PR:
Hello, I'm Phil Rowland, and I'm excited to be back for our fourth edition of the House View. I'm joined by our head of research, Sameer Chopra. Since our last podcast in early July, we've continued to see challenging market conditions, particularly in the real estate capital markets as cost of debt rises and sentiment wanes. Of course, we have the big national challenge of the day, which is our acute supply side issues in housing, but it's not all bad. Overall leasing activity has been quite buoyant, particularly in the office sector and there's been a growing focus on alternative asset classes. So, what lies ahead in this episode? We'll discuss the economic outlook, what to expect when it comes to asset pricing and the debt markets, and also the outlook for the leasing sector and some of the opportunities that investors are looking at in the alternative space. But to kick us off, let's talk about the overall economic outlook. So, Sameer, we seem to have skirted a recession, both in Australia and most other major markets globally. It's good to see inflation moderating at a range around 4 to 5 percent after being up at 8% in December of 22. So having said that, the slowdown is very evident to everybody. How would you frame the overall economic outlook for the next quarter and into 24?
SC:
Thanks, Phil. Yeah, look, we've managed to get through a large part of the fixed rate mortgage cliff without too significant of an impact on the economy. Retail spend is broadly flat to maybe even slightly positive over the last 12 months, but it's up over 30% on 2019 levels. And the employment picture has also been very robust with over a million jobs added since early 2020. And jobs and population growth have been the real positive surprise and they've helped to shield the economy. That being said, from here on we expect more pedestrian growth over the next four to six quarters, potentially at half of the usual rate of growth. So not a recession, but a slog. And what we find during these more challenging times is quality matters. During boom times everything gets a tailwind, but during tougher times, the quality really starts to matter.
PR:
Yes, absolutely. And I think we're definitely seeing this play out in the leasing market, particularly in office where this bifurcation of prime and secondary markets is really taking hold. And what's been very interesting has been the resilience of the leasing market, particularly in office in the last couple of quarters, which of course heavily contrasts with the investment sentiment in the sector. Occupier sentiment earlier in the year was strong, as companies came off a two-year period of strong financial and employment growth, really wanting to set their workplaces, post pandemic. But of course, the wider economic environment has shifted, there is no doubt about that. Normally with lowering levels of business covenants like we've seen over the last six months, leasing should have slowed down, but that's not actually what we're seeing, especially at the premium end of the market. So Sameer, what are the stats on rents and vacancy telling us?
SC:
Yeah, Phil, look, we've just done a check in with the teams on the ground, and rent growth is moderating now. It's almost flatlining as the year sort of wears on. But it's all very location specific. So if you look at office, there are two very sort of contrasting markets in Perth and Melbourne, with Sydney somewhere in the middle. So Perth has continued to see face rent growth and flatter sort of declining incentives. So we're on pace for low to mid-teens of net effective rent growth, which is really good. In Melbourne, net effective rents are likely to be down about 6% for the year, and that's mainly because incentives have started to increase in that market. Look, Phil for me, you know, the single biggest driver of rent outlook continues to be supply of new stock in the short term.
So, you know, supply continues to impact sort of the incentive outlook. Industrial is a different ball game. Rent growth continues, but with all this new supply coming in both in ‘23 and in ‘24, both existing and spec stock, along with a little bit of sublease, we are just starting to see some signs of incentives rising, while face rents are now sort of just holding firm, maybe rising a little bit depending on the sub-market. In industrial I'd say just keep an eye on the incentives and rent's kind of flat lining. But Phil, you know, you mentioned the strength in our leasing business. Is this widespread or just in some pockets?
PR:
Well, it's a bit of a generalisation I suppose. So it’s not totally broad-based, inquiry levels are certainly healthy in office. But we're seeing some softening in industrial. If we look at Sydney leasing for example, the size of the individual inquiries has increased by about 10%, in aggregate square metre of inquiries in ‘23 should exceed 2022 by about 10%. So occupiers are keen to come to the market with briefs well in advance of those lease expiries. So they can really methodically work through their really important shifts in their workplace settings post pandemic. Interestingly, some sectors that have been a little quieter of later, like technology for example, are now active again. To your point around industrial Sameer, leasing inquiry volumes are really returning towards more normal market conditions. So we're seeing some 30 to 35% reduction across the board from the peaks that we saw in in ‘21 and ‘22. The majority of that reduced demand is from the larger end occupiers in that sort of 15,000 square metre plus range. But we're still seeing good activity for those smaller ticket size deals.
SC:
One of the other things of course in the conversations is that outgoings are a real challenge. They've increased by 10 to 20% adding to cost pressure for clients and that's everything, right? Like electricity, building insurance, land taxes, and just on this outgoing particularly taxes and stamp duty. Speaking with our commercial valuation teams they've been highlighting the risk to capital values just from recent regulatory changes that we've seen.
PR:
Yes, no doubt. Alright, Sameer, I might just switch to some global perspectives. I think it's always important to consider that and get back to the leasing trends. Perhaps we can touch on what we're seeing globally on vacancy. There's a lot of focus obviously on US office vacancies, which range anywhere from 20 to 35% depending on the market. And of course, industrial vacancies have been in the low single digits in most markets around the world. So, what can we learn from how this picture is evolving? Do you think it's getting tougher?
SC:
Yeah, Phil, office is really interesting. The office vacancy is very nuanced globally. We do have that 20 to 35% in the US but you know, away from that it's high single digits in Europe and mid-single digits in parts of developed Asia. What I'd say is in the first half of this year, office vacancy globally appeared to be stabilising. So put it another way, it's a tough story and it’s not getting incrementally worse. Vacancy may be up, but at a much slower rate, industrial vacancy on the other hand has started to pick up more markedly, right? It is still low by historical context, but decision making is slower and slower take up means we are starting to see industrial vacancy increase. And just on industrial, I think the way occupiers are thinking about their inventory situation, I think we're going to start seeing more of this return back to ‘just in time’ from ‘just in case’ and that could, you know, put some upward pressure on vacancy. Each piece of inventory actually costs business a lot. It costs them in working capital, it costs them in storage, it costs them in obsolescence. So I'd say take up in industrial would be maybe slower than what we've seen before.
PR:
Yes, and on cap rates, the US, UK even New Zealand markets have started to readjust. And our line of sight on that is that, US cap rates for office have expanded by around 200 basis points, which is about 50 to 75 bps softer than what we were expecting things to settle just six months ago. So we're seeing big movements there, Sameer, there's no doubt about that, so just what's your take on that?
SC:
Yeah, Phil. That's right. You know, if you look at the Investor Intentions Survey, it paints a picture of tier one cities’ office cap rates ranging from five and a half to 8%. And industrial class A stocks valued at five to 6% range and shopping centres in that kind of 6% to 7% range. So, to your point, Phil, the outlook for cap rates has probably softened by another 50 to 75 basis points as the year has gone on. Things are getting a little bit softer in terms of pricing.
PR:
Those are big movements in the US. So from what you've observed so far, what's different in your mind and do you think those differences are going to hold?
SC:
Yeah, Phil, I think, in Australia we will probably see almost price parity with the US, maybe a little bit firmer than the US, particularly around markets like office where we don't have the similar sort of structural challenges, but when it comes to say, industrial or shopping centres, I don't see why there should be any big difference between us and Australian cap rates. So we've kind of softened by 50 to a hundred in the first year. I think in the next six months, I'd expect maybe another 50 to a hundred to go from here as well.
PR:
Okay. Well, one of the ways that cap rates in Australia might adjust more rapidly to their steady state, I suppose, is if debt maturity leads to asset sales and, and some repricing. What can we say on the maturity cycle?
SC:
So the kind of overall debt envelope in commercial real estate sector in Australia is about Aussie $370 billion, And our assessment, that just 4% of this existing debt comes up for maturity in ‘24, and then there's another 10% in 2025. The big maturity years are ‘26, ‘27, ‘28. So potentially about 15% of the debt will come up for refinance maybe in the next 12 months. I'm not expecting that'll be a catalyst event for a massive set of forced sales. I don't think debt is the driver.
PR:
Yeah. But, the cost of funding's increased by two and a half, you know, 3% and bank credit committees are continuing to be super vigilant on serviceability. So is this going to trigger more or less activity, as interest rates settle?
SC:
Yeah, it's really tough being a buyer right now in the market. It's really constrained the buyers. We've seen probably more interest right now from credit funds who look at the market right now and returns on some of these credit funds can be 10 to 12% in the current settings. And these credit investors are typically looking at turnaround situations. They're looking at developments and other segments where covenant structure might need to be a little bit different. But Phil, just on interest rates and sort of the outlook for interest rates, I'm not expecting any urgency to cut interest rates till late ‘24. But just having interest rates stabilise just lets people get on with the decision making.
PR:
Absolutely. So Sameer, let's talk alternatives, I suppose a brighter spot and we've both got young children that will be graduating high school shortly and looking at university options. I know we've both been looking at what that means from a student accommodation standpoint. Where are they going to house themselves? So, as you have gone through that process, what have you learnt from that about the PBSA market?
SC:
Phil, look, my son recently applied for a spot for on-campus living, and there were about 1600 applicants for 200 spots. It is very tight, it was a very stressful situation. There's around 1.6 million university students in Australia and currently we have one purpose-built student accommodation bed for every 16 students, one for every 16 students. So it's a deeply underpenetrated market.
PR:
Yes. I agree with that and even with some of the supply coming through over the next three years I think there's about 8,000 beds, the market's going to continue to remain very tight. So how are you seeing rents for student accommodation?
SC:
Yeah, look, there's a lot of dispersion in rents. A lot depends on location and you know, whether it's a new recently built facility with some amazing amenities around safety and socialising and gyms. So I've seen everything from, suites that are at $350 a week, up towards $800 a week. But, we have a lot of proprietary data at CBRE on this. And what it's showing is that on average, student accommodation has rent growth of about 5.5% per annum.
PR:
It's a pretty decent rent growth market.
SC:
Very.
PR:
And this is an asset class which has been favoured by global investors. Yields have been more resilient to changes than the more traditional sectors, but that are about 0.75% higher than build-to-rent. So the other alternative sector where we're spending more time with our clients is around the energy transition. There's certainly a growing role for real estate investors to carve out the value of the hard assets like land and infrastructure from energy supply. And this could be like what we experienced a little bit with the telecom towers and healthcare for example. It's a high growth business where we are dedicating more time and resources. Sameer, getting towards the back end of our chat here, I thought we would just go to a few thought-provoking ideas and thoughts, a couple of picks. So let's discuss the outlook for a few topics where there's been a lot of debate and a bit of controversy in the market. Why don't you hit your first one?
SC:
Alright, I'll start off with residential. Look, we've been very bullish on the residential market. I'd probably say well before others. It's partly because of the robust jobs picture that we just discussed. And our new controversial view here is that the fastest growth will be at the front end of the cycle and late cycle. So I'm expecting 2023 and 2025 will be sort of double-digit capital value growth, whereas 2024 will be more modest and next year it'll be more modest sort of flat, low single digits. So I'm calling it plus 10% this year plus five next year and then plus 10. So you get to about 25% price growth over three years and that reflects the cost of the higher cost of building new stock. My second controversial topic, Phil for you is, office occupancy.
I expect office occupancy to be back to 2019 levels in CBD offices around the country as late as maybe the end of this year, early next year. I was on a plane recently, Phil, and it dawned on me that it feels just like before and you know, and speaking to friends, their kids who are going to university are all talking about, better experiences like their parents had and retailers are talking about returning back to just in time supply chains. So why not the office environment? I expect office occupancy will start to, we won't even probably talk about office occupancy next year.
PR:
Well, that's almost like a belief in humanity I think you’ve g0t there Sameer. I’m with you. Well, it was interesting, our global Office Occupier Survey also found that over one third of firms still expect office utilisation to grow from current levels compared to less than 10% who expected it to fall from current levels. So there is upside, and portfolio optimisation could also lift that utilisation, but we also need to be cognisant of the opportunities that are offered from hybrid work as well. But, I tend to agree with you, I think that normalisation is a good trajectory. Okay what's the next one?
SC:
Third one is construction costs. So in my view, we know construction cost growth sort of peaked in 2022, June 22 when it was increasing at about 17%. And currently it's increasing, but at about 7% year on year. So it's kind of halved in terms of its growth rate. And my view is that we'll see flat growth by year end and the key here will be just what goes on with construction, labour wage pressure, whether it starts to ease as some of these residential projects get completed.
PR:
Yes. And just given the size of the infrastructure pipeline and the tightness in the labour market that you refer to there I still expect we'll get to mid to high single digits, construction cost growth, which I'm afraid continues to add the challenge to the development pipeline, particularly in housing as you reference. Okay. So last one, Sameer.
SC:
Last one is refurbishment CapEx. So a number of our clients have articulated some very large pipelines of new projects, refurbishments including on net zero initiatives. And these commitments were all made when debt was cheaper. Construction was cheaper, valuations were higher. I expect that we will probably see a major downshifting, unfortunately. Not because clients don't want to do this, but more because the economic climate does not let them do it.
PR:
I think it's fair to say, Sameer, there's some rain clouds building, but I'm hopeful you're not going to say we're pulling the covers out
SC:
Not yet.
PR:
Good. Okay. Well, hope everyone enjoyed our latest edition of Talking Property, The House View. We'll be back with our next House View early next year. If you like what you're hearing, make sure you subscribe. Until next time.
