Unemployment down & cause of yield softening

OPINION: THE unemployment rate continued to fall in February to a low in the monthly series, which commenced in February 1978 and equalling the lowest figure since December 1974 (4.0%).

This was a surprisingly strong result, Consensus forecasting an unemployment rate of 4.2% and employment growth of 15,000.

Ordinarily, a strong figure like this would prompt the market to increase the odds of another rate rise. Indeed, the odds on another rise in May (as measured by 30 Day Interbank Cash Rate futures) have gone up a little. However, unemployment is a lagging indicator of economic growth, i.e. it is one of the last things to turn once the economy has changed direction. Other indicators are suggesting the 100 basis point increase in the Target Cash Rate since last August, along with the spike in commercial rates caused by the liquidity crisis is beginning to bite.

Retail sales were flat in January and consumer sentiment recorded another big fall in February and is down 23.3% over the year. ANZ job ads for February recorded their first fall since November 2006, down 2%.

Many commentators are now saying we’ve seen the peak in official interest rates for this cycle and we may start to interest rate cuts either later this year or early next year. However, with oil now passing $US110 a barrel, inflation pressures will remain strong so I wouldn’t expect a cut too soon.

So what does this mean for commercial property?

Continuing strong employment will help maintain retail sales in the face of rising interest and fuel costs. This will help to support occupier demand for the retail and industrial sector though risks of a slowing are increasing. It also presents an interesting dynamic on the investor side.

On the one hand, higher interest rates have caused a significant amount of negative sentiment re commercial property investment. If inflationary pressures from low unemployment and higher fuel costs remain in place, keeping interest rates high or sending them higher, the outlook for yields does deteriorates, partly from higher interest rates reducing the number of buyers but also from the increased risks of a sharper economic downturn affecting future occupier demand.

On the other hand, if we have seen the peak in interest rates and the economy slows to trend or slightly lower, the outlook remains solid.

Jones Land LaSalle Research & Consulting data shows five periods of softening in Sydney CBD prime office yields since December 1970 (see table below). Unsurprisingly, the key factors accompanying a softening were:

• Big rise in interest rates (short and long) and/or
• Economic recession and/or
• Rise in vacancy and falling rents.

Normally two or more of these factors need to be present for yield softening. The exception was the 1981-1985 softening. Though that was accompanied by a relatively large economic slowdown and interest rates were already very high (15%), making property on a relative asset allocation basis look a not so attractive.

Currently, we only have part of one of the six factors, the rise in short rates and this is certainly affecting leveraged investors, notably the LPT’s. But LPTs haven’t been the major purchaser of Australian commercial property in over 12 months.

Total return focused equity based invested have. Indeed with total returns for Sydney CBD prime office property projected at around 14% for 2008, on a relative basis, Sydney CBD prime office property at current yields still looks a attractive investment as part of a balance portfolio. So with long rates still relatively low, strong forecast rental growth from a vacancy rate projected to stay around 5% in the Sydney CBD for the next five years and economic growth, that while slowing, should stay positive, all the ducks do not yet appear to be lined up for significant softening in prime yields.

Source: JLL

By John Sears, head of forecasting services, Jones Lang LaSalle.*

Australian Property Journal