Michael Easson

AM FRICS FAICD MSc Phd

The search for value in Australian real estate

Published in ‘The Letter, IREI – Asia Pacific’, July/August 2015
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The Australian economy is one of the strongest in the world, representing 2.52 percent of the global economy, with close to 25 consecutive years of economic growth.
Australia’s real GDP growth, which is well ahead of the average of OECD countries and less volatile, slowed in 2014 to about 2.3 percent annually, however, with inflation less than 2 percent. These are “to-die-for” figures for many European economies, but they highlight a weakening of Australia’s economic fundamentals as commodity prices drop and Australia’s mining boom fades on the heels of slower growth in and demand from China.

The property sector is where crosswinds test any pilot, though investors can find very good pockets of value.

So, what about investing in Australia today? The property sector is where crosswinds test any pilot, though investors can find very good pockets of value. If you believe location, location, location matters, then Australia’s proximity to the burgeoning economies of China, India, Indonesia and other Asian markets means the country looks like a safe bet over the long term.

General fundamentals

The fundamentals driving Australia’s performance include strong population growth, a well-educated workforce and relatively robust economic health. Consider the following:

The OECD opined in April, “Over the past decade, per capita income surpassed the average of the most advanced OECD countries, helped by high terms of trade and employment rates. However, productivity gains have been weak, and the economy faces a period of adjustment in the wake of the mining boom.”

Compared to most advanced economies, Australia’s population growth is very strong. According to the Australian Bureau of Statistics, the preliminary estimated resident population of Australia as at 30 September 2014 was 23,581,000 people. In 2013, there was a 1.8 percent annual change, combining natural growth and immigration. Permanent migration under two Australian programmes — the Migration Programme and the Humanitarian Programme — rose by 7.7 percent in 2012–2013, with 214,000 visas issued. During the past decade, the mix of immigrants has changed to two-thirds skilled migrants and one-third family reunions, an exact reverse of the previous mix.

The weakening of the Australian dollar — trading at or over parity with the US dollar two years ago — has seen a 25 percent correction, hovering around 75 to 80 US cents during the past year. There are many reasons for this, mainly related to falling commodity prices.

The growth in private pension fund savings — superannuation — is an indicator of the health of the Australian economy. Total superannuation assets increased by 15.7 percent during the year to 30 June 2013, and currently it is close to A$1.8 trillion (US$1.4 trillion). As a share of GDP, such savings leapt above 100 percent in 2013. Employers are required by legislation to pay a proportion of an employee’s salaries and wages (9.5 percent as at 1 July 2014) into a superannuation fund, and individuals are encouraged through tax incentives to put additional funds into superannuation.

Property fundamentals

In May 2015, the Reserve Bank of Australia cut interest rates to a record-low level of 2 percent. This figure highlights the fact the rock-bottom lows seen five years ago in the United States, the United Kingdom, Europe, Japan and elsewhere were not replicated in Australia. Indeed, the Australian property market has remained robust in the past five years, after a considerable dip in 2007–2009 when world factors hit hard.

The strength of the Australian REIT sector today marks a significant turnaround since the global financial crisis, which forced A-REITs to patch up their stricken balance sheets by undertaking painful recapitalisation, initially slashing investor value.

In deleveraging by raising fresh equity, A-REITs fixed up payout ratios, and their income streams have grown above inflation ever since. In stark contrast to before the global financial crisis, up to three-quarters of A-REITs’ total returns today typically are derived from rent paid by tenants, which generally are signed on long-term leases. Low interest rates are supporting consumers and businesses — and driving up demand. A danger sign, though, is the current wide spread between A-REIT yields and Australian 10-year government bond yields.

Property trusts have delivered annualised returns of more than 14 percent during the past one-, three- and five-year periods, according to the S&P/ASX 200 A-REIT index. The market remains uncomfortable with gearing levels above 30 percent — below the average “look through” level of 50 percent before the global financial crisis.

With direct property, there is an increasing flight to and search for value in the Australian market. Foreign capital continues to flood in — to office, retail, industrial and residential markets. With Australia’s economy closely correlated to China’s, continued growth in Australia turns on what happens to the north.

The temperature is at 2005 levels, with plenty of froth and irrational exuberance. Because core property — office and retail, in particular — has been bid up, driving yields lower, there is a gradual shift to core-plus strategies. Student accommodation, core-plus office, mixed-use residential, and transport-related property investing, including industrial and office parks, are experiencing an increasing flow of funds.

The core office market has seen an influx of European, Asian and North American investors during the past six years, but the pressure on yields is considerable as the flood of money seeks opportunities. The fault lines in the Australian economy complicate the story, particularly in areas where the downturn has been greatest, such as in the capital cities of Perth and Brisbane.

Opportunities

Unique in the major global office markets, Australia’s incentives for tenants in premium office challenge international valuation methodologies.

Currently, average incentives in the Sydney CBD are about 30 percent, which means this discount is applied on headline rents for the whole of the lease term. Net effective rent, taking into account real IRR requirements of, say, 5 percent, is significantly lower than face rent. After leases expire, the incentive merry-go-round starts again. Colliers International suggests incentives might ease in 2015 but only to 27 percent, historically still high. Such incentives and the real value of core office real estate need careful consideration.

Core-plus and secondary markets have seen a steady stream of investment. These sectors are often less volatile and less weighed down by incentives. Covenants with top 200 ASX-listed companies and government tenants are attractive wherever located. Some investors are seeking fringe office investments with low weighted-average lease expiry that need refurbishment. Some commercial buildings need an upgrade in their green ratings — the National Australian Built Environment Rating System (NABERS), which is similar to the US Green Building Council’s LEED Rating System. Generally, a rating of NABERS 4.5 stars or higher is required by the government and many blue-chip companies.

Other value-enhancing strategies focus on rolling out major new urban transport infrastructure projects across Australia. There has never been a bigger boom in new road and rail projects in Australia’s history. Road construction is being expedited as part of wider government plans, including federal-government incentives for the six states to sell assets and use the proceeds for new infrastructure (the Asset Recycling Initiative).

Sophisticated investors in the residential sector see property as a network asset — value depends on what happens around it — and look for opportunities close to enhanced and new transport infrastructure. With real estate prices for equivalent properties in Shanghai reaching comparable levels to Sydney, more investment is to be expected from Chinese businesses, as well as ordinary citizens keen to invest in a Western market in a similar time zone.

Mixed-use and transport-oriented developments, close to new heavy and light rail, can be expected to roll out within the coming decade, along with new office parks situated closer to new road infrastructure.

In short, the Australian market remains strong. With its economy closely correlated to China’s, continued growth in Australia turns on what happens to the north. There is a close watch on value opportunities beyond core, to core-plus, value-add and development. The next chapter in Australia’s property market is now being written.