Sydney CBD prime office yields won't approach pre-GFC lows until late in the decade: BIS Shrapnel's Lee Walker

Sydney CBD prime office property yields are set to firm by close to 100 basis points over the next three years.

However, according to BIS Shrapnel, it will take until late this decade for average prime commercial yields to approach to their pre-GFC (2007) low and the property forecasting company does not expect average prime yields to reach the lows achieved in the late 1980s boom at all this cycle.

BIS Shrapnel’s just released Sydney Commercial Property Prospects 2013 to 2023 report concludes that the main phase of yield compression between now and 2015 will occur during 2014 and 2015.

The next 12 months will see relatively little tightening in yields because the leasing market remains quite soft.

The missing ingredients are sustained rental growth, underpinned by strong leasing conditions, and investor expectation of capital gain.

There has been a lot of discussion recently about if and when Sydney prime office market yields will firm to underpin strong price rises.

And whether the weight of money chasing property assets will cause yields to firm.

Over the last 12 to 18 months, office sales in the Sydney CBD have ticked along at a reasonable pace, but they have not delivered conclusive evidence of an across-the-board reduction in yields.

Many market commentators believe a significant firming is imminent given the historically high margin between office property yields and 10 year bonds, viewed as the risk free rate for investment returns.

However, BIS Shrapnel believes it will take more than this.

Unlike retail and industrial property, we have never been able to identify a significant independent influence from long term bonds on the formation of Sydney CBD prime office yields.

And while BIS Shrapnel agrees that the current strong investor demand for quality commercial assets, particularly in CBD locations, from both foreign and domestic players is likely to contribute to some yield tightening, they note that most investors are currently focused on yield, not capital gain.

BIS Shrapnel considers that a significant improvement in yields will await a more substantial rise in rents and growing expectation of capital gain.

Right now, the Sydney CBD office leasing market remains quite weak, with low levels of net absorption, a vacancy rate around 7% and only modest rental growth.

The last time prime property yields in the Sydney CBD firmed significantly was between 2006 and 2007, notably a period when the CBD vacancy rate fell below 4% and growth in gross effective rents was close to 30%.

On BIS Shrapnel’s forecasts, a steady recovery in the CBD leasing market over the next two to three years will see vacancy rates fall below 5%, triggering a strong recovery in rents.

In an environment of rising rents, competition for properties is expected to increase, with investor focus moving toward total returns (both yield and price growth).

As expectation of capital gains increases, prime yields are forecast to fall more sharply.

By 2015, BIS Shrapnel forecast CBD prime average yields will fall to 5.8%, down from 6.7% at December 2012, underpinning a strong rise in property prices.

And later in the decade, as the market experiences a second phase of stronger leasing and investor demand, the yield tightening will continue.

Lee Walker is senior project manager - property at BIS Shrapnel.