Has the honeymoon for industrial property in Sydney ended?

Has the honeymoon for industrial property in Sydney ended?
Has the honeymoon for industrial property in Sydney ended?

Yields on industrial property in Sydney have fallen to record low levels, even lower than pre-GFC boom levels, according to new analysis by BIS Shrapnel.

The contraction in yields has been so extensive in Sydney that it has delivered the highest investment returns of any major non-residential property market since the GFC, with the exception of large format retailing. The performance was even more remarkable given that rental growth has been weak, says BIS Shrapnel.

It has been underpinned by falls in long interest rates, which in turn created the competition for property, and industrial property in particular. Average prime capital values in Sydney’s Outer Western region have risen by nearly 50% since 2009. 

At December, prime yields in the Outer Western region averaged 6.4%, 40 basis points below their pre-GFC financial engineering-induced boom in 2007 and a massive 230 basis points below GFC levels. 

Properties with 12+ years of WALE (Weighted Average Lease Expiry) are being negotiated in the mid 5% range, previously the domain of Australia’s major CBD office markets at their cyclical peaks.

WALE is a way of measuring the average time period in which all leases for a property will expire.

However, signs are emerging of potential change. 

A new study by industry specialists BIS Shrapnel concludes that industrial markets across Australia and, indeed, around the world are facing the prospect of a major disruption as a result of rising interest rates. 

“For the past two years we have been saying that long interest rates are unsustainably low in the longer term. They would eventually have to rise. The question is not if, but when and by how much”, the study’s author, Christian Schilling, says.

“Last November, we witnessed a step-up in bond rates following the US election and investor expectations have started to change.”

“We think there is more to come. Our forecasts are for a 150 to 170 basis point rise in the Australian government 10 year bond rate, most likely late this decade/early next decade.” 

“However, we may see long interest rates more quickly and by more than previously thought.” 

While the timing and magnitude of future rises are not set in stone, they will affect many parts of the industrial market. 

“Industrial property yields and bond rates are highly correlated: it’s not a 1:1 relationship, but when bond rates rise, yields soften and vice versa”, says Schilling. “Rising bond rates translates to lower valuations and investment returns.” 

It means that actual investment returns will be lower than what the market expects. “Investors buying now may struggle to achieve their hurdle rates of return over the next five years”, Schilling says. 

But softer yields also affect construction. Lower end values mean developments will no longer stack up at prevailing rents and costs. 

“Developers will have to pass on the increase in costs in the form of higher rents and/or lower incentives. Depending on how quickly the market adapts, we could see a significant pause in construction. In that case, higher rents will come about via falling vacancies.”

Regardless, rising bond rates will cause a major phase of transition in the industrial market. 

“It’s clear that the honeymoon period with double-digit investment returns from industrial property is coming to an end. The next few years will pose a challenge for everyone in the market.”

Tags: 
Sydney Industrial Market

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