Real estate to remain resilient after the election

With the Federal election now over, we have been analysing the likely impact on real estate markets across Australia.

With opportunities still to be found in a number of markets and sectors, we believe that Australians’ love affair with real estate looks likely to remain. The key is for investors to look beyond the politics and get back to the basics by focusing on economic fundamentals and understanding the opportunities for placing capital at this stage of the real estate cycle.

Economic fundamentals could trump political fundamentals

Australia’s economic situation is rapidly evolving, arguably moving ahead of any political events. Economic growth levels are now below their long-term average of 3.3 per cent since 1991, back at levels when Australia last experienced a recession. Low inflation, slow wage growth and decelerating employment growth could point to longer term risks for the broader economy. The likelihood of interest rate cuts in this kind of economic environment is high.

Understanding what’s different about this cycle

While real estate prices are at a historic 30-year peak, the drivers of this cycle are fundamentally different to previous cycles and must be taken into account when assessing potential demand for real estate. The main difference is that this cycle has been driven by equity rather than debt.

In the last three major commercial real estate downturns in 1989-91, 2001-02 and 2008-09, debt to equity ratios were way above long-term averages, as developers built large pipelines of speculative developments with the average gearing of an AREIT at 60 per cent in 2007. Today, Australian REITs have an average gearing level of less than 30 per cent.

Typically, the hallmark of a cycle peak is where real estate yields exceed the yields on offer from ‘risk free’ alternatives such as government bonds. Through the last three major corrections, commercial yields have been sharper than risk-free products. However, since 2010, yields for prime commercial real estate have remained at an average of 250 basis points higher, providing a comfortable buffer.

With further rate cuts on the cards, we anticipate spreads will broaden to create extra liquidity and extra demand for all real estate sectors. We also anticipate further yield compression as investors – both domestic and offshore, continue to look for opportunities.

Interest rate outlook and its impact

The decision of the Reserve Bank of Australia (RBA) to keep rates on hold at its May meeting was undoubtedly weighed against the risk of announcing any change during a Federal election – the last of which was in 2007 when they announced another hike.

In line with most economists, and given the current low growth cycle the Australian economy is entering into, we believe the RBA will have little choice but to cut the cash rate by at least 25 basis points. Whether this triggers improved confidence or increased lending is unlikely.

While central banking policy is important, its relevance is being overshadowed by the cost of funding for our largest lenders, and regulatory changes limiting the growth in certain types of property loans. In short, access to debt, and liquidity will remain the most important indicator to where the lending market will trend in the months ahead.

Lower for longer

While we’re seeing commercial pricing reach record levels and the cycle at full maturity, we anticipate this cycle to be prolonged, driven largely by the lower cost of capital and increased offshore demand for Australian real estate.

With this in mind, we are certainly in a competitive environment, however value can still be found. We believe commercial real estate in particular is appropriately priced at a premium given the compelling investment opportunity it presents.

Placing capital – some known knowns

Despite the relative predictability of real estate cycles, compared to the past, the cycle we are in is not without risks. Allocating capital through a changing local and global political environment, with accelerating technology disruption and mixed economic cycles, requires agility and adaptability to ensure you can maximise returns – not all real estate assets were created equal and some sectors will respond better than others.

One of the big signals to follow is government spending, particularly infrastructure spending. In the Federal budget and during the election, there were over $100 billion of new commitments made, unleashing a record level of road, rail and port development from which investors can capitalise and real estate will continue to benefit.

In an environment where risks are mounting and investors are increasingly chasing yield, the income returns on offer from commercial real estate will, in our view, need to form a much larger component of investor’s portfolios.

Undersupply of office and logistics product, record levels of population growth and infrastructure spending, combined with a lower cost of debt environment I believe will provide a potent level of support to a prolonged, positive growth cycle for real estate.