Many believe that the GFC shock has brought property markets back to reality. And there is a sense in which that’s true – but only partly. The adjustment hasn’t finished.
Property people are starting to understand just how strong markets will be. But equity and some debt markets are misreading risk. Excessive caution in those debt and equity markets is inhibiting development, constraining prices and setting us up for a shortage of space, a period of capacity constraints, and underwriting the strength of the next upswing.
Certainly, there remain problem loans for banks with entities hit by the GFC-induced fall in prices and unable to raise the equity to reduce gearing to acceptable levels. But we shouldn’t confuse these entities with the prospects for property markets.
Investors are largely absent, often misreading property risk and return, and missing an extraordinary investment opportunity. We’ll need them to finance the next round of development. In particular, the super funds have been extraordinarily timid, taking their risk/return readings from the rear vision mirror. Their allocation to property is too small. They’ll come back, but later.
Property markets have bottomed and are coming off their low points. Demand has recovered, while supply remains suppressed. The market is nowhere near equilibrium:
- We’re not building enough
- Rents and prices are too low
- There’s a shortage of equity funding
- Banks are excessively cautious.
It can’t stay like this – and won’t
In terms of the outcome, the overriding logic is that we are not building enough. Development collapsed during the GFC, initially as pressure by banks to reduce gearing dried up funding and later as the correction in yields took prices below replacement cost levels. Commencements of office, retail, industrial and hotel building collapsed. We’re not building enough to meet even moderate demand. And demand has already started to recover.
It’s worth remembering that the GFC wasn’t an isolated shock. It was a response, a correction following the preceding financial engineering boom where property geared up worldwide. Weight of money drove a long phase of ‘yield compression’. We ended up overgeared, overvalued and on the way to being oversupplied. In Australia the GFC prematurely curtailed construction with minimal oversupply.
We all know what happened in the GFC-induced correction. The fall in prices increased gearing, causing most property vehicles to breach LVR covenants. Banks applied extreme pressure to reduce gearing, slaughtering development finance. Some entities were able to raise equity to reduce gearing. Others remain on the banks’ problem loan books. Only now are many property players emerging from survival mode and starting to look around for opportunities. Much chastened by the crisis, they’re all more cautious about debt. With investment and debt finance markets also extremely cautious, there’s a shortage of funding.
The GFC-induced correction isn’t over
So far, we’ve only had Phase I, an investment market correction to yields and prices. But that’s left the market out of kilter. We’re not building enough. Prices are too low, mostly below replacement cost levels. Funding, particularly equity, is scarce.
Phase II involves a correction in leasing markets to bring rents back to levels sufficient to underwrite financial feasibilities and prices back above replacement cost. But that only happens as leasing markets tighten sufficiently to underwrite rent increases. And, given the lead times in development, leasing markets will stay tight for years, underwriting further rent rises and taking prices beyond replacement cost levels. We’ll overshoot.
Only then, after a period of rising rents and prices, will we see Phase III as investors come back in force, driving firming yields.
During the GFC period, we spent time trying to understand what property is worth, looking at yield formation, the extent of overshoot during the yield compression boom, how far yields would soften and the extent to which the softening of yields was a correction rather than a shock.
The experience and the outlook is different between markets.
Retail and industrial property, particularly higher yielding properties, were picked up in the financial engineering boom. We forgot risk; hence the yield compression. Office property seems largely to have missed the boom. All were hit by the correction.
Retail property performed relatively well through the downturn. The strong Australian dollar and high margins cushioned retailers from economic conditions, maintaining rent levels and centre incomes. But the softening of yields led to a fall in prices of between 10 percent (regional centres) to 20 percent (sub-regional) and 30 percent (bulky goods). Poorer properties fared worse.
We think the stability of income led to re-rating of retail property. Yields have peaked and started to firm, but won’t go anywhere near 2007 levels this decade. We’re looking at solid but not spectacular returns for retail with IRRs around 10 to 11 percent over the next five years. But we are concerned that all the good news is in the market. The risk comes with the impact on margins and retailers of a fall in the dollar. Meanwhile, the large investors love retail and, given that retail is locked into competitive refurbishment, we expect development to recover quickly.
Industrial rents held fairly well through the downturn, but the softening in yields caused price falls of 20 to 30 percent. This was largely a correction following the overvaluation of the boom. While demand for property will return, there’s plenty of good industrial land to keep a lid on site values. But tenants won’t get the free ride they’ve had for decades, when expectation of yield compression kept a lid on rents. We expect moderate rent rises to underwrite new projects, with only minor firming of yields.
Hotel property was caught in the correction, with a moderate weakening of revenues and a blowout in yields taking prices down a third, below replacement cost. Meanwhile, recovery in business travel has more than offset weak tourism in the cities. High occupancy and rising revenues will underpin a strong cyclical upswing.
The eastern seaboard and Perth office markets were hit both by falling rents and softening yields in the downturn. Prices fell below replacement cost levels. With little speculative development and long lead times, suppression of supply means sharply tightening leasing markets and sustained low vacancy rates two, three and four years hence. We are forecasting strong rent and price rises over the next five years, doubling in some cases, underwriting IRRs (passive investment – no gearing, no development) between 15 and 20 percent.
Thinking long, not short
This is an extraordinary time for property markets. It’s certainly not a time to be sitting on our hands, though some have little choice (for lack of finance).
Gearing is more conservative now. Property needs to attract equity. And it makes a lot of sense for investors. You can lead a horse ...
But both equity and debt markets are excessively cautious, still mis-reading risk. Risk was high in 2007 when the market was over geared, overvalued and in danger of being oversupplied – but not now. Apart from the problem loans, gearing has been reduced. Following the correction, property is undervalued, not overvalued. And there is no danger of oversupply – the opposite in fact. Risk is low, not high.
And that’s not the only conventional wisdom that’s drawn the wrong conclusions from the GFC correction.
The market wants long lease expiries, not short. I don’t. I can understand that logic from lenders, but we can add substantial value by re-leasing buildings at higher rents in three to five years time. Rent reviews meet my objection – if you can get them.
Some want only prime properties, not secondary. I don’t. Certainly, secondary property had a greater correction, having been picked up in the FE boom. But demand for secondary properties will increase as rents rise and trigger corporate budget constraints. They’ll show good returns.
Some developers try to bring projects forward. If I had a good site now, I’d wait, particularly if I needed substantial pre-commitments. It’s better to lock in higher rents later. This is the time to pick up sites, but not yet time to develop.
In the rush to securitisation in the boom, property companies tried too hard to please the analysts. And were crucified by the same analysts when the market turned. Surely we have learnt that we have to do the right property thing?
But the point is that the current mis-pricing and excessive caution have opened up opportunities. The market will change – a lot. There’s a lot we should do now. And we’re starting.
Property players are now emerging from survival mode and looking for opportunities. The first step is evaluation and reshaping of portfolios, to do the best they can with what they have, given constraints on availability of finance. I don’t mind that they draw different conclusions.
This is the time to think long, not short. This is the time to set up to realise returns in three to five years time.
Frank Gelber is chief economist and director at BIS Shrapnel.