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.
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:
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.
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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