Most people look to a federal budget with a view to how it affects them directly, but it’s often the indirect, second-order effects that emerge over the longer term that turn out to be more important.
So it is likely to be with the 2022-23 federal budget.
It offers a pre-election sweetener of household financial relief and a package of road and rail infrastructure that comes at the longer-term cost of continued budget deficits and growing national debt. It is this second-order, macro-economic effect that is likely to have the most impact on commercial real estate investors.
Government deficits generally flow through to higher inflation and higher interest rates — and it is interest rates that form the ultimate backdrop for real estate. Borrowing costs are already rising, with commercial loan rates now somewhere between 2.5 per cent to 41 per cent while capitalisation rates on sectors like office and industrial are as low as 3.5 per cent to 42 per cent.
In our experience, the last time Australia had an inverse cap rate like this was leading into the global financial crisis (GFC).
Now in our view there’s no suggestion that a similar blow out in cap rates like we saw post-GFC is on the cards this time around — generally gearing levels in real estate trusts at about 30 per cent are well below the 50 per cent plus levels pre-GFC3.
But real estate investors need to keep in mind what in our view is the unbreakable link between elevated levels of government expenditure, higher inflation and higher overall interest rates.
It’s not just because central banks usually respond to inflation. It’s also because the government must borrow to fund its spending over the next decade and this is likely to put upwards pressure on bond rates, which have risen from what they were before the pandemic.
With bond yields going up and the cost of borrowing going up, we anticipate there will be some yield reversion and cap rate expansion, potentially sooner than our current forecast of 2024.
To be sure, there is immediate support for commercial real estate in the federal budget.
The $18 billion in infrastructure spending4 is welcome — if a government is going to run deficits, they might as well spend it on good structural reform. And the budget’s underlying economic forecasts of around 3 per cent economic growth and 4 per cent unemployment5 are likely to be supportive for commercial real estate.
They especially underpin base office demand — when unemployment historically sits at 4 per cent, vacancy rates typically sit below 10 per cent nationally.6
So, the budget forecasts are a good leading indicator.
It’s also worth remembering as a real estate investor that inflation is generally not a bad thing for real estate income. It means the economy is running hard, confidence is up, and businesses are growing. Most commercial assets are also somewhat protected against inflation as rental agreements generally have escalators that adjust for rising prices.
The upshot for investors: income fundamentals look very strong but there are short-term risks emerging on the pricing side.
But what does that mean for investment decisions?
The initial takeaway is that the best approach in our view is to stay relatively committed to the commercial real estate sector. Some investors are being tempted to sell to take advantage of recent capital growth but there can be downsides to that kind of decision.
Construction costs and supply costs to build are rising and influencing the amount of supply and available product in the market. Real estate is becoming a scarce resource and getting set in the sector is in our view becoming harder. And finding an asset class that can deliver comparable returns to commercial real estate can still be challenging.
The second insight for investors is to stay focused on diversification. There is more to commercial real estate than the three big sectors of office, retail and industrial, with emerging opportunities in build to rent residential, medical offices, life sciences and data centres.
A further theme over coming years is likely to be the continued outperformance of sectors aligned to environmental, social and governance (ESG) factors. Assets that can deliver genuine ESG outcomes such as higher sustainability ratings and better social outcomes should remain ahead of their less ESG friendly peers.
And a laser focus on the quality of income is critical — the assets that will generate good returns are likely to be the ones with long-term stabilised income.
Ultimately, in our opinion the budget supports investment in premium real estate assets with high-quality leasing covenants that can deliver optimal income returns through a period of volatility driven by higher interest rates.
1. AMP Capital Real Estate Research as at March 2022.
2. AMP Capital Real Estate Research as at January 2022.
3. AMP Capital Real Estate Research as at January 2020.
6. AMP Capital Real Estate Research as at March 2022.
Subscribe below to Market Watch to receive my latest articles.Luke Dixon | Head of Real Estate Research, Real Estate, AMP Capital
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