As we move into a new part of the investment cycle, a rise in bond yields will in time make them more attractive for investors, however there is still a long way to go according to Dr Shane Oliver, Chief Economist. Here, Shane explains why commercial property will be attractive for investors looking for yield.
Commercial property remains an attractive hunting ground for yields, even in this current environment where bond rates are improving.
Australian unlisted commercial property has been very strong this decade notching up returns of 11 per cent per annum on average over the combined office, retail, and industrial space.
Now we are moving into a different part of the cycle.
The US Federal Reserve raised rates three times last year as the economy grew, and as the risk of deflation receded and was replaced by the risk of higher inflation. We expect the Fed to raise rates about four times this year, while rates in Australia are probably not likely to rise until 2019.
The rise in bond yields will over time start to make them more attractive for investors but there is a long way to go as yields are coming from such a low level, and in the meantime parts of the commercial property space is enjoying stronger fundamentally driven demand.
Rising rents, particularly in the south-east Australian office markets, combined with a strong industrial sector, stemming from demand for logistics related real estate; is more than offsetting weakness in the retail space and is keeping returns solid for now.
Our expectation is for a gradual rise in bond yields, to around 3.5 per cent by end 2019 for Australian 10-year yields. We also don’t see US recession a risk until around 2020.
Against this backdrop, overall returns from unlisted commercial property are likely to remain strong for a while yet as stronger leasing conditions take over from falling yields as a key return driver.
Interestingly, the choice between unlisted commercial property and A-REITS is now line ball with the latter having reversed their recent outperformance and now offering similar yields to unlisted.
But returns are likely slow to around 9.5 per cent over the next year or so as the “search for yield” tailwind fades.
However, a key point is that even though commercial property yields have fallen sharply they still offer a strong premium relative to bond yields suggesting we are a long way from a major cyclical downturn in commercial property.
The key threats to watch for are a sharp rise in bond yields and a deterioration in the global/Australian economic outlook.
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