Why the retail property sector is one to watch

Since 2007 there have been three clear downturns in unlisted retail real estate.

That year heralded the arrival of the global financial crisis, when Australian retail experienced less of a downturn than other real estate sectors like office or industrial and illustrated its lower beta to normal market cycles. It also proved the thesis that quality retail is more resilient given its weighting to non-discretionary spend and the assistance from fiscal policy.

The next downturn in early 2020 was off the back of COVID-19 – a particularly tough environment for retail given mandated closures and retail assets were rebased across the board.

Sustained inflation

Finally, just as things were recovering, prices again have been tested from sustained high inflation. It’s too early to call this one over, and while there are different drivers to the GFC, there are similarities in spending and saving, although interest rates are moving higher, not lower.

So, what are the learnings that are relevant today?

There have been three main “green shoots” or conditions prevalent for valuation stabilisation.

The first is the relationship between listed and unlisted real estate markets, where the former acts as an earlier indicator for returns on the latter.

Since 2007, listed real estate quarterly returns have demonstrated a leading positive correlation to unlisted returns when shifted by one or two quarters.

What is the market saying now?

Momentum needs to build

The listed real estate index has remained quite volatile, falling 3.6 per cent during the quarter to September 30. It looked more of the same at the start October but has since recovered and is up 1.95 per cent quarter to date. From a signalling perspective, this condition is starting to point in the right direction, but the broader equity market is volatile and momentum needs to build.

Secondly, there’s confidence in interest rates conditions – certainty in stabilisation signals a path upward for real estate valuations. You don’t need a switch in cycles from rate hikes to cuts, you just need stabilisation.

Certainty in interest rates brings more participation to the market, increases transaction confidence and frequency and helps erode any bid-ask spread. Investors are better able to assess the costs and risks associated with financing commercial real estate.

The Reserve Bank has retained a tightening bias after raising rates on November 7. The market is partially pricing in another hike and has pushed out the likelihood of a rate cut further out in 2024. Economists are looking for rates to peak around the first quarter and then come down in the second half. This outlook for a rather muted 2024 could bring back confidence in real estate forecasts.

Finally, historical analysis shows certainty of credit (at a reasonable price) is also an early indicator for stabilisation.

Credit spreads typically move before unlisted returns. This was the case during the GFC and similarly during COVID-19, but with a tighter lag. New loan commitments and the Westpac indicator of “finance harder to get” have also proven to be decent leading indicators to unlisted real estate returns during market corrections.

Today, while spreads have tightened from their March 2022 wide levels, they are still off their 2021 levels. Historically, a tightening of spreads leads to an uptick in the retail market within 12 months.

Promisingly, the September data for the availability of financing showed improvement and notably an easing in the ability to get finance from some extremely tight levels.

Idiosyncratic moves

We acknowledge that every downturn and recovery is different and picking turning points can be fraught. But looking back at history, we do know that at an asset transaction level, valuation recoveries have started off as idiosyncratic moves and quality locations move relatively quickly once the aforementioned conditions take hold.

While these signposts are relevant for real estate valuations broadly, our analysis has focused on the opportunity in retail. This sector has repriced the most from peak to trough and may enjoy a relative value focus as more certainty returns.

Will the sun come out tomorrow? Sorry, Annie – be a little patient. But that shouldn’t stop anyone starting to prepare for when it does, nor to consider bespoke opportunities that may be offering value today. As the skies clear, this market is one to watch.

Katrina King is general manager, capital solutions, for QIC