Fitzroys Capital Markets Update and 2024 Outlook

Posted on 02nd February 2024

Commercial real estate buyers waiting in the wings

Buyers of major commercial real estate assets are waiting in the wings, anticipating the bottom of the market in the current cycle, with some astute counter-cyclical investors already emerging.

Paul Burns, in the Fitzroys Capital Markets Update and 2024 Outlook, said the significant increase in the cost of money has had a meaningful impact on both the value of property, and its salability.

“All types of property have been impacted - some more than others - and all risk profiles have been impacted - again, some more than others,” Burns said.

“Increasingly, it looks like the Reserve Bank’s fiscal policy is having an impact. More and more indicators suggest we are at a peak insofar as interest rate movement. When there will be a move in the other direction is yet to play out, but it seems to be a question of when, not if. Inflation has just reached a near-two-year low.”

“Turnover of investment property has been very modest recently. This is not a function of willing vendors, but very much because buyers are holding off until they can see the bottom of the market,” Burns said.

“Astute counter-cyclical investors are already emerging. Inevitably, as vendors observe a change in the Reserve Bank’s attitude, prices that vendors are willing to sell for today will not be accepted tomorrow,” Burns said.

“Picking the precise date when ‘the bell rings’ is very difficult. Buyers who buy near the bottom will look back with great satisfaction.

“Cashed up, lowly-geared investors are looking forward to the opportunities that are emerging and will emerge. These groups generally include high-net-worth privates, and ‘pooled investors’ who can tap into their network of investors to raise funds for discounted opportunities.

“Investors generally remain focused on property with secure, long-term leases to bankable tenants. Any exposure to vacancy, current or pending, is marked down harshly. Investors place a high value on their equity, when financiers require a greater equity component, the total return expectations increase significantly.

“When funding restrictions begin to ease and commercial property is again looked upon favourably by funders, investors will be more willing to take on counter-cyclical risks.”

Typically, larger institutional investors and REITs are under pressure to sell and so have been offloading quality assets as discounts, generally to meet redemptions, he said.

“Otherwise, there is a variety of reasons why vendors are offloading property. They may have pressures to sell however they may be motivated for positive reasons – to free up capital so they can take advantage of other opportunities, or because they have added value and are looking to recycle,” Burns said.

Yields have come under pressure in this part of the cycle as 10-year bond yields have risen. Property yields may start to tighten again once interest rates begin to fall.

The Federal Government’s Mid-Year Economic and Fiscal Outlook showed inflation is expected to fall to 3.75% this financial year, then to 2.75% in the second half of 2024 and into 2025, and then 2.5% in the following two years - the middle of the Reserve Bank of Australia’s target range of 2% to 3%.

Industrial remains a standout

“Industrial property has withstood the headwinds more than other classes; however, it seems there is a slowdown in transactional activity and maybe a levelling off of prices - the sector may no longer be as resistant to market forces as it once was,” Burns said.

“The ongoing e-commerce and online shopping booms, as well as heightened demand for transport and logistics and manufacturing, will continue to drive demand for well-located warehouses and facilities and keep vacancies near historic lows. That will see ongoing investor interest.”

He said that whilst retail centres have continued to sell, there has been a “conspicuous” softening of yields.

“Centres with a higher percentage of specialties have inevitably traded at a higher yield. Many conservative investors are seeking ‘bottom draw’ investments and are willing to pay more for risk and management-free investments.”

Yields for sub-regional centres - larger centres with more specialty retailers - have come off by around 100 basis points. Major retail asset transactions have recently been for neighbourhood shopping centres, which have a greater focus on essential services tenants and have typically traded on tighter yields. These include Burns’ recent $50 million sale of Coles-anchored Torquay Village, on behalf of IP Generation to a private Malaysian investor, on a circa-5.75% yield.

“Amid the broader market slowdown and a highly publicised gap between expectations of sellers and vendors, neighbourhood shopping centres have continued to trade strongly and on healthy yields on the rare occasion that they’ve come up for sale. Investors are seeking surety and so turning to defensive bricks-and-mortar assets with essential services tenants that have proven their resilience through the turbulence of the past few years,” Burns said.

Challenging office market

“Commercial office properties have been very challenging, generally as a consequence of the very soft leasing market, which financiers are acutely aware of,” Burns said.

“In many cases, properties have been offered and attracted little or no interest at vendor expectations. This highlights the requirement of engaging with well-connected and highly active agents.”

Burns said some recent transactions have stood out, very much going against the trend.

“A reasonable number of these have seen owner-occupiers on the buy-side - a purchaser category with the ability to outgun conservative investors who need to factor in a very difficult leasing environment,” he said.

“Office investments have a way to go but with the increasing return of workers to the office, we anticipate the commencement of a recovery in 2024.”

The Melbourne CBD has withstood the downturn much better than other office markets, Burns said, however, the turnover of CBD office sales fell significantly in 2023.

“Buyers could not get to the vendors’ price expectations,” Burns said.

“Likewise, there was a spread in yield expectations for securely leased office investments and others, as well as between premium-grade and secondary-grade assets amid the ongoing flight to quality.”

Meanwhile, alternative asset classes will continue to play a growing role in investors’ portfolio plans.

“Federal and state tax concessions have been attracting more local and offshore capital to Australia’s fledgling build-to-rent sector, which is supported by a fast-growing population and supply shortage throughout the broader residential market,” Burns said.

“The healthcare and life sciences sectors are similarly supported by strong demographic tailwinds, including an ageing and growing population, and are also attracting large swathes of capital from domestic and offshore players, from existing and new entrants to the sectors.”

Economic backdrop

The Australian economy is set to continue outperforming other industrialised countries. The International Monetary Fund expected Australia to grow by 1.6% in 2023 and is forecasting 1.7% growth over 2024. The Federal Government’s Mid-Year Economic and Fiscal Outlook forecasts 2023/24 GDP growth of 1.75%, increasing to 2.25% in 2024/25 as inflation subsides and household disposable income improves.

Australia’s unemployment rate remains low, at 3.9%.

Economists are broadly predicting interest rates to be at or very close to their peak, with a period of stability ahead into the second half of 2024. The Federal Government’s Mid-Year Economic and Fiscal Outlook showed inflation is expected to fall to 3.75% this financial year, then to 2.75% in the second half of 2024 and into 2025, and then 2.5% in the following two years - the middle of the Reserve Bank of Australia’s target range of 2% to 3%. The most recent data from the Australian Bureau of Statistics showed inflation had come down to 4.1% in November, its lowest level in two years. Predicted further falls in inflation will concurrently see the RBA begin to bring the official cash rate back down into 2025 and 2026.