Welcome to the March 2022 edition of Banner Asset Management’s Quarterly Property Report.

Residential house prices are extending their recent gains in early 2022 but at a much slower rate than the record pace of 2021 (1), although rents are still rising at well above average rates. Record low interest rates continue to support the market but growing expectations for rate rises this year are slowing demand.

Australia’s economy returned to growth in the December quarter after contracting in the September quarter by 1.9%. The 3.4% growth in Gross Domestic Product in the year to December (2) was helped by the lifting of COVID-19 restrictions in the two most populous states – NSW and Victoria – as well as the Australian Capital Territory.

Economic growth was fuelled by a rise in services spending, government spending, rising employment and the release of household savings built since the start of the pandemic. Growth rates in spending on non-essential items such as haircuts and beauty salons were the highest on record. Air travel recorded the strongest growth in the quarter, up 56.5%, while accommodation and food services rose 26.1%. Housing investment, including construction and renovations, fell by 2.2%, but was above year-ago levels.

The national annual growth rate in residential property prices stood at 18.2% at the end of the first quarter of 2022, below the 20% mark for the first time since August last year, after reaching a cyclical high of 22.4% in January 2021 (3).

The annual growth trend is likely to ease in the coming months, as the strong gains recorded in early 2021 drop out of the 12-month calculation and as increased numbers of properties come to market ahead of expected rate rises. Industrial property remains the best performing sector of the commercial real estate market, driven by the remaking of supply chains, an influx of offshore institutional investment and a shortage of speculative supply. Office markets have remained resilient in the face of serial disruption to economic activity.

Prospects for different types of commercial real estate (CRE) continue to reflect the impact of structural change, including from the pandemic. Industrial property prices have grown strongly, driven by demand for data centres and distribution centres. In the office sector, the shift toward remote working – as well as a growing appetite for environmentally friendly, health-conscious spaces – is reducing demand for lower quality properties.

In our Spotlight section this quarter, we look at the outlook for interest rates, which have become topical in more recent times and inflation in 2022 and its resultant impact on the property market.

Economic growth was fuelled by a rise in services spending, government spending, rising employment and the release of household savings built since the start of the pandemic.

The government forecast in its latest budget that the economic expansion will continue with real GDP expected to grow by 4.25% in the 2021-22 fiscal year (1). The unemployment rate is forecast to reach 3.75% in the September quarter of 2022, its lowest rate in close to 50 years.

A record 13.4 million people had jobs in February, 3% more than a year earlier (2). The participation rate continues to rise, up 0.2%, since January and 0.6% since March 2020. However, employers are reporting labour shortages in some pockets of the economy even as international borders began to reopen. The strong labour market is expected to see wages growth accelerate to its fastest pace in almost a decade.

Australia’s east coast economies and most populous states, New South Wales, Victoria and Queensland, began abandoning lockdowns at the end of 2021 in a bid to restore normal levels of economic and social activity. The new approach has seen the rapid spread of the more transmissible but less virulent strain of COVID-19.

Borders in Queensland, South Australia and Western Australia have been reopened to allow more normal levels of activity. Supply chain strains continue to affect several industries as larger numbers of workers are forced to isolate after contracting the disease. But isolation times have been halved to seven days.

A Federal Budget released at the end of March promised cost of living relief, including one-off payments and a temporary cut to the Federal Fuel Excise to combat soaring petrol prices. The budget forecasts smaller ongoing deficits thanks to booming tax receipts from a commodity price boom, record corporate profits and continuing jobs growth.

The Reserve Bank of Australia has signalled its intention to raise rates in coming months by noting in its latest monetary policy decision that inflation “has picked up and a further increase is expected.” This marked a shift from previous statements in which RBA Governor Philip Lowe had cautioned that the RBA would remain “patient” while there remained “uncertainties” as to how persistent the pick-up in inflation was likely to be (1).

Australia’s annual inflation rate was running at 3.5% in the December 21 quarter, prior to a recent spike in the March 22 quarter to 5.1% that surpassed market estimates of 4.6%. The more policy-sensitive underlying measure has also increased to 3.7% YoY from 2.6%, compared to the RBA’s two to three percent target range.

In its latest Monetary Policy decision, published on April 5, Lowe said: “Higher prices for petrol and other commodities will result in a further lift in inflation over coming quarters,” noting important inflation and wage growth figures are due in the coming months. “The board will assess this and other incoming information as it sets policy to support full employment in Australia and inflation outcomes consistent with the target,” Lowe said.

End of Quantitative Easing signalled by US Fed

In the US, the Federal Reserve lifted its benchmark interest rate by a quarter of a percentage point on March 17, the first increase since 2018, and signalled the start of what it expects to be a series of hikes this year with further rises expected at all six remaining policy meetings. At the end of its two-day policy meeting, the Federal Open Market Committee increased the federal funds rate by a quarter of a percentage point, bringing the target range to 0.25% to 0.50%.

Subsequently Lael Brainard, who is awaiting Senate confirmation to become the next Fed vice-chair, said the Fed will also begin a “rapid” reduction of its US$9 trillion balance sheet as soon as its next policy meeting in May and is prepared to take even stronger action, if necessary, when it comes to raising interest rates in order to bring down inflation.

Economists expect any US move would pressure other countries to follow with central banks around the world expected to wind down or cease bond buying programs that have pumped trillions of dollars into their domestic economies and global financial markets as they try to rein in inflation.

Tighter monetary policy emerges globally

Following the Fed rate hike, the Bank of England raised its key interest rate from 0.5% to 0.75%, its third back-to-back increase since December. The quarter-point rise returned interest rates to their pre-Covid level and places the BoE at the forefront of a global move to tighten monetary policy.

The European Central Bank announced it will scale back its bond-buying stimulus plan in response to inflation being driven up by the war in Ukraine. The ECB said in a statement after its governing council’s meeting in Frankfurt on March 11 that it would “take whatever action is needed…  to pursue price stability and to safeguard financial stability”. Analysts have interpreted the ECB’s move as a signal that it could raise interest rates in the fourth quarter to contain soaring inflation. This would be the first such move for more than a decade.

New Zealand’s central bank raised interest rates by half a percentage point on April 13, marking its biggest hike in 22 years and the fourth time in succession it has raised rates at its policy meeting. The Reserve Bank’s Monetary Policy Committee lifted the official cash rate to 1.5% from the 1% level set in February, the first time it has delivered an increase of that magnitude since 2000. The RBNZ also reaffirmed forecasts previously published that show the cash rate is expected to climb to 2.5% over the next 12 months and peak at about 3.25% at the end of 2023.

With its latest move, New Zealand has joined the club of more than 30 central banks around the world that have raised interest rates by at least a half point in one go this year.

Meanwhile in China, the central bank has kept policy rates unchanged with most analysts expecting the People’s Bank of China to lower borrowing costs and cut reserve requirements for banks or lower interest rates to pump more cash into the economy soon to prop up the cooling economy.

The first quarter of the year has seen CoreLogic’s national measure of housing values, the Home Value Index (HVI), rise by 0.7% in March, a subtle increase on the 0.6% lift recorded in February. The uptick in the monthly rate of growth was primarily driven by stronger conditions in Brisbane, Adelaide, Perth and the ACT, along with several regional areas, offsetting a slip in values across Sydney and Melbourne.

+2.4%
Australian dwelling value 2022

The first quarter of the year has seen Australian dwelling values rise by 2.4%, adding approximately $17,000 to the value of an Australian dwelling. A year ago, values were rising at more than double the current pace, up 5.8% over the three months to March 2021 before the quarterly rate of growth peaked at 7.0% over the three months ending May 2021.

+0.3%
Sydney dwelling value 2022

Sydney’s growth rate showed the most significant slowdown, falling to 0.3% growth in the first quarter of 2022 from a peak of 9.3% in the three months to May 2021 to give a median dwelling value of $1,116,889. Melbourne’s housing market has seen the quarterly rate of growth slow from 5.8% in April last year to just 0.1% over the past three months. Its median dwelling value is $805,232.

+5.8%
Australian dwelling value 2022

+9.3%
Sydney dwelling value 2022

There were a few exceptions to the general slowdown, in growth rates, with regional South Australia recording a new cyclical high over the March quarter and some momentum seen returning to the Perth market where the rate of growth is trending higher since WA re opened its borders.

The prospect of higher interest rates is a downside risk for housing markets going forward, especially with housing debt relative to household incomes at a record high.
It seems likely the weaker housing growth trends, especially in Sydney and Melbourne, could be extended as interest rates lift. A softening in housing values could also result as new housing demand falls as the cost of mortgages rise and buyer hesitancy becomes higher.

Sales activity slows in line with price growth

National housing turnover is also easing, with preliminary transaction estimates for the March quarter tracking 14.3% lower than the same period in 2021, but still 12.2% above the previous five-year average, according to Corelogic.

Nationally, the volume of housing sales is coming off record highs but there is some diversity across the capital cities in the latest figures. Corelogic estimates sales activity through the March quarter was 39% lower than a year ago in Sydney and 27% lower in Melbourne, while stronger markets like Brisbane and Adelaide recorded a slight rise in sales over the same period.

Regional Australia continues to show some resilience to a slowdown with housing values across the combined regional areas rising at more than three times the pace of the combined capital cities through the March quarter. Regional dwelling values increased 5.1% in the three months to March, compared with the 1.5% increase recorded across the combined capital cities. The rolling quarterly growth rate in regional dwelling values has consistently held above the 5% mark since February 2021.

Australian Bureau of Statistics (ABS) regional population growth figures for FY 2020-21 help explain the strong housing conditions outside of the capitals. The number of people living in regional areas of Australia increased by almost 71,000 residents, while residents living in the capitals fell by approximately 26,000, due mainly to a sharp drop in Melbourne and, to a lesser extent, Sydney.

The prospect of higher interest rates is a downside risk for housing markets going forward, especially with housing debt relative to household incomes at a record high.

It seems likely the weaker housing growth trends, especially in Sydney and Melbourne, could be extended as interest rates lift. A softening in housing values could also result as new housing demand falls as the cost of mortgages rise and buyer hesitancy becomes higher.

Strong investor demand throughout the pandemic has compressed commercial property yields to record lows, particularly for industrial properties, which in turn has increased values to record highs.

3.71%
Prime Industrial Yield

Increases
Property income is expected to start to increase in the short- to medium-term

For the first time, the Australian average weighted Prime Industrial Yield of 3.71% has moved clearly below Prime CBD Office Yield of 4.53%, as at the end of 2021. However, rising funding costs may impact the market in several ways, challenging these high prices and values. First, it may reduce the amount investors can borrow and therefore bid for properties. A reduced number of bidders and the lower competition this creates may be enough to ease trading activity and price growth.

Property income is expected to start to increase in the short- to medium-term, as the economy rapidly rebounds from the impacts of COVID. Driving this will be a reduction in vacancy rates as well as a more general lift in inflation. Projections for increasing inflation should feed through to rents linked to the CPI over the next couple of years. So softening yields or cap rates may, at least in part, be compensated by this potential rise in property income over the next 1-2 years, as the driver of price and value switches from cap rate compression to income.

Sydney
The demand for warehousing and distribution space has continued to grow and by the end of 2021 around 1.2sqm had been leased in Sydney, surpassing the previous two years and setting a new record high. Vacancy levels continued to decline to record low levels to measure 126,061 sqm in Sydney by the end of December 2021, a 36% decline from the Q3 level and a 78% decline in year-on-year terms (1).

“Strong demand for warehousing in Sydney’s western precincts suggests there has been an increase in the number of occupiers moving away from ‘just in time’ inventory practices to higher inventories that require more storage space.”

Melbourne
The sharp rise in demand from occupiers extended throughout the fourth quarter to see around 2 million square meters of industrial space leased for the year. This was more than 10% up on 2020 levels and more than double the volumes recorded five years ago. Vacancy levels dropped to 266,745 sqm by the end of last year, its lowest level since March 2019. Rental growth continue to pick up in Q4 with average prime rents showing a Q-on-Q increase of 2.2% and year-on-year growth of 4.1%.

“There was even bigger growth in the Southeast and West which increased 12.9% and 4.8% respectively over 2021.”

Brisbane
Leasing take-up decreased in Q4 though that came after strong growth in Q2 an Q3. However, tenant take-up activity remained well above the five-year quarterly average, which lifted annual leasing take-up to 826,260 sqm or 92% above 2020 levels. Vacancy levels fell a further 19% in Q4 to be 44% lower by year’s end than at the start of 2021. With total vacant space at 353,692 sqm available at the start of 2022, prospective tenants have narrowed considerably. However total new supply in 2022 is expected to be around 600,000 sqm with about a third already under construction.

“Average prime rents increased by 4.6% over 2021 to $119 sqm, while average incentives have also ticked down across existing stock to 15.6%.”

The ‘new normal’ will likely feature a transition to a hybrid work model which will present a challenge to some sectors.

However, a positive flow of pent-up leasing demand in the prime office market through the second half of 2021 reflects a strong underlying and ongoing preference by Australian businesses for well-located, high-quality office spaces. Employee wellbeing, sustainability, technology, and connectivity are all increasingly seen as important in the post-Covid world for office-occupying businesses in driving the collective best from their staff. The ability for markets, sub-markets and assets to deliver on these tenant priorities is expected to drive a divergence in performance across Australia’s office markets throughout 2022.

Sydney
The Sydney office leasing markets showed tangible signs of recovery over the second half of 2021. The Sydney CBD recorded 35,500 sqm of net absorption over final six months of 2021 and the strong result was mirrored across a number of suburban office markets. Sydney’s office markets were characterised as having a high level of liquidity across the risk spectrum and a number of new pricing benchmarks were achieved. Market transaction volumes totalled $7.52 billion, or 48% of the total Australian office sector. The vacancy rates in Q4 2021 remained largely unchanged from Q3 though when compared with Q4 2020 the vacancy rate was up 9.2% from 5.6% (1). In terms of new supply around 150,000sqm is expected to become available in 2022.

35,500 sqm
Positive net absorption Sydney CBD

Melbourne
The Melbourne office leasing markets were disrupted by multiple lockdowns in 2021, which negatively impacted occupier decision-making. Leasing enquiry and activity started to improve over the latter part of 2021 and the Melbourne CBD recorded positive net absorption of 36,800 sqm over the second half of 2021. Melbourne office market transaction volumes were $3.54 billion in 2021. Excluding the acquisition of 695 Collins Street, investment activity was stronger in the Melbourne Fringe and suburban office markets than the CBD. Melbourne’s vacancy rate jumped to 10.4% in Q4 of 2021, up from 8.2% in Q2 but is expected to stabilise going forward as confidence slowly returns. However, the recovery is likely to be slower than in Sydney with vacancy rates likely remain in double digits throughout 2022 and into 2023.

36,800 sqm
Positive net absorption Melbourne CBD

Brisbane
The Brisbane office leasing market was less disrupted by lockdowns in 2021 and sublease availability in the Brisbane CBD (1.04% of total stock) was significantly lower than the Melbourne CBD (3.65% of total stock) and Sydney CBD (1.91% of total stock). However, national occupier decision-making was more elongated and leasing enquiry was stronger from small and mid-sized organisations. All the office market transactions above $100 million in 2021 occurred in the Brisbane CBD. Vacancy rates stabilised in Q4 at around 13.5%, little changed from previous quarters. The Brisbane market did see some marginal growth in rents, but effective rents have contracted by 7.8% since 2020.

13.%
Stabilised vacancy rate Brisbane CBD

The rise of inflation 

Inflationary pressures are now more evident across Australia with rising prices for petrol and other commodities set to ensure it will grow for some time yet. Consequently, the prospect of rising interest rates has begun, which is expected to have an impact on all forms of property investment.

Australia’s annual inflation rate has only recently risen to 5.1% in the March 22 quarter (from 3.5% in the Dec 21 quarter), although in underlying terms inflation it is running at 3.7%. This is far better than many other developed countries like the US and UK where inflation rates are at 8.5% and 7.0% respectively.

Inflation experiences

In a speech in March, the RBA Governor noted three key reasons why the US inflation experience was different to that of Australia, with Australia’s inflation half that of the US. These were:

Firstly, household gas and electricity prices are up by 25% and 10% respectively in the US, compared to only modest price rises in Australia;

Secondly, goods prices have risen by 9% in the US (excluding energy costs), compared to an increase of circa 3% in Australia; and

Finally, labour costs have risen more noticeably in recent times in the US compared to Australia.

Closer to home China’s inflation is running at 8.3%, although in Japan the CPI in March only rose 1.3% over the year.

Economists expect the Reserve Bank will act soon to contain this inflation surge by announcing its first rise in official interest rates in more than 11 years in June at the latest, and financial markets are expecting the cash rate will keep rising and could reach at least 2.5%.

Debt repayments may struggle

In its latest twice-annual Financial Stability Review, the RBA warned that as debt levels at present are high relative to income for many households and businesses, and if interest rates increase, then it will impact households’ ability to meet debt repayments.

“Higher inflation will reduce the funds households and businesses have to make those payments, particularly if incomes do not increase alongside higher interest rates. Loan performance could then deteriorate significantly,” the RBA said.

The RBA did note however, that businesses debt repayments may be limited by their relatively low leverage. For households, the RBA also noted that they are broadly seen to be better placed to meet potential higher debt payments as many have been making excess mortgage payments in recent years as a result of the historically low interest rates.

Commercial property outlook varied

In the commercial property market, however, the impact is likely to be more complex as the broader economy is still set to grow following the pandemic. Australia’s economy is forecast to see real GDP grow by 4.25% in the 2021-22 financial year, stabilising to around 2.25% the following fiscal year, according to the latest budget forecasts.

This is likely to lead to increase demand in many sectors of the market in time.

Strong investor demand throughout the pandemic has already compressed commercial property yields to record lows, particularly for industrial property, which in turn has increased values to record highs. At the end of 2021, for the first time, the Australian average weighted Prime industrial yield at 3.71% had moved clearly below Prime CBD office yield of 4.53%.

Property income growth seen

The Commonwealth Bank of Australia, in a commentary on the unfolding situation, said: “History highlights a positive relationship between the cost of funding debt, investment yields and cap rates applied to commercial property valuations.”

As funding costs rise over the coming months if not years, CBA sees the impact for commercial property in a number of ways.

“First, it may reduce the amount investors can borrow and therefore bid for properties. A reduced number of bidders and the lower competition this creates may in itself be enough to ease trading activity and price growth.

“At the same time, property income is expected to start to increase in the short- to medium-term, as the economy rapidly rebounds from the impacts of COVID. Driving this will be a reduction in vacancy rates as well as from a more general lift in inflation.”

“So, although market interest in commercial property remains high, particularly for prime-grade assets, a period of softening in cap rates is likely as rising cost of funds impacts transaction feasibility. Lower valuations, however, may yet be compensated by a lift in income over the short to medium term, driven by market improvements or a lift in the CPI,” the bank concluded.

Many properties also carry inbuilt protection against the effects of rising inflation, with annual rent reviews tied to the consumer price index (CPI) or CPI+, providing rising income throughout the term of a lease. In a recent Build Australia article, it was noted that commercial property shares an interesting relationship with inflation that may be described as an “inflation hedge”.

This was due to commercial property leases typically including inflation proof clauses that allow for flexible structures where annual rental payments can be adjusted as per the current level of the CPI. This can be more significant during times where rising inflationary pressures are evident.

Analysis by BNP Paribas Real Estate found that in Europzone economies there was only a modest and highly variable correlation between interest rates and property yields. Between 2005 and 2007 the correlation turned negative as property yields declined and bond yields rose. After the last interest rate peak in 2008, bond yields began to decline as property yields rose into 2009 and then stabilised through 2010-2013 as interest rates fell. The correlation turned positive again in 2015 as, possibly because of the increasing importance of central bank quantitative easing (bond buying) programs.

“It is not necessarily true that an increase in interest (or bond) rates must be associated to an increase in property yields,” BNP Paribas said. “History teaches that frequently this is not the case and other explanations need to be considered. The most likely explanation is that real estate behaves like a hybrid between fixed income and equity. Higher interest rates are normally related to higher growth rates, which, in turn, should result into faster income growth for real estate assets, all else equal. Consequently, real estate investors should accept lower initial yields on a real estate asset.” Property investment management company Charter Hall has also found that in periods of higher inflation, the tendency has been for annual returns of commercial real estate to be elevated.

“Commercial real estate has historically provided a solid hedge and performed well in periods where inflation increases against the backdrop of economic expansionary periods,” it said.

Commercial property debt strong

Another area which is expected to do well in this emerging environment of higher rates amid solid economic expansion is the commercial real estate (CRE) debt market – a market dominated by the banks but where non-bank operators have grown market share by operating specialist funds.

CRE debt yields combine the standard base rate plus a margin on the loans to account for any risk posed by the borrower, so any increase in the base rate caused by increases in official rates directly results in higher returns to investors, provided of course margins remain stable. Holding commercial real estate debt may prove an appealing alternative for investors who are attracted to investments in commercial real estate and like the prospect of increasing yields as interest rates rise.

Post-Covid, the commercial property market is in for a period of major change. Higher interest rates look inevitable but, as they are expected during a period of higher growth rates, investors should see a rise in income growth for real estate assets.

As long as there are no major surprises along the way, commercial property looks set to ride out the changes ahead with some solid returns for investors.

We provide an opportunity for investors to gain exposure to the real estate debt market through lending to established and proven developers for development projects, or for strategic acquisition of sites earmarked for development in the future.

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At Banner Asset Management we provide opportunities to invest in direct real estate through funds alongside other project partners.

In the residential space, our focus is on medium density development (apartments and town-houses) in the bigger population centres of Sydney, Melbourne, and Southeast Queensland, which provide greater liquidity and depth than other markets in Australia. This includes mixed-use residential projects that incorporate uses such as office space or retail. We also invest in non-discretionary retail and the industrial sectors, as growth in e-commerce drives demand for warehousing and logistics.