With non-residential property yields continuing to fall sharply as property investors bid up values, some are wondering whether it is all going too far. Are we heading for another property market crash like that in the office sector in the early 1990s?
Our assessment is that the conditions are not in place for a commercial property crash and that in the absence of much higher interest rates, non-residential property yields are likely to fall further over the next year or so. However, the decline in yields is reducing the longer term return potential from non-residential property.
Rising rents + falling yields = surging returns
The big drivers of returns from non-residential property – office, retail and industrial – are growth in rents reflecting underlying supply and demand conditions for buildings and changes in the yield that investors are prepared to accept when buying and selling properties. Over the last three years in particular both of these considerations have been boosting returns. Rents have been improving on the back of strong growth in the economy and more importantly investor demand has been pushing down yields. Essentially, strong investor demand has pushed up the value of buildings faster than their rents (resulting in falling yields) because investors have felt that still relatively high property yields are attractive compared to the yields offered by other investment alternatives. This process started with retail and industrial property but has spread to office property as the office market supply and demand fundamentals have improved. As can be seen in the next chart, retail, industrial and office property yields are down sharply over the past few years.
Source: Jones Lang LaSalle, AMP Capital Investors.
Yields relate to prime property averaged across Sydney, Melbourne & Brisbane. The range of yields is up to 2-3% higher. Composite is a mix of office, retail & industrial.
Non-residential property yields are playing catch-up
The fall in inflation since the 1980s pushed down interest rates and income yields for bonds, shares, listed property trusts and housing. However, non-residential property yields were laggards in this process (see below). This was probably due to the bad experience investors had with office property in the early 1990s, a move against illiquid assets, scepticism on the part of property valuers that low inflation/low interest rates were here to stay and scepticism as to the rental growth non-residential property will provide.
Source: Thomson Financial, Jones Lang LaSalle, AMP Capital Investors
Many of these considerations have faded in recent years. With the early 1990s experience now a distant memory, investors have started embracing illiquid assets in recent years as a way to boost returns. There is now a greater acceptance on the part of property valuers that low inflation is here to stay and solid property market fundamentals have resulted in reasonable rental growth in recent years and a reversal of scepticism about the asset class. As a result of more favourable investor attitudes, non-residential property yields are catching up the decline in yields available on other asset classes.
But how much further can yields fall?
The following chart shows the composite non-residential property yield (as shown in the first chart) compared to an average of real bond yields, earnings yields (ie, listed company profits divided by share prices) and the residential rental property yield (all for Australia). In the 1980s the two lines were reasonably close, but a large gap then opened up. While the gap has since narrowed, if the relationship between non-residential property yields and the average yield on bonds, shares and housing were to move back to its 1980s average then non-residential property yields can fall by another 1% or so. It is also worth noting that Australian non-residential property yields are typically above those for global property, adding to their potential to fall further.
Source: Thomson Financial, Jones Lang LaSalle, AMP Capital Investors
This is consistent with the message from the Property Risk Premium, ie, the likely return potential property offers over bonds. The chart below conservatively assumes that property rental and capital growth will be in line with inflation of 2.5% pa. This has been added to the composite non-residential property yield and the 10-year bond yield has been subtracted to show the Property Risk Premium.
Source: Thomson Financial, Jones Lang LaSalle, AMP Capital Investors
Note that this relates to prime property – it would be 1-2% higher for an average of all property grades. While the excess return expected from non-residential property over bonds has narrowed since 2003, it remains high suggesting that there is still some scope for a further decline in yields. Note that each 1% decline in property yields will boost capital values by around 15%.
Either non-residential property yields are likely to decline further towards the yields on other assets, or the other assets will see their yields rise versus property. Either way, non-residential property offers attractive relative returns.
But is 1990s bust on the horizon?
This is all well and good, but things seemed fine back in the late 1980s, just before a massive collapse in office values! In addition to the fact that property returns have been more modest this time (running around 15% pa) compared to the late 1980s (when they were around 25% pa), two considerations suggest we are safe for the next few years at least. First, the conditions which led to the early 1990’s commercial property bust, ie, over building and super high interest rates leading to a deep recession, are not in place. While new supply of retail and industrial property space is on the rise, the supply of office space looks pretty benign. The chart below shows annual office space absorption and office space supply against the CBD office vacancy rate with projections for the next five years. Given the long lead times, the office space projections are reasonably reliable and at this stage don’t indicate a major overbuilding problem, unlike the early 1990s. Similarly in the absence of much higher interest rates a repeat of the early 1990s recession and slump in property space demand seems unlikely any time soon.
Source: Jones Lang LaSalle, AMP Capital Investors
Second, non-residential property offers a more attractive risk premium over bonds today than at the start of the 90s.
However, two points are worth bearing in mind. First, as with all asset classes falling yields will reduce the longer term return potential from non-residential property. Second, there is a danger that the current buoyant conditions could encourage a surge in the supply of new properties after the normal 3 or 4 year lag leading to downwards pressure on rents and values when it comes through.
Conclusion
There is still scope for non-residential property yields to fall. Non-residential property continues to offer attractive returns relative to other asset classes. But the lower yields will mean that the return advantage will narrow over time.
By Dr Shane Oliver, head of investment strategy and chief economist with AMP Capital Investors.*