Great year for commercial property but could hot yields be ending?

But not all commercial property markets are doing equally well, both now and into the near future.

It’s useful to divide total returns into three components. Income growth plus the impact of firming yields drive capital growth. Add yields to get total returns. Since the GFC-induced downturn a decade ago, the bulk of returns have been associated with firming yields.

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But we’re coming to the end of the period of firming yields. From now on, we’ll need income growth to drive capital growth and hence total returns. And that’s what I’m looking for into the future.

For industrial property, the current darling of the investment community and the sector experiencing the strongest inflows of investment capital, returns have been driven primarily by firming yields. Industrial yields, having been substantially higher than other mainstream sectors seven years ago, have come right back to the pack. Hence the strength of capital growth. Rental growth has been relatively moderate, at least until the last year or so when it has risen more strongly. But there is a limit to how much yields can firm.

Certainly, the inflow of funds will drive some further firming. I’m not looking for anything like the contribution of firming yields that we’ve seen in the past. The key to future returns will be the ability to achieve rental growth. Rents are picking up, but will need to pick up further to underpin total returns.

Office markets are coming towards the end of the period of firming yields driving capital growth. The contribution from firming yields will be lower into the future. But it’s chalk and cheese between markets on rents.

The oversupplied markets of Brisbane and Perth have been driven primarily by firming yields with very little contribution from rental growth. With vacancy rates likely to stay high into the middle of next decade, I expect rental growth to remain weak. Yields are a little higher than Sydney and Melbourne, but I always thought that weight of investment funds looking for office yields better than available in Sydney and Melbourne kept Brisbane and Perth yields lower (and prices higher) than the prospects for those markets warranted. As the contribution from firming yields moderates, total returns will soften.

Industrial warehouses have been one of the commercial property industry’s boom sectors.

In Sydney and Melbourne, strong leasing markets and rising rents have made a major contribution to capital growth and total returns, along with firming yields. The next year should see some easing of the tightness of leasing markets as new projects come on stream in both Sydney and Melbourne, with a moderate rise in vacancy rates softening rental growth. Many will be quick to call the end of the cycle. But it’s not. Neither market is oversupplied and the softening will be temporary and quickly absorbed, leading to a resumption of strong rental growth for another three to five years. This cycle has a lot further to run in those markets, underpinning strong returns albeit lower than the extraordinary returns we’ve seen over the past seven years.

We’ve also seen an overflow of investment funds into emerging alternative property sectors such as healthcare and childcare.

The problem area is retail where a flight of capital is hitting yields. The major players are part way through an exit from many of their retail investments. Everyone is nervous. Certainly, weak retail sales and the shift in expenditure from goods to services, together with the continued rise of internet shopping, is hitting retailer and centre incomes. Retailers and centres are responding by investing to make centres more appropriate to the structural shift in expenditure patterns. It remains to be seen how big the impact will be on margins, rents and centre incomes once retail sales have recovered – and that’s not for a while yet. Meanwhile, growth in centre incomes remains extremely weak and yields will soften further as major investment houses continue to reduce their exposure.

Overall, property returns are moderating but still pretty good. Inflow of funds will continue to boost asset markets. But we need to be a lot more careful about the income growth prospects of those markets.

We need to play the cycle and we need to understand influences of medium-term structural shifts such as in retail. In other words, we need more active strategy in terms of allocation between asset markets. And that allocation will change over time.

Next year, the environment will be much the same. The economy will remain weak (but positive) as the residential building downturn runs its course with a corresponding impact on growth. That will affect demand for the various sorts of property, but there’s not a lot of supply coming on either. The impact on leasing markets will be quickly absorbed.

The period since the GFC-induced downturn has been a great time for property investors. We need to accept that future returns will be lower as the firming of yields moderates, but still pretty good compared with alternatives. That’s particularly true in our lower for longer interest rate environment.

Are yields too low now? Not at the current level of bond rates. Indeed with bond rates below 1.5 per cent, yields have (a little) further to firm. Into the future, the risks lie with continued weakness of the economy and interest rates. Once the residential building downturn has run its course two years hence, growth will pick up.

The real threat is of a rise in bond rates. We don’t know yet when or by how much. But we do know there will be an impact on yields and prices, and hence returns. When it does come, there will be nowhere to hide. All investment classes will be affected and we’ll need to reassess our allocations. Given the weakness of the world economy and continuing uncertainties, that’s not for a while yet. And there will be plenty of warning through world growth, emerging inflation and tightening monetary policy. Meanwhile, we can continue to invest for income growth associated with property cycles. Interesting times.

Frank Gelber is an economist.

This article originally appeared on www.theaustralian.com.au/property.