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Jason Huljich, Joint CEO of Centuria Capital, explains the concept of the property cycle, and where investors may wish to consider investing as we move through different phases.
Whether you are a property investor, considering a foray into real estate for the first time, or a professional investor, your ability to understand the property cycle – and in particular what it tells us about where markets are right now – can help you make a more informed decision. The property cycle is an important concept, not only because the more information you have, the better your decisions are likely to be, but because there is such a strong link between property markets and the overall economy. And the strength (or weakness) of the overall economy directly impacts property investment markets – specifically the rates of return investors can expect.
The Reserve Bank of Australia (RBA) has acknowledged the importance of property markets, specifically the need for central banks to pre-emptively respond to credit price cycles1. According to the RBA, property prices matter – not only because of what they tell us about future economic activity, but because property holdings tend to be leveraged which makes them closely linked to credit cycles. Indeed, Australia’s recent experience with cycles in property markets in the 1980s and 1990s both ended somewhat painfully when a recession hit in the early 1990s. Having said that, cycles in the 1980s and 1990s occurred against a backdrop of de-regulation, which allowed for the entry of foreign banks, increased competition, and saw credit growth outstrip deposit growth for the first time.
The Australian financial services landscape is very different now – and some of the regulatory factors that exacerbated the negative effects of economic slowdown and recession on property markets no longer exist. But property cycles do still exist – and the recurring property cycle should be a reality that all property investors take into account. At the same time, every crisis has its own unique features, and every cycle is different – so there is always something new to learn by looking at where we are now, where we are likely to be going, and at what past cycles tell us about what to expect this time.
One useful way of understanding property cycles is by looking at the cycle as if it were a clock – the cycle starts at midnight, moves through identifiable stages, and ends up back at midnight.
6 – 12 o’clock: The first stage is the so-called ‘boom’ where the economy and demand for property picks up, vacancy rates fall, rents start to rise, valuations increase, and developers start to develop property to respond to the strengthening market. 12 o’clock is the theoretical peak of the market.
12 – 6 o’clock: The next stage begins as new supply starts to come into the market and the downswing period begins. Prices begin to fall, and at the very bottom of the cycle, when the hand reaches six, there is an oversupply of property resulting in a so-called ‘bust’ as demand is met, rents stall or decrease and valuations fall.
Supply then slows or stops, which means that as demand starts to grow again and supply isn’t sufficient, rents start to rise and the whole thing starts again. The cycle is more recognisable in property markets compared with other assets because there is an inevitable lag between an uptick in demand and the time it takes for supply to come online – new properties take time to build.
For investors, understanding what time it is on the property clock can play an integral part in their decision of where and when to invest. However, it’s crucial to understand that while property generally moves in a cycle, it’s rare that each cycle will follow a predictable or identical path, because the factors that influence property prices and returns are different from cycle to cycle and city to city. Which means investors should look not only at where we are in the cycle, but at all the factors likely to impact their investment – from macro considerations, like interest rates, to market-specific return drivers, like infrastructure development and demographic trends.
Back in August 2019, it seemed the cycle had run its course – and the clock had struck midnight. The Property Council/MSCI Annual Property Index, which tracks the performance of more than 1500 assets in listed as well as unlisted vehicles, reported that the total return of 8.3% (as at August 2019) was the lowest since 20102, and that the yield compression cycle, which started in 2013, appeared to have come to a head mid-2018. Since then, yields had compressed by only 10 basis points3 – leading investors to ask whether the yield compression (and property) cycles were over.
So, the view that the cycle was over held water, but since then it appears that the clock may be moving backwards – and there are a number of reasons for this. The most significant is the lower for longer interest rate environment. Investors not only believe that rates are likely to remain very low for a very long time, but they are also seeing yield curves inverting around the world. In fact, the global stock of negative-yielding debt now exceeds US$17 trillion, or 30% of all investment-grade securities4.
The lower-for-longer interest rate environment is an important consideration for property investors because low rates keep the cost of debt down. This allows for more investors to buy more property, but also keeps the average yield differential between property and other assets, like cash and bonds, high. Since the reduction in long-term interest rates from mid through late 2019, we have seen further cap rate compression in property markets. It now looks like the clock has moved back to 10 o’clock, potentially leaving further upside for property investors.
So, what does the next 12 months look like for commercial property markets? In our view, further yield compression in office and industrial property in the next 12 months is likely.
Recent reports point to increased institutional interest in real estate, including in sectors like build-to-rent, which had previously been considered low-return.5 Again, there are a number of reasons for this. Property generally is seen as a defensive asset in times of uncertainty – but more importantly, the stable income streams that well-managed, quality commercial property generally offers can outstrip those from other sources. And the Australian market in particular, remains comparatively attractive. According to MSCI’s Global Head of Real Estate, Jay McNamara, institutional clients are saying that they intend to increase their allocations to real estate.6
In a recent speech, Guy Debelle, Deputy Governor of the RBA highlighted the sizeable downturn in housing construction and the fact that 2020 appears to be the low year for residential construction. More importantly though, he said that the effect of this downturn on the economy is greater than the direct effect of the decline in construction – because it spills over into other parts of the economy.
The good news, according to Debelle, is that it is possible to see through the 2020 trough to the other side – when housing construction will pick up, and prices lift – largely because market fundamentals, in the form of population growth will continue to support demand and bring investors (and developers) back into the market.
All of this is good news for commercial property as well, because population growth, unemployment and migration all affect returns from commercial property. A larger and growing population positively affects consumption, and strong employment plays into wage growth. In addition, larger, growing populations require transport, which also helps drive prices for commercial property up in areas well-served by new transport links, or those which become transport hubs.
Despite some yield compression across the board, we expect investors in commercial real estate, office and industrial, will remain in the box seat when it comes to comparative returns.
Market fundamentals in Sydney and Melbourne remain strong, Brisbane and Perth are improving, and for asset-specific opportunistic buyers, like Centuria, there are opportunities in a range of other markets, including metro markets. Demand from domestic investors remains strong, but given Australia’s economic fundamentals, along with expected returns from real estate compared with many of our APAC neighbours, we anticipate flows from offshore groups to pick up and spark increased competition in the market.
Nonetheless, domestic investors with an intimate knowledge of the market, relationships with key market players and a track record of success buying (and selling) assets well will still have the edge.