Australian real estate: heating up

Executive Summary

The Australian real estate sector is experiencing yield compression, with values increasing across most asset classes. This is being driven by a stable low interest rate environment and strong interest from both domestic and offshore investors seeking yield. However this yield compression is occurring at a time when the fundamentals supporting property demand appear to be softening, and the economy is showing signs of slowing. This is prompting concerns from some commentators of an asset price bubble.

Our research into the major Australian real estate sectors does not indicate a bubble market. Indeed when viewed in terms of the spread over government bonds, Australian real estate is more attractive than other key international gateway cities. Comparison to other investment classes, including stocks, bonds and cash, also reveals that Australian real estate has displayed relatively high and stable returns.

While not cheap, Australian real estate asset pricing remains attractive in a global context.

When we examine the fundamentals driving the performance of Australian real estate, the outlook is mixed, much like the broader economy, varying by sector and geography. Although the asset prices remain cheap in a global context, the current climate is favouring vendors, and buyers need to be careful about the quality of assets they are acquiring.

In our view, the most attractive sectors for direct large scale investment are office, industrial and retail.

Additionally, alternative assets offer attractive opportunities for investors willing to put effort into unlocking this value.

The Opportunity

Our analysis shows that, in terms of pricing and fundamentals the strongest sectors appear to be Office, Industrial, Retail and alternative assets. Within these assets, we see the following key opportunities:

  • Office: While the fundamentals of the Australian office market are relatively soft, they are beginning to improve in Sydney and Melbourne. We are forecasting a period of yield compression due to increased competition for a small number of assets and historically high yield spreads. The current, relatively high vacancy rate makes the attributes of individual assets vitally important for investment appraisal and value creation with attractive opportunity’s available to the informed investor. e.g An Australian REIT recently acquired a portfolio of office assets from the NSW state government as part of a sale and lease back agreement with a WALE of c10 years, c70% let to the NSW government offering an initial yield of 9%.
  • Industrial: Prime assets are tightly-held, limiting options for new investors in the sector. A capital partnership with an existing developer seems to be the most likely route for investing at scale.
  • Retail: Although the sector is dominated by a few large players, anticipated asset divestments may present an opportunity for market entry. Careful due diligence is recommended to ensure that assets have strong trade areas and tenancy mixes.

Alternatives:

  • Healthcare: The current trend for privatisation of government assets should see a number of opportunities open up in the sector. These may include new development partnerships, and sale and leaseback opportunities.
  • Student Accommodation: Strategic partnerships with operators or universities appear to be the best path for investors to build a portfolio in this sector. New development is the most likely path, as there have been limited transactions of trading assets.
  • Car Parking: Investment grade assets tend to be tightly-held, and new development opportunities are increasingly limited. There may be some scope for limited opportunistic investment.

Other sectors may still present solid opportunities depending on the asset. In the hotel sector, we expect the relatively high yield available will continue to attract offshore investment, particularly for trophy assets from Ultra High Net Worth individuals.

In the residential sector, local developers keen to capitalise on increasing prices are presenting offshore investors with opportunities to provide senior and mezzanine debt. However these opportunities need to be weighed up against the risk, particularly in subordinated debt.

* Please Note: Relative Pricing based on comparison to: spreads on government bonds; longer term prices and fundamentals.

Economy: The Big Picture

The Australian economy has been one of the strongest performing developed economies in recent history, entering its 24th year without recession in the second half of 2014. However recent economic indicators paint a mixed view of the Australian economy. Although the most recent GDP figures show continued growth, unemployment is trending up and the exchange rate remains persistently high, causing a drag on export competing sectors.

After a period of above-average growth in 2012, GDP growth again dipped below trend in 2013, partially due to the winding down of the commodity boom that helped sustain Australia through the Global Finance Crisis in 2008 & 2009 (GFC). As the unprecedented level of mining capex flowing through the economy trails off as that sector moves from the construction to production phase. It is evident that economy is in a period of transition, with non-mining sectors such as building and construction picking up the slack from declining mining investment.

There are increasing signs of softness in the labour market with unemployment reached a 12 year high of 6.1% (trend) in July 2014. Although housing construction and infrastructure spending is helping sustain employment, the stubbornly high Australian dollar continues to drag on export competing sectors such as manufacturing and tourism.

The strength of the Australian economy in recent years has been correlated with strong growth in commodities prices, which has fuelled significant capital investment in the mining industry. Commodity prices have been trending downward since late 2011 as Chinese demand for base metals falls. However, Australian export volumes continue to rise as projects initiated during the period of price growth come on stream. This increase in volume should compensate for the decrease in prices to support the total level of export earnings, but the transition from the construction to the production phase means that there will be limited support for the soft employment market.

Looking forward, the decrease in mining investment should in part be compensated for by a pick-up in infrastructure spending and housing construction. However there are persistent signs of weakness in the economy that mean growth is likely to be below trend for the next year or two. Along with the rebalancing between sectors, there is also likely to be a shift of economic growth from the mining states of Western Australia and Queensland back towards New South Wales and Victoria.

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Source

Emerge Capital Partners

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Australia
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Real Estate & Construction

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