Over the 2017 financial year, the Australian property market saw values continue to rise, notwithstanding the emerging headwinds that have started to threaten segments of the market.
In the commercial property sector, prices have stayed quite high and yields have generally been low. Interest rates remain low and there is continued strong demand from local and international investors. In the markets where we have invested, we observe rising tenant demand for office space. This contrasts with the residential property segment, where APRA’s intervention to curb lending has driven up borrowing rates and started to cool that market. This dynamic did not apply to lending in the commercial sector through the 2017 financial year, but we do not believe that low interest rates will continue indefinitely. The US has started to raise interest rates, but we believe Australia will be slower to respond, given our weaker economic growth prospects (Australia has yet to absorb the full impact of the mining downturn) and contained inflation levels.
Australia is made up of many commercial property markets and investment dynamics vary broadly across the country. Sydney and Melbourne have seen continued growth in property values and strong underlying market fundamentals. The effects of the mining downturn are pronounced in cities like Perth and Brisbane, which are still experiencing lower demand, higher vacancies and higher yields. In this market update, we focus mostly on the cities where we have acquired properties, or have contracted to do so.
In Sydney, low vacancy rates have been attributed to strong tenant demand coupled with declining stock availability. This is associated with the Metro rail project and increased residential conversions. The low CBD vacancy rates, 6.2% as of January 2017, have brought down incentives, making effective rents rise. These attractive fundamentals have acted as tailwinds for investment demand in the commercial market. Local and offshore buyers have continued to compete for investment-grade office stock, which has remained in limited supply. Yields have continued to compress as sale prices continue to set records, particularly for CBD assets with redevelopment potential.
Savills reported that market yields for A-Grade CBD offices in Q2 FY 2017 were at 5.4%, down approximately 50bps over the previous twelve months. A-Grade office yields in Sydney’s other business districts; North Sydney, North Ryde and Parramatta ranged from 6.25% to 6.65% in Q3 FY 2017.
In Melbourne, strong tenant demand saw approximately 90,000 m2 of net stock additions in the city fringe absorbed in the twelve months to December 2016. Tenant demand remained strong in the second half of the financial year, although tenants looking for space have found their options increasingly constrained: the next tranche of supply is not expected to hit the market until early 2018. The CBD vacancy rate at January 2017 was 6.4%. Given these dynamics, landlords have been able to push face rents up, particularly for premium grade space. Unlike the rest of the country, where scarcity of investment supply has driven down yields, Melbourne has experienced both high transaction volumes and yield compression over the year. Savills reported that market yields for A-Grade offices in the were 5.75%, down 50bps over the previous twelve months.
The Brisbane commercial market has been uneven. Brisbane CBD sales volumes were down for the 2016 calendar year, compared to the previous twelve months, as owners held assets during a time of record pricing. For the first quarter of 2017 calendar year, there were no sales in the CBD, although sales in the Brisbane fringe held steady in number and total transaction value.
Broader market fundamentals remain challenging for property investors in most parts of Brisbane. However, there are some brighter signs. The first half of the 2017 financial year saw CBD vacancies fall for the first time since the mining slowdown hit in mid-2015. This was primarily driven by premium properties, where vacancies fell from 21.1% in July 2016 to 12.2% in January 2017. A grade office vacancy also declined over this period, but vacancy in B and C grade properties both increased over the period.
There are, however, pockets of Brisbane that exhibit stronger fundamentals. The city-fringe market, which includes South Brisbane, Milton, Bowen Hills and Fortitude Valley, is experiencing lower vacancies and stronger tenant demand. The Brisbane fringe overall vacancy rate (which includes C,B,A and Premium Grade Properties) was 12.6% as at December 2016. The Brisbane Showgrounds/RNA Urban Renewal Precinct, where IIG has acquired the Kingsgate Property (the asset in the IIG K1 Property Trust), continues to show the greatest tenant demand, according to Savills. The area had the lowest vacancy rate in across the CBD and fringe – 9.9% as of December 2016.
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We expect Australia’s economic growth and inflation rate to remain low over the short term, which we believe will continue to encourage investment in commercial property and likely push yields even lower. We are cognisant, however, that the market is likely nearing its peak and a correction in the medium term is likely as interest rates start to pick up.
The heady property prices of the last few years have continued to make finding value in new acquisitions challenging. IIG has maintained an opportunistic approach, seeking to acquire strategic growth assets that can be adapted to a higher use, like the Younghusband Woolstores properties in Kensington, in addition to more defensive income investments sourced off-market, including 25 King in Fortitude Valley and 100 Broadway in Chippendale (part of the Central Park precinct). Unlike previous years, we have had to secure attractive investments at a much earlier stage, as both 25 Kings Way and the Central Park properties have required IIG to fund development through construction.