2016 the year the residential property cycle starts to ease: Kevin Stanley
GUEST OBSERVER
2016 will be the year the residential property cycle starts to ease, with growth in both pricing and development set to trend lower.
As the residential property cycle recedes, the focus will shift to commercial property. Although investment activity is already running at a high level, interest in commercial property is set to intensify further in the year ahead.
With pricing likely to be pushed one notch higher to reach record levels, emphasis will turn to increasing returns through improvements in rental levels or a property’s net operating income. Each commercial property sector and market offers very different growth potential.
Residential development set to ease
Recent years have seen an unprecedented rise in residential development, driven by high rise and high density apartments. The extraordinary growth across the industry reflects a surge in investor activity and a significant shift to apartment living in all of Australia’s major cities.
However, apartment development is likely to slow this year ― following a trend that emerged in the middle of 2015, when approvals started to drop. A decline in approvalsasshown in Chart 1, is typically a signal the commencement of new construction activity will ease within six to 12 months.
With fewer approvals, commencements have indeed tapered, although they’ve plateaued at a high level. This is likely to see buoyant construction activity continue into 2017.
During the next phase of this unwinding process, as projects are completed, fewer will commence to take their place. The overall effect will be an eventual reduction in development activity which is likely to then continue at a more sustainable level.
Ultimately, this means some of the developments approved over the last few years will not proceed in this cycle. Owners may choose to sell those sites, providing an opportunity for others to develop uses more aligned to the changing demand-side conditions of 2016.
Brisbane and Melbourne to lead site sales
The markets which have pushed hardest in apartment approval and development over the last few years are most likely to witness site sales in 2016. Brisbane and Melbourne stand out as the cities where developers are most likely to sell sites, as markets with sufficient demand for alternative uses in both the short and long term.
Although the Australian economy is forecast to grow below trend in 2016, underlying demand conditions in some sectors are sufficient to support alternative inner-city uses provided for in new development outlined in Chart 2.
Tourism-related activity is growing on the back of the lower value of the Australian dollar and high growth in tourist arrivals from Asia, particularly China. This is leading to demand for more tourist accommodation to cater for various consumer markets.
Similarly, demand for education is enjoying steady growth, particularly for higher education from international students. Purpose-built student accommodation is considered a pre-cursor to provide for this demand.
The easing back of the apartment development sector could be the opportunity student accommodation providers need ― enabling them to secure their desired sites in strong locations at more reasonable prices.
Other uses may underpin development or refurbishment of existing buildings on sites previously earmarked for residential. These include boutique retail, office, medical, child care, service industrial, car parking or mixed use.
Local or State Governments may also see an opportunity in 2016 to buy sites to provide for public uses, such as schools, medical or transport-related, to better serve the large and fast-growing high density residential communities of these inner-city locations.
Alternatively, existing developer-owners in these areas may look to purchase sites to consolidate properties and plan for projects in the next residential development cycle
Turning to investment
Beyond the likely shake-out in the residential development sector, interest in commercial property as an investment is expected to continue at a high level in 2016.
As uncertainty grows in global financial markets, more investors are driven to purchase quality commercial property. The start of 2016 has already been marked by volatility in markets around the world, including Australia.
With increased investment activity over the last few years, pricing has been pushed to an all-time high, across all price points. However, although prices are high, interest rates remain low making it attractive to buy quality real estate at current prices.
However, its also important at this point of the cycle to take into consideration factors which create a high quality commercial property asset, in both the short and long-term. These include:
•Strength of location for the use(s);
•Prospect of re-letting in the case of a vacancy;
•Strength of the tenant as a leasing covenant;
•Length and terms of the lease;
•Level of the rent relative to the prevailing market;
•Prospects for rent or other property income increases;
•Physical condition of the property and the need for any capital expenditure;
•Redevelopment potential;
•Land use zoning; and
•Any building operating costs which cannot be passed onto the tenant
Leasing demand holds strong
Purchasing commercial investment property at a high price places greater emphasis on the ability to increase income from the property and improve future returns.
The prospect for property income growth is driven by the strength of both leasing demand for a property and its location, as well as the number of available suitable properties competing for tenant.
In 2016, the strength of leasing demand for commercial property is likely to be highest in Sydney and Melbourne. In these two cities, growth in population, employment and the economy generally is leading the country and providing the best short-term conditions to reduce market vacancy and increase rents or other property income.
New opportunities in the mining capitals
A significant trend in 2016 will be investors turning back to consider commercial property in Perth and Brisbane. Although these two markets have been adversely impacted by the restructure of their economies as the mining sector winds back, it seems the downturn phase of this restructure is largely over.
Looking ahead, recovery is the next phase for the Western Australian and Queensland economies and their commercial property markets. This may take some years, but it looks like the worst is over –and both Perth and Brisbane are likely to enjoy an increase in investment interest and activity over the next few years.
Expansion into growing markets
Higher investment yields can be found in Adelaide and Canberra commercial property and this started to stimulate investment activity in both markets in 2015. We expect this activity to increase in 2016 as relatively higher yields will continue to be found in these markets, compared to those in larger cities.
This is also in the context of downward pressure on yields being maintained across Australian commercial property, particularly for quality assets.
There will also be opportunities to invest in commercial property in regional Australia in 2016. However the outlook in these locations varies considerably and is tied to local economic and property drivers as well as being very sensitive to tenant competition.
Those factors which contribute to a quality asset, as outlined on page 2, need to be very carefully considered and applied in smaller markets, as the level of underlying tenant demand is lower and the economies of these cities continue to be heavily impacted by industry restructure.
What does it mean for investors?
While 2016 is expected to be a volatile year and one underpinned by an acceleration of change to property drivers, there is still plenty of opportunity to engage with the market.
The easing in high density apartment development is likely to see an increase in the sale of sites once earmarked for residential projects. These sites may provide the opportunity to offer uses to service the market created by a fast increasing population in these new high density suburbs. Ideally, shorter-term uses in existing buildings may provide the option for more intensive development in the future, when the residential development cycle strengthens once again.
In the meantime, the popularity of commercial property as an investment is set to increase further in 2016, amidst volatility of global and local financial markets.
The challenge will be buying the right property at the right price and working to improve income returns into the short to medium-term. While the larger cities offer greater short-term possibilities in this regard, buyers need to be selective elsewhere, as the timing around improvement in the fundamentals is less clear.
Kevin Stanley is head of property strategy and research, Corporate Financial Services, Commonwealth Bank.