The sudden market realisation that US borrowing costs are likely to rise significantly this year will drive demand for real estate investments that offer income growth, according to AMP Capital Head of Real Estate Research Luke Dixon.
The US stock market endured its biggest plunge in six years earlier this week, triggering ongoing volatility across the globe, as investors started to factor in the chance of three or more US Federal Reserve rate hikes this year.
The Fed raised rates three times last year and AMP Capital predicts it could raise rates as many as five times this year.
“These global factors will have a significant impact on real estate markets in Australia,” says Dixon. “Investors are going to be really focused on lifting the productivity and income performance of their assets as capital values slow in the face of higher capital costs.”
One sector where growth in demand is likely to outpace cost of capital increases is industrial, which will benefit from a structural shift towards online retail spending.
“Our view is that in Australia the industrial sector is best placed to take advantage of the global and structural changes occurring in our economy,” says Dixon. “It has capacity for higher income growth moving forward, higher liquidity of stock and lower total entry costs relative to other asset classes such as office and retail.”
Ecommerce giant Amazon launched in Australia late last year and, along with local rivals, is expected to lift fulfillment capabilities to deliver better, faster delivery options.
“The industrial sector has a particularly strong narrative around ecommerce growth going forward,” Dixon says. “Our view is that the arrival of Amazon in Australia will be a strong catalyst for industrial space demand. We are forecasting over 500,000sqm of gross take up from ecommerce providers over the next five years.”
“That is going to lead to an upswing in demand for industrial nationally, particularly in markets like Sydney and Melbourne that have high population density and high population growth,” says Dixon. “They will benefit from rental growth based off this demand.”
Technology-related manufacturing will be another growth spot in the industrial sector, he predicts.
“We believe areas such as solar panel manufacturers and specialised technology manufacturers are going to be growth sectors that will propel rents higher than the long-term average of four per cent across most major industrial markets,” Dixon says.
Whilst capital costs will increase, income levels are lifting as the Australian economy enters its 27th year of continuous economic growth. The broadening of this growth as Queensland enters a more sustained economic recovery, points to sustained demand momentum for all commercial asset classes in 2018. Even before this week’s equity market turmoil, interest rates in the US, Canada and UK had already lifted bond rates, and global growth projects to a record high of 3.8% according to the IMF in 2018.
This indicates that we are in the early stages of a global transition from the ‘lower for longer’ theme of the past five years, to a higher cost of capital environment moving forward.
It’s not all good news in the property sector though. The very forces that are helping drive demand in the industrial space for logistics centres, is likely to put pressure on many customer-facing retail stores.
“There are some headwinds,” says Dixon. Ecommerce will undoubtedly deliver benefits for industrial demand, however the structural shift towards online will negatively impact sales growth in the retail sector going forward.”
To adapt to the escalating rise of online retail, he predicts good shopping centre owners will be investing heavily in upgrading spaces to include more interactive experiences such as dining and entertainment, in order to generate income growth.
“As we move into a higher cost-of-funding environment, investors will be targeting assets best placed to produce strong income growth through the cycle.” Dixon says. “That means attracting the best tenants in the fastest growing markets to guarantee that income during potentially a weaker economic growth period.”
AMP Capital expects the Reserve Bank to raise the official cash rate from the record low of 1.5 per cent in late 2018 or early 2019. Increased borrowing costs tend to lead to a depreciation in real estate values, however this has been a lowly geared real estate cycle relative to past cycles, which points to pricing deterioration being minimal, and dependent upon the severity and number of future rate increases.
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