond rate and the average yield on the assets held by the Australian Real Estate Investment Trusts.
As the below graph, from Cushman & Wakefield shows, the spread between property yields and the 10-year bond rate has closed progressively since the GFC and, with the recent rise in the bond yields, has compressed to a new low.
In other words, the gap between a risk-free bond, and commercial property with all its challenges, seems out of whack.
Values could decline 10pc to 30pc
Matt Webb, a director of industrial at valuation firm m3property told my colleague Larry Schlesinger, that it was “hard to justify” buying an industrial property on a yield of 3.5 per cent, when the ten-year government bond yield was 3.4 per cent.
In simple maths, the restoration of the classic spread between bonds and property yields – assuming the bond rate does not retreat – could involve a decline in values of around 10-30 per cent.
It’s a very wide estimate. And it ignores some of the nuances of bond yield/property yield debate.
For the purists the key figure is not the nominal bond rate but the inflation adjusted bond rate, which as the graph shows is still well short of the average yield.
The graph is also a reminder that the level of inflation will be a key determinant in the new real estate pricing.
In the 1970s and 1980s real estate was seen as an attractive inflation hedge because it cut the real value of the debt whilst boosting the value of the income.
When the market picks up again, the assets which capture the inflation in their rents, like shopping centres or apartment buildings, could outperform those with low, long-term fixed rent increases where the income growth may fall behind.
Cushman & Wakefield’s head of research in Australia John Sears says investors are concerned with both interest rates and the impact those rates will have on tenant demand.
In that vein, Citi’s Australian real estate team, recently noted that in a “challenging interest rate outlook over the next 24 months, we prefer defensive convenience retail positions owned by companies with lower financial gearing and higher interest rate hedging.”
They argued that the two AREITs in that sector, the Charter Hall Retail REIT and SCA Property Group, should be “better supported” in a tougher retail market.
“Cap rates are set to rise but select retail exposures are growing net operating income ahead of this derating effect on a five year view,” Citi wrote.
‘Cannot get too negative on commercial property’
A CBRE head of research, Sameer Chopra, sees a tug of war between higher bond yields and higher rents.
Whilst bond rates have risen significantly in the past six months, so have rents, strongly in the case of industrial property and apartments but also, by single digits, in office and retail property.
At the same time construction costs have risen restricting 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 very rarely trade – needs to be considered in assessing the new price level.
“You cannot get too negative on commercial property at the moment because rates will be coming down,” he says.
Drew Bowie, the managing director of MA Asset Management acknowledges the risk of a slowdown in activity in commercial property markets, particularly from shorter-term investors, who will be concerned that their acquisition cap rate may be well out of the market in a year’s time.
“We do expect however, that longer-term investors will continue to be attracted to good quality assets that will see through cycles” he says.