PR:
Hello, I'm Phil Rowland and I'm excited to be back with our Head of Research, Sameer Chopra for our first edition of The House View for 2024. We've already chatted to a number of our major clients this year on our Talking Property podcast to find out what they're focusing on this year. So, plenty of insights to inform our discussion today and of course a lot can happen in three months. Certainly, a fair bit of water has run under the bridge, which is shaping the operating environment that we're in. On a positive front, we’re seeing signs of inflation moderating, we've probably seen peak interest rates, employment remains resilient, and it feels like we're getting to the top of cap rate expansions. All of which is flowing into what we can see is some improving investor sentiment. But of course, we are in a very, very volatile and uncertain geopolitical environment, which is deeply concerning, and we can also see some of China's economic woes starting to heighten. In this edition of The House View we'll be discussing CBRE's key predictions following the release of our Market Outlook report. We'll hit pricing, investor intentions, vacancy, cost of living, and of course we'll throw out some predictions that I'm sure will generate some debate. So, Sameer, let's get started. I'd like to kick off with the elephant in the room. Is it time to buy and would you go now, or will you wait till later in 2024?
SC:
Phil, look, I'd say it is time to get constructive on commercial real estate. I think there are three compelling reasons right now. Firstly, my sense is that we're at the 9:00pm mark on repricing. So, in other words, we're three quarters of the way through the cap rate expansion. Markets have largely corrected. Super prime industrial cap rates are now 130 to 170 basis points higher than where they were 18 months ago. Office CBD Prime is about 100 to 160 basis points higher, retail and hotels by more modest, but 50 to 75, living sectors by about 25. And I think bidders can achieve this sort of final stretch of cap rate expansion during negotiations. Secondly, Phil, I think a bit more of a complex topic, but there is this thing called the denominator effect.
Typically, a super fund or an investor would have their portfolio allocation with about 60% sitting in shares, 15% in bonds, about 8% in real estate, and the rest sitting in cash. Recently what we've seen is a very strong rally in shares and bonds. Shares are up by about 20%, bonds are up by about 5%, and so the portfolio allocation needs to be reset higher for real estate. My view is that new allocations may start to replace redemptions as we go through 2024. And finally, Phil, we expect bond deals to start descending. I've got bond deals at 2.75% over the medium term. They're currently about 4.1, 4.2%, and this should spur investment activity.
PR:
Well, to contrast a bit of that Sameer, maybe I can just cover what we're seeing in the US. Cap rates have increased by roughly 150 basis points between early '22 and and late '23 depending on market and asset type, and of course this implies about a 20% decline in values for most property types. But we think cap rates have probably got a little way to go and may expand by about another 25 to 50 basis points in 2024. Office cap rates rose by at least 200 basis points. And similarly, there was a significant expansion in logistics by around 150 basis points. Retail by 160 and multifamily up about 180 basis points. Having said that, our most recent APAC Investor Intentions Survey showed investors view Australia favourably in ‘24, certainly alongside Japan and Singapore. What that survey also indicated is by sector, offshore investors really like industrial, probably the most. But I suppose just coming back to Australia, Sameer, what about new developments? How are these being impacted by these higher cap rates? We've obviously got elevated construction costs and of course higher interest rates and cost of debt. So, how's all that flowing through and impacting development pipelines?
SC:
Yes, Phil, this is an area where we're working very actively with a number of clients. A lot of work is going into investment cases for new developments and it's tough, right? Like let's say if you plug in today's cap rates, which are, let's say 150 basis points higher than where they were two years ago. You add in another sort of 35-40% higher construction costs, put in debt sitting at six and a half, low single digit rent growth. It's tough. It makes it really, really hard to stack up an investment case.
PR:
Yes we're seeing that a lot. So, but with vacancy at the levels they are across most sectors, even premium office, do you think rental growth could be better than low single digits?
SC:
There's definitely a case for that, Phil and I think this is where we need to get a lot more constructive and clients need to get a little bit more micro into precincts. My suggestion would be, increase the rent at the outset. So, rents could start off on a much higher bar for some of the latest warehouses, some of the best offices or good residential sites. And there's a case to assume that bond yields return back to the cycle average. So, you know, helping with that cap rate compression.
PR:
Alright, so given all that Sameer, what are some of the angles that can be run here?
SC:
Yes, we've got a couple of angles. So Phil, one, you know, I'd say we're seeing pockets of strength in Australia, and I'd suggest that investors can get very localised in their understanding of the dynamics. So, even if you look at office, in the last year we saw a 25% spread in rent growth between parts of Melbourne and Brisbane. So, you could have had exposure to office and it could have been a great year or a tough year. I'd say as you think about the longer term, the first idea I'd have is one, look at precincts. There's a lot of large-scale infrastructure development that the government is putting in and we should ride their coattails. One is the Sydney Metro rail, you've got the Western Sydney Airport, Melbourne's Arden Health District, Brisbane and Perth also have rail lines going in.
PR:
I think the precincts and the infrastructure is a comparative advantage of Australia. Absolutely. And these precincts offer clients an opportunity to deploy money in a really programmatic way over a five, 10, 15-year period, and importantly into a really diversified product. And of course we have large infrastructure investment, which really adds to the value and benefits of these select locations and sectors. Last year I spent quite a bit of time on Western Sydney and I'm always impressed by the sheer scale of what's being delivered. We've obviously got the Western Sydney airport, which is due to open in 2026, and this will be a game changer for the region's economy and its connectivity, particularly up into Asia and of course the development of the surrounding Aerotropolis. So, if you map that against the new Metro line between the airport and Parramatta, you've got major motorway upgrades, you've got Parramatta light rail, Western City Parklands, which will create a massive urban park. I think it's larger than Central Park in New York. So, you combine all these initiatives and investment. It will improve transportation, it will create jobs and really boost Western Sydney's economic prosperity and in a district that is home to 10% of Australia's population, I might add.
SC:
Massive opportunity. Our second idea is that returns also vary a lot during periods of interest rate change. I expect that we'll have value investors hunting for undervalued office, like grade A type office. That's where we're seeing some clients. And also shopping centre assets. But over longer periods of interest rate change, the assets that perform well are those that can sustain really strong rent growth and that’s my third idea, 'beds, meds, sheds', or industrial, healthcare, residential and student accommodation should be well placed in this lower interest rate environment that hopefully we get in the next few periods. Our US team also favours industrial and multifamily, same thing. Strong fundamentals. And I think Phil, retail has also got these improving fundamentals, supply related, but improving fundamentals. Phil, any colour that you're getting from clients on new sectors that they're looking at?
PR:
Yes, well, in December we had a set of interviews with a number of Australian real estate leaders and to your point around beds, meds and sheds, Sameer, that is certainly a recurring theme. There's a lot of focus on the living sector and alternative assets, like healthcare and life sciences, in product types like private hospitals, medical precincts, innovation districts and seniors living. But at the same time, there's an ongoing focus on strong performing core asset classes like industrial and to the point around core asset classes, despite the lingering sentiment around office, there's real conviction from some of our clients around core office product, particularly premium assets as we see that new supply starting to shrink and occupiers continuing to focus on high quality assets that obviously plays into their employment proposition. So, I think that those themes are coming through strongly.
SC:
Phil, you mentioned core office. What are we seeing in terms of our own leasing volumes in CBRE's business in Australia?
PR:
Maybe I'll take industrial first. Overall industrial take-up was about 530,000 square metres in the fourth quarter of '23. That was down about 20% on a year-on-year basis. But we did see a recovery in the fourth quarter compared to the third quarter and pre-lease activity helped last year, even when the vacancy was very tight. Early indicators, January has had a reasonably promising start on an inquiry basis. For office, we saw more healthy levels of leasing activity throughout the year. Volumes grew about 25% year over year with a particularly strong second quarter. Of course, this was essentially driven by that momentum that we've seen around the flight to quality, so that premium product and new developments. Of course, we've still got a fairly resilient labour market, so that's what we're seeing driving those volumes. We are seeing it sort of come off a little bit and I expect that to continue as we see occupiers become just a little bit more cautious and we get through the backlog of demand post pandemic. So, that was a local angle. Sameer, when you are talking to your international colleagues, what are you hearing from them around the global leasing activity and particularly vacancy too?
SC:
Phil, similar to the points you were making about Australia, leasing activity did slow down in 2023, but there were some really interesting dynamics below the surface. So in office, vacancy rates are being driven more by demand conditions, whereas in logistics and retail, it's much more of a supply related picture. So, if you look at vacancy and logistics, across the world, it looks like vacancy has increased by about 3% year on year. Mainly because we've had a very strong supply response. In office, vacancy was already very high in the US, it's running at a 15 to 35% range, depending on the city. It's in the high single digits in Europe, but showing signs of stabilising. And in retail, vacancy has improved due to supply curves. And maybe just to give you some flavour around the numbers, if you look at logistics, Chicago logistics vacancy is around 4%. In the UK it's about 5%. In contrast, Sydney and Melbourne vacancy is 0.6% and 1.5%. So, we have a much, much tighter market here. In office, vacancy in Washington DC is 21%, in Ottawa Canada it’s about 13% to 14%, London is 9% and then Canberra is 8%. So again, sharper than some of our global comps. And in shopping centres, US vacancies now sub 5%, that's about where we are sitting in Australia as well.
PR:
Maybe switching gears a little bit, I just wanted to touch on cost of living. It's obviously an important topic, not only here in Australia, but globally. And it's a major concern amongst the business community, amongst government, and of course the property sector. Even as some goods and fuel prices start to normalise, it's very apparent that consumers are starting to feel that massive pressure from higher interest rate costs. And of course, these basic necessities of rents and electricity and insurance, which do remain pretty elevated. Sameer, one of the major considerations for the property sector is construction costs. So how are you seeing that?
SC:
The cost of construction, it's up by about 40% over the last four years. So, along with higher funding costs, it's going to make it really hard to bring supply-based competition to the market. I think that's the real worry, to actually get inflation down you need more supply and with these high construction costs, these really tight funding markets, it's tough to bring new supply.
PR:
Look, I think the sector that's obviously feeling the most is in apartments. The supply of new apartments is sitting near decade lows of 55,000 a year. We definitely need to accelerate that and of course, given the housing crisis, a number of our clients are looking at affordable and essential worker home opportunities just given the need for that type of housing. Sameer, what are your thoughts on the scale and timing of affordable and essential worker housing?
SC:
Phil, I think the first thing people need to understand is it takes about three to five years to drop supply into the market. So, I think delivery of this affordable and essential worker home opportunity will take three to five years before it starts to gain traction. And after that it might be possible to start delivering something in the range of a few thousand apartments under some sort of scheme. But in the short term, because this is a near term issue, there's scope for higher rent relief subsidies to manage cost of living challenges.
PR:
Just staying on that for a second. So, what type of subsidy might be needed do you think to provide that kind of rent relief?
SC:
Rents are up a lot. Rents in Parramatta are up 20% in the last 12 months. They're up 20% in the southwest of Perth, they're up 17% in North Melbourne. So, realistically a subsidy would need to be in the range of 50 to a hundred dollars per week just to offset some of this cost growth that we've had. Now, we know that a third of Australians are renters and if you offer this to the 10% of families that are really struggling, then I think the annual cost for the government's only about 750 million. It's very doable.
PR:
Well, rental affordability is obviously not just an Australian issue. It's a global phenomenon. You know, we're seeing this in the US, the UK, Spain, Singapore, New Zealand, and of course it's partly driven by the attractiveness of global gateway cities. And, and there are a handful of cities and countries that have really picked up significant inflow of new migrants. So, this demand shock is causing, real outsized challenges in housing and of course the property sector really does need to keep offering up these creative solutions in close coordination and partnership with government to address these kind of challenges. Sameer, I want to get towards the end of our discussion here and it's time for our controversial predictions, and we can revisit these in three months and we'll see who's right and see where we land. So, I thought we'd hit three things, vacancy, office visitation or CBD visitation and interest rates. Perhaps we can start with vacancy. What's your prediction there?
SC:
Phil, I expect that we will see vacancy stabilising or falling across the board in late 2024, all sectors. So I'd expect that, vacancy rates in office, retail and residential will be lower in the second half than the first half of '24. And maybe we'll see this in logistics as well. That's a tougher one. And this is because of supply getting pushed back and still strong occupier activity. I think supply is getting crunched.
PR:
Okay. I can kind of see that. I'm a little more cautious than you on how quickly occupiers are making leasing decisions, particularly in logistics where the take up was so strong in '21 and in 2022. We could still see vacancy rising. What about return to office?
SC:
Yes, return to office. I expect that peak day CBD visitation or office attendance will be at similar levels to 2019. And I think we'll see it pretty soon. It's been encouraging Phil, just to see the CBDs are very busy in Jan. You know, people seem to have really come back and our data into the fourth quarter of last year was suggesting that peak day visitation was running at 83% of pre-pandemic levels in Sydney and almost close to 100% in Perth.
PR:
Yes, I think that that general trajectory of people coming back to CBDs and the general trajectory of people returning to office is positive and there's no reason to see that slowing. And I think we've clearly seen a lot of organisations just continue to reinforce the importance of being together, having the in-person experiences. The way that office precincts are being curated is really helping in that regard. So, whilst hybrid work is something that is here to stay, I don't necessarily see that as being the demise of office or necessarily we see visitation come back. Okay. Interest rates. Last one.
SC:
This will probably be my most controversial one. I expect at least two interest rate cuts in Australia during 2024. It'll start around the third quarter and the reason I'm probably in that space is that interest rates are very restrictive right now. People are paying about 2-2.5% more in interest rates than they would in normal circumstances. This is also making further challenges and contributing to a tight supply market in real estate down the road. Very much the case in case in residential. So I'm expecting, Phil, at least two at a touch. Maybe even three.
PR:
Oof. Alright, well I think I might put the money on that one. <Laugh>. Yes, I don't know, I think on this one Sameer, I'm not sure I'm with you. I think whilst that would be welcome, I'm just not sure about that. I just think the strength of migration, the resilience we're still seeing in employment, I think that's going to make that case difficult. But we'll see.
SC:
Well Phil, I think I'll try and have more certainty on my interest rate predictions rather than whether Australia will lose a cricket game.
PR:
<Laugh> Oh, very good. Well, on that note, I hope you've enjoyed our latest edition of Talking Property: The House View. Sameer and I will be back with our next House View in early April. So, if you like what you're hearing, be sure to subscribe and in the meantime, CBRE will be releasing new Talking Property episodes each fortnight. So let us know if you have any topics you'd like us to discuss via
talking [email protected].
