Property strategies in challenging times

Office market: Over the last three years, the office market has been challenged. However, compared to other major cities globally, the vacancy rates in major Australian cities, whilst elevated — Sydney at 11 per cent, Brisbane 13 per cent, Melbourne 14 per cent, and Perth at 16 per cent — are still lower than the global average.

“The office market is facing some key challenges,” says Damon. “From a cyclical perspective, demand might be sensitive to the economic slowdown that we’re currently experiencing, and from a structural perspective, the market is adapting to the impact of hybrid working.”

Another trend in the office market that he identifies is the flight to quality. Occupiers are concentrating their demand for space into modern, high-quality buildings, in good locations. This trend has implications in terms of asset selection and performance. High quality buildings in desirable locations are better placed to retain their tenants and grow rental returns, whereas secondary buildings in poor locations will have greater difficulty in retaining tenants, as companies seek quality office space that appeals to their staff.  

Retail market: According to Damon, the retail market has been a ‘quiet achiever’ post-COVID. During the pandemic period, retail sales ran at approximately double long-term averages, with discretionary retail spending having a boom period throughout 2022. However, with higher interest rates and cost of living pressures, the growth rate of discretionary retail spending declined significantly from early 2023.

“The good news is the vacancy rates within most shopping centres are trending down, apart from CBD retail,” says Damon. “Overall, large regional shopping centres are well placed to weather the slowdown in retail activity that we’re experiencing.”

Damon adds the rental income coming out of retail assets has been sustainable, in view of potentially more headwinds for the sector. Retail assets have also generally been trading on a higher investment yield compared to the office and industrial markets. “So, from a relative value perspective, the retail sector looks attractive.”

Industrial market: The industrial market has been the ‘golden child’ of the property sector over the last couple of years. Throughout the previous 12 months, this sector has achieved extraordinary rental growth in the Australian market, with major markets recording a 15-30 per cent increase in rental growth. Damon says this growth has been driven by a surge in demand for industrial space that occurred during COVID.

“The demand peaked in 2022, as the surge in online shopping drove vacancy rates down to near zero in some markets,” says Damon. “Moving forward, we expect demand to taper off as the economy slows. However, from a supply perspective, we don’t believe there is sufficient supply entering the market to force vacancy rates back up to pre-COVID levels.”

According to Damon, the industrial market has solid fundamentals in place, which provides a positive outlook ahead. The sector has: a sound demand/supply situation; it will benefit from Australia’s population growth; and it will also gain from the rising appetite of e-commerce, which will drive demand for industrial space over time.

JANA Investment Advisers — was able to make a number of key observations into what’s happening in the property market globally.

“If you look at the Australian index for unlisted property to the end of June 2023, it declined by -1.3 per cent. However, in the U.K. that decline was -17.1 per cent, and in the U.S. it was -10.7 per cent. So, there is quite a dispersion in negativity across the globe,” says Mary. “The driver for this negativity was the rise and speed of interest rate hikes.”

In terms of the types of assets overseas investors are interested in, Mary says there is a definite lack of capital to access anywhere, with illiquidity prevailing. “What do people do when they’re uncertain about where valuations are, they sit on their hands,” she says.

But having said that, Mary notes that a few of the bigger players, like Blackstone, are looking at: data centres (which has traditionally been an infrastructure play but there are leases now where it’s becoming a property play); student accommodation; single family housing; healthcare; life sciences; and hospitality (Blackstone owns Crown in Australia).

Another trend Mary identifies from overseas is the demand by tenants for sustainable property. She says there is a reasonable consensus globally around property sustainability.

“In Australia, we’ve been on a sustainability and ESG journey for many years. Our peak body — the Property Council of Australia — is in regular dialogue with the Government. So, the ‘built form’ — the height, volume, and overall shape of a building, as well as its surface appearance — in Australia is taken very seriously by the Government.”

As an example of the number of benchmarks that are used to rate an office building in Australia, Mary refers to the skyscraper, Gateway, at 1 Macquarie Place, Sydney, which was built in the 1980s.

“It is well located and has a line of tenants wanting to get into the building, despite its age and being almost fully occupied,” she says. “Yet, it has a NABERS (National Australian Built Environment Rating System) rating — a sustainability rating that provides a rating from one to six stars for a building’s efficiency across: energy, water, waste, and indoor environment — of 4.5 stars.”

European investors are also focused on the area of sustainability, with Europe also using a similar ratings criterion for its buildings. 

“Organisations have signed corporate responsibility statements in relation to sustainability. As a result of this sustainability overlay, you can expect that a certain sector of the office market (usually older buildings) will be impacted, because the level of capex to bring a building up to a NABERS rating of 4.5 stars won’t deliver a return on the capital invested,” says Mary.

Damon adds there are some global benchmarks that are used, like the Global Real Estate Sustainability Benchmark (GRESB) — ESG performance data and peer benchmarks for investors and managers — which are implemented globally, enabling investors to benchmark the performance of assets.

When it comes to accessing alternative sectors, like ‘build-to-rent’ housing — large-scale, purpose-built rental housing that is held in single ownership and professionally managed — unlike the U.K. and U.S., this type of housing hasn’t really taken off yet in Australia.

Louis Christopher — Managing Director at SQM Research — believes there are a number of reasons for this, such as Australia’s taxation regime, where negative gearing doesn’t really work well for trust structures.

“As a researcher and a rater, we’re not seeing any product in the ‘build-to-rent’ space come through yet or any enquiry about how to access the market at this point in time. However, I’m sure that will change moving forward.”

Instead, SQM Research believes there are sectors of the Australian property market that are well placed for growth in the years ahead. One sector is data centres, although SQM Research isn’t currently seeing individual property syndicates with data centres in them. However, it does believe they are coming, because the rents are quite strong with data centres. Another area SQM likes, particularly with Australia’s strong population growth, are storage centres. Louis adds that rents in this sector of the market are growing much higher than CPI.

In terms of healthcare, he argues this sector is already well established in Australia, but acknowledges there are still opportunities for investors. “With Australia’s forecasted population growth rate, there will be ongoing demand for healthcare services. The rents achieved with healthcare have been running above CPI consistently for some time, and while we won’t see yields again of 9-12 per cent, we should get a good run with rents.”

When weighting to property within a multi-sector portfolio, Mary cautions that real estate is an illiquid sector, which hasn’t the type of liquidity to buy and sell assets like equities. However, if she could, Mary would be underweight and looking for opportunities to re-weight to neutral.

“But in a practical sense, that’s not the case,” she says. “Most people would be at weight or a bit above. From what I’m seeing, allocations to property can be anywhere between 8 per cent through to 15 per cent, but I think that will probably come back down to around 10 per cent.”

When allocating property, Louis warns to watch out for the REIT index, which is heavily concentrated towards the Goodman Group — a commercial and industrial property group that owns, develops, and manages real estate, including warehouses and logistics facilities.

“Goodman currently is trading on a very tight yield and given the weighting of Goodman to the REIT index, it’s a little concerning. There are definitely better opportunities available in the sector,” he says.

Given the current liquidity squeeze on capital and risks around property valuations, Mary believes for investors to regain their confidence to re-enter the property sector, they need to be confident that interest rates have peaked, indicating that we’re over the worst of inflation.

“There also has to be some level of resetting of valuations. When this occurs, I think we’ll see a flow of capital back into the sector,” says Mary. “Australia is unusual in that it’s considered part of Pan-Asia from a capital flow perspective. We’re also a well-regarded and transparent country for property. So, once the market resets, I’m confident we will see capital flow back to the Australian property sector.”