Hello, and welcome to our quarterly Talking Property series, The House View. Together, CBRE's Australia and New Zealand CEO, Phil Rowland and head of Research, Sameer Chopra will investigate what's next for the Australian property sector, the potential disruptors, emerging opportunities, and what's top of mind for the industry's major players. We hope you enjoy their conversations.
PR:
Hello, I'm Phil Rowland and I'm excited to launch our new Talking Property series with our Head of Research, Sameer Chopra. We're going into this year after a very challenging second half in 2022. The inflation genie firmly out of the bottle interest rate rises and of course a deteriorating economic outlook that is weighing pretty heavily on investors and occupiers. So what's next? What is going to shape the market this year? So Sameer, maybe we can just start with the overall economic outlook.
SC:
We expect the economy to grow and I think the word grow is important at somewhere between 1.5% and 2%. That'll be a little bit below trend, but we're not forecasting a recession. You know, I often describe Australia as being boringly good. If I can use an analogy, it's a little bit like the Glenn McGrath, it's line in length. We don't have these big peaks or troughs, and I think that's kind of the attraction of Australia. And, you know, similarly, New Zealand will also grow next year, though modestly, at around the sort of 1% growth rate. And then inflation was about just over 7% this year. And we've got it dipping to about 4% to 5% range, closer to 4% towards the end of the year. And interest rates will start to stabilise. There's quite a divergent view out there in terms of interest rates. In Australia there's expectations that interest rates will be somewhere between 3.35% and 3.85%. But I'd say, you know, the hard yards are done, that that was done in 2022. We're now nearing the peak and there's anything from zero to three interest rate rises to go in Australia this year. In New Zealand, interest rates are expected to peak at about 5.5%. So I think, you know, it's still going to be tough, but we're nearer the end than the beginning.
PR:
Well certainly from us, from I suppose a CBRE standpoint, Sameer, it's probably fair to say that we feel like we've kind of seen the worst second half of last year was very challenging particularly in the capital markets space, which as everyone knows was very subdued in the last two quarters. But on a brighter front, we are seeing leasing volumes hold up. December was quite a surprise actually and we expect that to sort of carry through into the first half of this year, particularly in office. And despite the supply constraints in industrial, we still see some very strong demand in that space. Obviously capital markets activity is going to remain subdued until we see what you described - a bit of normalisation around interest rates. And probably no real activity until the second half until we see that price discovery kind of stabilising. One thing that we also do see is domestic occupiers in Australia are probably going to be more active than international occupiers. And I think that is just centered around probably a sense of stronger confidence here in this market. You can see it coming through in financial performance of our corporates here in Australia and just the general stability they have in their balance sheets.
SC:
Yeah, Phil, we're picking up similar trends actually overseas. You know, in the UK they had a pretty robust November leasing performance. Leasing activity and office picked up through November. But the US you know, things are still pretty tough. So I think decisions are taking longer to sort of execute.
PR:
Alright. So maybe that's a little bit of an outlook on economy. What about commercial real estate pricing? The big story in 2022 was obviously bond yields increasing by 2.2%. But this wasn't fully reflected in direct asset values where we've seen cap rates expand by sort of 15 basis points for office and about 50 basis points for industrial. But what's the evidence from the US and the UK suggesting?
SC:
Their activity was far more aggressive. The cap rate movements were far, far more aggressive in the US and in the UK than in Australia. You know, for example, in US office we've seen about 110 basis point cap rate expansion in 2022, so far more aggressive. And then in industrial we've seen about 70 basis points of cap rate expansion in the US.
PR:
So where do you see cap rates settling in Australia then?
SC:
Yeah, Phil, look, I think we're about a third of the way through the repricing in Australia. We're expecting prime office will settle around 5.4%. In industrial, you know, we're expecting total cap rate expansion bottom to top of about 110 to 120 basis points, and retail will be more resilient. So, you know, very little sort of movement. Having said that, you know, I think the price discovery will take at least another one, two, maybe even up to three quarters. You won't get full price discovery maybe till the third quarter. At the end of the day, you know, pricing will probably be similar between the US and Australia. So we're expecting 5% to 6% sort of cap rates, but the valuation impact is going to be more muted because rents are growing far more aggressively than expected.
PR:
So let's get onto the rent story. You know, there's a lot of recessionary talk. You can't escape that, but despite that, we did see rents grow in 2022. So what's the magnitude and your expectations for rent in 2023?
SC:
In 2022 we had really aggressive rent growth in industrial and also residential, but even, you know, office and retail posted sort of mid-single digits. Looking out to 2023, we're expecting office and retail will repeat performance, so we'll probably get mid-single digits again. Incentives will need to still remain relatively high. Landlords are going to need to work hard to secure these deals. So at least in the first half of this year, we're still expecting incentives remain high. In industrial and resi we're expecting, you know, rent growth could be high single digits, vacancy super tight, super, super tight. Really good demand conditions. So, you know, I'm, I'm expecting high single digits again.
PR:
So let's think about some of the big themes for 2023 that's going to be playing on everyone's minds that's going to be impacting returns. And you know, I suppose some of them, as we think about it's going to be migration and tourism. We're starting to see early data on that. The resurgence of CBDs, construction costs and premiumisation, which I'm not sure that's a word yet, but maybe Oxford will pick that up. So let's dig into these. Sameer, what's your view on migration and tourism? I know you're a big punter of that.
SC:
Yeah, look, I think migration and tourism, first of all, the big surprise was the Australian government increased the migration target last year. We've gone from having a target of 160,000 to 195,000. So there's 25% more migrants that'll be coming to Australia, which is quite good. You know, we expect Australia and New Zealand will have amongst the highest population growth globally, um, over the next decade. And I think that makes us a very attractive place to invest. And we've got these live trackers at these airports and what we're seeing is really good arrivals into the country in terms of permanent migrants, international students and tourists. International students, we're expecting first quarter of this year will be a record year. We would never have seen as many international students as we were about to see in this quarter.
So I think it'll be very good market for students. And then finally tourism arrivals have picked up. India's back to pre-Covid and New Zealand and UK are similarly good. They're about 25% below where they were in 2019. I think once the Chinese start to come, it'll be a really big tailwind for retail, for residential, but you know, it'll be, it'll have flow on effects. It'll really push vacancy rates down and vacancy's tight already. Vacancy in inner-city retail, inner-city residential. Super tight, it'll get super, super tight. Really exciting market.
PR:
Well, of course, the other big theme is the resurgence of our CBDs. And whilst it's been slow painful progress, there is evidence that we are seeing foot traffic improving into the CBDs. Our CBDs recent survey,of Australian and global consumers had highlighted that commute time is a key factor in choosing new jobs and also locations for homes. And when you consider the patterns that we can see in food and beverage and entertainment, the emphasis in local governments around 24-hour economies, the general trajectory around the return to office, whilst subdued is still directionally the right way. And then of course we think about the improving transport infrastructure into CBDs, the outlook is strengthening. What's your kind of view on that Sameer?
SC:
Yeah Phil, one of my favourite data points is we're seeing, you know, looking at vacancy rates for residential, we're seeing that suburbs that had been sea change, tree change type suburbs, the vacancy's going to gently be trending up through the course of 2022. Inner-city has just seen vacancy drop very, very significantly. So, you know, people are acting on this lower commute, we're seeing people coming back into the CBD. The first place where we pick this up as a potential trend was in London back in November 21, where, you know, there was long queues for people looking to rent houses and apartments in London. And that's now translated into what we're seeing in Australia as well. It's one of the reasons I'm super bullish on inner-city residential as we expect, you know, as Airbnb, international students, people wanting shorter commutes, domestic residents, all sort of hub in closer to the city. I think we're going to have a very exciting market in the fringe and inner-city space.
PR:
Okay Sameer let's talk construction costs. There is obviously a very sizable development pipeline here in Australia amongst our largest commercial real estate firms. I think it stands at about $160 billion. And of course through 2022 we saw significant escalations in construction costs. I think about 11%. So what's your view on construction costs as we move into 2023?
SC:
Well, this is probably our most controversial view. We're expecting construction costs will fall this year by something like 10% to 15%. So construction costs to fall by 10% to 15% this year. And there's two components to that. One is raw material prices have started to decline very, very sharply. International freight is dropped by 80% through the course of last year. And you know, this will start to feed through because we import everything. Fittings, taps, you name it, we import it. Oil prices have dropped by about a third. Timber and steel prices have also dropped by a third, so we're expecting raw materials will become a lot cheaper. And then the other part is just labour and what we're starting to see is, you know, labour availability, it's still tight but it's starting to improve in the last quarter or so. And that's mainly because residential construction in Australia slowed very, very significantly. So, you know, construction costs should moderate, but I'm still very worried because, you know, land values are very high, funding is really, really hard. It's really hard to get financing. So, you know, we expect a lot of the development pipeline will keep getting pushed out. It's, it's going to be challenging. Speaking to a lot of our development team, you know, they're saying it's still tough.
PR:
Final theme premiumisation or, said another way, flight to quality. That's certainly a much talked about theme, but certainly one that is vital. Particularly in the context of office where vacancy rate for top quartile, CBD office stock by rent value, is just 5.5%. So certainly a key trend that we saw in 2022 was the vast majority of office relocations were to high rent, high quality buildings. But just given the economy is slowing, just given general sentiments, Sameer, do you think this can be sustained going forward?
SC:
If it's a really fascinating theme, you know, this concept of premiumisation and people aspiring to better in every aspect of their life, and we're seeing this in every aspect of real estate, you know, premium residential, premium retail, premium offices. And you see it in sharper cap rates, you see it in much lower vacancy to the point you're making. You see it in in much higher rents for these places. We've built a rough rule of thumb that somewhere between 20% and 25% of the market wants premium product. You know, about a quarter of all the seats sold on a typical Qantas plane that flies internationally is business class or premium economy - a quarter of seats. A quarter of Australians send their kids to private schools. You know, 15% of people are buying premium luxury cars. So that's kind of a demand equation and you know, we've seen it's relatively insensitive to economic cycles so people continue to aspire, continue to spend on this product. So I would expect it's going to remain pretty robust despite the economic cycle.
PR:
Right. So I thought we would just close up with some anecdotes or sort of feedback that we are sort of picking up from, you know, our discussions with the market. Sameer, I've got a couple and I'm sure you've got a few on your mind. I suppose the one that is resounding for me is that despite the global turmoil that has been occurring in 2022 and the challenges that have come with that relative to inflation and rate hikes and of course the war in Ukraine, there's still strong conviction on Australia. Stable government, very well managed economy that's rateable to your point earlier, good migration story, and a really healthy corporate sector. And so what I'm hearing anyway is that that's culminating in a really positive outlook for property in Australia. And I think the sort of related to that, I suppose is that there's no shortage of liquidity and strong interest in Australia from foreign capital partners. And that the current environment, whilst it's really, really challenging, that when we get to neutral ground on interest rates and we can get through price discovery and values normalise over the next two to three quarters, we're expecting a lot of activity in the capital market space.
SC:
In my own conversations with occupiers and landlords, one of the things that keeps coming up is fit out costs. I think it's been super topical just given how expensive fit outs become. And people are looking for new ways of trying to engineer better fit out, but at the same time try and mitigate the costs of this fit out. It's put a lot of upward pressure on incentives. So the single biggest question we get is, you know, what do we do with fit out? When do we execute on fit out? There are some of the things that have been coming up most frequently.
PR:
Yeah, there's definitely some cost sensitivity there. I think from an occupier perspective, what I would say is that, organisations are starting to sort of figure out hybrid working and have sort of increasing confidence of being able to sort of operate in that environment. We're sort of seeing this sort of coalescing in the middle around hybrid and flexibility, being a structural shift and an aspect of the future. And you know, occupiers and progressive organisations are actually seeing the role of office playing an even more important role in the future of organisations and becoming more intentional on its use. And so I think that bodes well for the office sector, particularly. Thanks Sameer. A lot to think about as we roll into 2023. Well, I hope everyone enjoyed our new series. Please keep an eye out for our next edition of
Talking Property: The House View.
