Commercial property returns likely to slow, but will still remain solid: Shane Oliver

The past three years have seen solid 9-10% per annum returns from unlisted commercial property. This has been driven by a recovery from the GFC related slump of 2008 and 2009, moderate economic growth and more recently as the desire for decent income bearing investments from investors has pushed down investment yields pretty much across the board, but in particular, for retail property.

Reflecting the search for yield listed property, or Australian Real Estate Investment Trusts (AREITS), have been even stronger with gains of around 17% over the last year.

Going forward returns are likely slow, but still remain solid reflecting a range of contradictory influences.

The biggest drag in the short term will be the soft economy. While recession is likely to be avoided in the year ahead, growth is likely to be sub-par and unemployment will likely rise. This will mean subdued space demand and softish retail sales growth for a while yet although some improvement should start to become evident in 2014-15 as the benefit of lower interest rates and the fall in the Australian dollar flow through.

Increasing supply, particularly in office space in the major capital cities, will likely combine with subdued space demand to ensure weak rental growth. Average office vacancy rates are already 10% and are likely to remain around this level for the next few years.

Finally, investor demand for decent yield bearing investments will continue to benefit commercial property, particularly with average commercial property yields of just below 7% continuing to offer a decent yield pick up over Australian ten year bond yields of around 4%. However, yield related investor demand may slow a bit as improving global growth combined with a move by the US Federal Reserve to slow its buying of US Treasury Bonds puts upward pressure on government bond yields globally and in Australia.

The end result is that investment returns for unlisted commercial property are likely to slow to around 8% over the year ahead on the back of constrained space demand, increasing supply and solid but slowing investor demand. Within unlisted commercial property the main opportunities are likely to be in industrial property reflecting its relatively attractive yield levels and quality retail property in strong population corridors.

Retail property in low growth areas remains particularly vulnerable and office property is likely to underperform thanks to increasing levels of supply and subdued space demand.

AREITS having outperformed over the last few years are likely to perform in line or even lag unlisted going forward. Distribution yields have fallen to 5.5% as they have benefitted the most from falling bond yields. This leaves them vulnerable as bond yields move higher over time.