INTRODUCTION
As the Australian economy continues to adjust to the changing global economic landscape, it is evident this is causing bifurcation not only between real estate asset classes but also within them. Here we take a macro-level review of what has occurred to date.
At the headline level, a surge in inflationary pressure has prompted an aggressive interest rate hiking response that has subsequently caused economic growth to slow.
- There have been 12 interest hikes, totalling 400 basis points, over the past 17 months.
- The latest monthly estimate of inflation, as at June 2023, was 4.9%, above the target range of 2% to 3%.
- The latest GDP reading was growth of 0.4% quarter-on-quarter, or 2.1% year-over-year to June 2023.
While these factors point to a cyclical downturn, it is important to also recognise the resilience of the Australian economy. The Reserve Bank of Australia has been battling inflation pressures for almost 18 months and has embarked on the fastest hiking cycle in decades. However, economic growth remains firmly in positive territory to the extent that the possibility of a “soft landing” is becoming increasingly plausible – something that was thought largely as a low likelihood just a few months ago.
Commercial real estate is strongly tied to economic conditions which are impacting the sector. Indeed, while the national economy appears to have avoided a recession (technical or otherwise), commercial real estate is showing recessionary indicators, at least for some areas. National investment volumes are down over 60% year-on-year in H1 2023, capitalisation rates have softened by 25-50 bps and there has been over 117,000 square metres of negative net absorption across Australia’s office markets in the past six months. While these figures point to difficulties the sector is facing, they do not tell the whole story.
Commercial real estate is not a single homogenous entity, although sometimes it gets portrayed as such. Rather there is great diversity within the sector, not only between asset classes, but also between assets. It is important to understand that commercial real estate is not one-dimensional, and that it is this heterogeneity that will drive the sector forwards and deliver opportunities into the future.
OFFICE
The office sector is facing the greatest pressures from structural change as flexible working practices become increasingly adopted. While data shows that employees who have greater choice of when and where to work have significantly higher workplace experience and engagement scores, collaboration from in-office attendance helps to boost productivity and supports employee retention by building corporate culture.
What does this mean?
- Creating office spaces that employees choose to work in – high quality office assets with high levels of amenity in high-demand locations.
- Landlords will likely need to allocate larger annual capital expenditure budgets to their assets.
- Some offices will require extensive repositioning programmes to bring them up to current market requirements. These programmes should focus on amenity, wellness and sustainability as tenants will increasingly look to partner with landlords to help them meet CSR and ESG goals as well as using their office space as a key factor in talent attraction and retention.
- The benefit for landlords will come from higher occupancy rates, shorter letting up periods and therefore greater surety of cashflow. The latter is of particular importance in the current interest rate environment
INDUSTRIAL
The industrial sector has been a net beneficiary over the recent structural changes. Strong tenant demand has been driven from several areas including population growth, e-commerce growth, automation and the reshoring of essential manufacturing. National vacancy rates remain exceptionally low at circa 1%, which together with limited new supply, have help drive incredible rental growth. Taking Sydney as an example, rents have increased 66% since December 2019 and 55% in the past year. As impressive as this is, it pales compared to some markets overseas. For example, rents in Los Angeles are up 89% since December 2019, while rents in Inland Empire (Southern California) are up 110% over the same period.
What does this mean?
- Rents in Australia have further to run, especially as vacancy is not expected to shift materially over the near term.
- In terms of heterogeneity, such market conditions lend themselves more favourably to assets with shorter weighted average lease expiries (WALE). These assets will allow resetting rents to current market levels and therefore avoid being locked into below-inflation annual rental increments.
RETAIL
The retail sector has been buffeted by a number of headwinds as “bricks and mortar” retail has been increasingly challenged by the rise of e-commerce. Furthermore, it has withstood perhaps the largest stress test ever as the pandemic forced ongoing shutdowns. However, retail destinations still continue to perform strongly, highlighting not only the resilience of the sector but also the diversification within it.
It is only over the past few three months or so that retail turnover in aggregate turned negative as interest rate hikes have curbed consumer expenditures and run down excess savings built up during pandemic lockdowns.
What does this mean?
- Smaller shopping centres, focussed on non-discretionary retail, continue to hold up well as they are supported by ongoing strength in food retailing.
- Larger shopping centres have had to pivot and establish themselves as key retail destinations.
- The growth of e-commerce has driven the need to create a high-quality customer experience to generate footfall traffic.
- “Retail” is not just about shops as centres continue to adjust their tenant mix. This is most readily seen in the increased allocation to food and beverage (with café, takeaway food and restaurant retailing still performing strongly), but also to alternative uses such as medical that bring repeat customers and longer dwell times. The most successful centres are those that have established themselves as an essential part of the community and have been embraced as such.
BUILD-TO-RENT
Arguably, build-to-rent (multifamily in the U.S.) is Australia’s newest and fastest-growing commercial real estate asset class. While it is considered mainstream in the US, accounting for the largest share of investment volume, it remains relatively niche in Australia.
To a large extent, this has been due to cultural legacy, given Australians’ preference for detached housing and taxation structure. However, demand patterns are shifting to higher-density living, not least due to the greater affordability of this product but also the need to accelerate housing supply, with higher-density development being more supply-side efficient.
The build-to-rent sector has responded rapidly, especially in 2023, with a number of new entities entering the market.
- The government forecasts a ‘bumper crop’ of 250,000 long-term migrants over the next 24 months, placing more pressure on an already strained housing market
- These migrants will primarily settle in Sydney and Melbourne and be more amenable to higher-density living. Currently, there are 40,000 units either completed or in the pipeline, of which 58% are located in Melbourne.
- Tight national residential vacancy (1.2% currently) and demand will exacerbate affordability issues.
The average length of time required to save for a unit or a house in Australia is 12 years and 16 years respectively which means Australians are likely to be locked into renting for longer. While this speaks for the greater need for housing in general, there will be a key role for build-to-rent as institutional landlords not only contributing to the volume of new supply but also diversity in product offering as well as alleviating pressure on the build-to-sell market.
CONCLUSION
In conclusion, the Australian commercial real estate market is navigating a dynamic landscape shaped by a combination of global economic shifts and domestic structural and cyclical changes. In this evolving landscape, commercial real estate stakeholders must recognise the nuanced opportunities and challenges within each asset class. Adaptation, innovation, and an understanding of changing market dynamics will be key to success in the Australian commercial real estate market moving forward.
