Kathryn House
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, 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 conversation.
Phil Rowland
Hello, I'm Phil Rowland and it is great to be back with CBRE's Head of Research, Sameer Chopra, for our final edition of The House View for 2024. Housing continues to be a headline topic in the property sector as we try to chart a path towards greater supply, which ultimately will address a critical social outcome for the country. But of course, we can't overlook other social infrastructure that is equally important for the future of the country. So in this episode, we'll touch on the outlook for the healthcare, retirement living, and childcare sectors, all very active sectors with their own unique dynamics. We'll also look at leasing activity and supply in the traditional sectors of office, industrial, and retail, and the prevailing challenge of economic rents. And later in the podcast, we'll also cover some trends we're seeing in other parts of the world, along with some views on the key risks and opportunities in the property market as we move into 2025. So be sure to stick around for that. Sameer, good to have you for our last edition for 2024.
Sameer Chopra
Thanks, Phil.
Phil Rowland
I did want to start with global interest rates. Though I know I've hit a few topics there in the introduction that we'll get to, but we are seeing some long awaited easing of rates offshore, particularly with the Fed's announcement last month. So we're entering the fourth quarter of the year where there's now synchronised global interest rate cutting. We're seeing it in the US, parts of Europe, Canada, the UK, and of course New Zealand have all begun this phase. So as we anticipate the RBA's local response, it'd be good to get your views on what this means for Australia property and what we can learn from previous interest rates cycles. So what are your thoughts?
Sameer Chopra
Thanks, Phil. Look, I think the question that'll increasingly get asked is now how will capital markets react? Will we see deal activity pick up? And which sectors or real estate stock benefits from this? And just on that vein, I caught a really interesting snippet from our US team. It came across in the cap rate survey. They do this quite frequently. And the latest cap rate survey suggests that US multifamily assets will be amongst the first and initial beneficiaries of cap rate compressions, and it'll come through first in gateway cities. So if you take that same thematic and apply it locally, perhaps we'll see initial cap rate compression in the highest quality assets. So in Australia, that could be in CBD prime office, in super regional and regional shopping centres, and in super prime industrial in that inner ring area. And this will be one of the most important issues ust to figure out where might you see capital values regrow initially.
Phil Rowland
Well, that makes sense to me. We've certainly seen the highest quality assets being more resilient on the leasing front, and some of the recent larger trades in the office sector would indicate a continuation of a flight-to-quality theme. An additional consideration is, of course, the debt market. You would assume that the cost of debt will become more favourable, helping to make the investment case stack up.
Sameer Chopra
But Phil, at the same time, there's a contra argument here, which is that this discount to book value is also closing as the REIT share prices respond. And if you're a seller, maybe some of them will wonder if they should postpone the decisions by 6-12 months just to wait for a better market environment.
Phil Rowland
While there's certainly no shortage of capital that needs to be deployed, estimates are that the Asia Pacific real estate funds are sitting on 60 to 70 billion of capital, which Australia will naturally be the beneficiary of. With investment volumes down 50% off peak levels over the last couple of years, there's clearly a lot of pent-up demand from investors looking for the right opportunities and returns.
Sameer Chopra
Phil, this concept of this dry powder, I just wonder if some of this dry powder now has some moisture in it. Real estate as an asset class, it's just underperformed other strategies like equities, particularly US equities. So I think as an industry, we need to re-earn the trust of the pension funds and asset allocators. So my view is in the near term, maybe we'll get 0 to 10 bps of cap rate compression in the very best assets next year, and then a more meaningful sharpening in '26 and '27. There is a case, on the bull sides, there is a case for us to retest the levels that we saw in '22. If equities can trade on new peak valuation multiples, why not real estate, especially if new supply remains very curtailed.
Phil Rowland
Well, this would apply that the RBA are going to start cutting rates in '24, Sameer. So what's your final pick for the year?
Sameer Chopra
I'm still, Phil, predicting a cut at the end of the year.
Phil Rowland
Righto. Well, we'll see how that one lands. Okay, let's turn to social infrastructure, Sameer. The demographic fundamentals for healthcare, retirement living, and childcare are compelling. And again, we have this enormous supply side challenge. You and I both attended our Healthcare and Social Infrastructure Conference in Melbourne last month. Clearly no shortage of interest in this sector as investors look to build scale. My main takeaway from this event was the strength of the fundamentals as Australia's population grows and ages, but also what appears to be the resilience in the investment activity despite some of the regulatory and development challenges.
Sameer Chopra
Phil, the demand side conditions are strong across the social and retirement living sector. If you look at childcare for example, there is an extra 100,000 kids aged 0 to five in childcare that's been added over the last eight years. This has propelled demand in childcare. If you look at retirement living or even healthcare in Australia, currently there's about 4.75 million people that's 65 and above. And this is projected to increase to nearly 7 million by 2040, so 4.75 million 65-year-olds growing to 7 million by 2040.
Phil Rowland
Really compelling statistics. I found it really interesting hearing Sandro Peluso's view that while the sectors faced this regulatory uncertainty, particularly in healthcare, transaction activity has remained pretty robust. And there was also a lot of discussion about a slowdown in the development pipeline. While not solving the supply issue, it has helped keep yields low in a rising interest rate environment. I know you've done a deep dive in each of these sectors, Sameer. So let's look at the supply side for a moment, starting with, say, senior living. What are the stats telling us?
Sameer Chopra
Look, Phil, new supply of senior living stock has been growing at half of the pace of the increase in the target market. So the supply of aged care beds and retirement villages is growing at somewhere between one and 1.7% per annum. Whereas the growth in that population, that target market, is about 2.4%. Just to put it in perspective, Phil, the sector, there's 430,000 places, that's beds and units, which makes up the senior housing sector. The sector is four times larger than student accommodation. It's 10 times larger than the current built-to-rent sector. It's quite a sizeable sector.
Phil Rowland
That relativity of scale is pretty stark, Sameer. So what are your biggest takeaways for investors in senior living?
Sameer Chopra
Look, one of the interesting things, Phil, here is just the low levels of institutional ownership. For example, the market share of the top five operators in retirement villages is just 13%. In aged care units, it's just 17%. So my sense is that there's significant opportunities for consolidation over the next decade. The other point I would make, Phil, is that product quality and amenity expectations continue to evolve as new retirees take advantage of bigger asset balances that they have. Older Australians tend to own their own homes outright. If you look at people that are 75-years-old, 83% of them now own their own home outright.
Phil Rowland
And home values have increased markedly. The average home now worth 960 grand.
Sameer Chopra
Plus you add in superannuation. The typical super balance for a couple that's 65-years-old is around 750,000 on our calculations. So the asset values in aged care and retirement villages, they just haven't kept pace with this increase in that residential price growth. So in a relative sense, moving into these facilities today is a lot more attractive than it was recently.
Phil Rowland
What about childcare, Sameer? What are the supply-demand statistics telling us?
Sameer Chopra
Incremental demand for places in childcare, incremental, runs at about 15 to 20,000 per annum. And approvals for new supply, in the last 12 months, it's actually picked up. It's sitting at about 30,000. So this could be one of the few markets where we're actually getting some level of demand-supply balance.
Phil Rowland
That's good. Okay, so as we get more regulation clarity on fees in both aged care and childcare, it should help investors with their decision-making. So lastly, an adjacent sector is hospitals, and we've previously spoken about the significant investment that each of the state governments is making into public hospitals, I think with 36 large redevelopment projects and about 20 new builds planned or underway. So this creates enormous opportunities for real estate investors in healthcare precincts. So how do you see this taking shape?
Sameer Chopra
I love healthcare precincts, Phil. They create massive opportunities for real estate owners across private hospitals, specialist hospitals, labs, medical offices, essential worker accommodation, and amenities. A fully comprehensive healthcare precinct is a $3 to $4 billion asset, and we see scope for at least 15 to 20 of these to be rolled out across Australia.
Phil Rowland
Yes, it's significant and it's really interesting. When you zoom out and think about what Australia is doing in infrastructure, it's really strengthening its comparative advantage, this investment into road, aviation, rail, defense, healthcare, the Olympics. It's something that creates a really wide spectrum of investment opportunity. And of course the government is planning for it, needs to deliver it obviously, and will continue to rely on development and capital partners to make it happen. All right, so let's change gears a little bit and look at what we're seeing in the traditional asset classes. And let's just focus if we may, Sameer, just on leasing inquiry and rental growth. So what's behind the softening of inquiry levels that we're seeing?
Sameer Chopra
Phil, look, I'd say that quantity of leasing inquiries is softer as we head into the fourth quarter and potentially into 2025. Two things are in play. A lot of leasing activity was front-end loaded. Like in '21 and '22 there was a lot of work done in industrial leasing and in '22 and '23 in office. Some of this is just because there's a lot of new supply coming to market. And Australia is a high pre-leasing market so there's a lot of pre-leasing activity. That's now just tapering off as supply gets constricted.
Phil Rowland
Look, there's no hiding behind the fact that we are seeing a slowing economy, and the softness and economic conditions means there is some hesitation beginning to creep in to undertake expansion or relocations.
Sameer Chopra
Just on the fundamentals, Phil, I suppose the good news is that we haven't seen elevated sublease. This is something we keep a very close eye on, and in office and industrial, subleases remain very manageable. So the picture's not for face rents to decline. In fact, we're seeing low single-digit annual face rent growth across most of the assets in the third quarter.
Phil Rowland
Right. But what about incentives? How are they moving?
Sameer Chopra
This is where you're getting the bifurcation. Incentives have crept up further in secondary locations, but they're holding and maybe even firming in the best locations. So maybe just to use an example, Phil, an extreme example, we're seeing incentives in the prime CBD core drop down towards the high twenties level. They were at mid-thirties. Now they're high 20 levels. And that gives you about a 12% net effective rent growth, a very good outcome for landlords, similar to what we've seen in Brisbane's Golden Triangle. Logistics as well, we're seeing in the outer markets, incentives are increasing slightly, say by a few percentage points. And that's largely driven by pre-leasing activity, but they're quite firm in the inner ring markets where occupiers are just opting in for renewals.
Phil Rowland
Well, let's just touch on supply for a minute. I know it's certainly topical in residential where we're now expecting apartment supply to hover around 50,000 a year over the next five years compared to a previous forecast of about 60 to 70,000. Of course, the issues around construction costs, cost of debt, planning delays are not just restricted to the resi sector, right? So what are the stats in the other sectors telling us?
Sameer Chopra
Look, Phil, we're pulling back across the deck, and part of this is just supply getting pushed back. A lot of it's kind of shelving of development. And just to give an example, my colleague Sass Jalili shifted her supply numbers on logistics for 2024. They've been cut by 40% over the last 12 months. Shopping centres is another sector where we've been historically pulling back on supply. And right now, I'd say it's 20 to 40% cancellation rates as projects continue to become unfeasible.
Phil Rowland
Well, that brings us to discuss economic rents and replacement value, Sameer. There's this sizable gap between current average value and replacement costs across almost every aspect of Australian real estate. In most cases, the gap is around 30 to 40%.
Sameer Chopra
Look, Phil, this is probably one of the most important topics with clients as they do due diligence on acquisitions and developments. The replacement costs have moved out by 30 to 40%. So you need to achieve rents which are now 30 to 40% above where they were sitting just a couple of years ago.
Phil Rowland
All right, so just walk us through the maths on where the economic rents are sitting. Maybe let's start off with office and then let's look at industrial.
Sameer Chopra
In office, Phil, we'd estimate that economic face rents for Sydney CBD for a new construction, new built has increased by 42% from 2020 to now. The last five years, gone up by 42%. And the drivers here, Phil, there's been about 100bps of cap rate expansion. Construction costs have jumped up by 32%. There's about 19% inflation in outgoings. You've got to bake in an extra 10% of higher incentives. So if you think about a current cap rate of 5.25% for a new build, you need to be achieving rents of $1,920 a square metre. Whereas just five years ago, $1,350 would've been good enough.
Phil Rowland
And for Melbourne and Brisbane, we estimate economic rents have increased by nearly 60 and 40% respectively since 2020.
Sameer Chopra
And it gets even tougher in logistics. We estimate that the economic face rents for Sydney new build has doubled over the last five years. And the driver here is that usual cap rate expansion, 100 to 150 basis points, but you've also got 60% increase in land value and then you've got this construction cost inflation. So we'd estimate that economic rents for Sydney industrial new development is somewhere around 250 to 270, used to be 130 five years ago.
Phil Rowland
And residential, we've seen strong evidence of replacement costs which are 30 to 40% above those 2020 levels with the implication of course that new supply will continue to be directed at that premium end, targeting locations and specific occupiers who can afford to pay the higher economic rents and values.
Sameer Chopra
And it also provides a tailwind for valuations in legacy assets. And to put it crudely, you can't build it for the same price as the real estate that's already out there. And for most developments now, Phil, I'd say it needs a very comprehensive view of who is the target occupier segment, who is the target buyer out there? There are segments who pay these high rents or these high prices. It's just a matter of finding out who are they and how big is that cohort.
Phil Rowland
Well, higher economic rents and replacement costs are not just a local phenomenon obviously. So let's just jump to see some international perspectives, Sameer, and discuss what we're seeing in other markets. I've got a couple. The first one that caught my eye was when we recently caught up with Ada Choi who now leads our Asia research team. It was really interesting to hear her talk about the big divergence that we're seeing in the Asian office markets. You look at India, in particular, has seen really, really strong take up with occupiers with this big recent surge in offshoring activity. Obviously not new to India, but we've seen this recent wave. And then in stark contrast, China's seeing this net absorption of about 40% below its five-year average. So a real two-speed situation in Asia. The second one for me was our US data showing that office net absorption turned positive for the first time since 2019. So more than half of the markets we track in the US have reported positive net absorption, which is a very welcome and positive signal.
Sameer Chopra
Yes, Phil. And just going around the globe, in the London office sector, our data is also showing a clear preference for large floor plates. So larger floor plates, those that are over 20,000 square feet, they're leasing better than smaller floor plates, those that are below 5,000 square feet. And leasing in these larger floor plates is up 5% on historical levels, and on the smaller floor plates is down 18% on historical levels.
Phil Rowland
That's even as corporate occupiers just really want the best quality space in the most central locations and within each individual sub-market. And they would really want to fulfill those requirements across as few floors as possible.
Sameer Chopra
Phil, look, just sticking with London, I found this survey that we recently conducted in the residential market there. Fascinating. Probably one of the best surveys I've come across. The number one factor when it comes to choosing where people want to move to in terms of their housing is safety, and safety rated ahead of housing affordability and proximity to public transport.
Phil Rowland
Interesting. Okay, Sameer, let's round it off now with some calls on the risks and opportunities as we look into 2025. You want to go first?
Sameer Chopra
Phil, let me go first with what I see probably is a risk that worries me the most. I worry about the scope for property taxes to increase again. We've just been through a period where land tax and stamp duty, foreign stamp duty, have increased. But for me, the biggest risk is that these could continue to inflate and escalate further in the next few years as state governments and councils try to balance their budgets.
Phil Rowland
Yes, clearly. Well, I think those risks are very real for me. And somewhat related to your point is I think costs and margins will continue to be a real risk going forward. While we're seeing inflation ease, I remain really cautious on the cost of doing business. There are still plenty of cost items that remain elevated, whether you think about utilities or wages for example. And there's been a number of regulatory changes that have very real time and cost impacts. So all of these have increased for both occupiers and landlords and something for us to continue to be vigilant on. Sameer, so I know you're a glass half full guy, so what about your top picks on opportunities?
Sameer Chopra
Phil, glass half full or maybe even more. On the bullish side, the replacement cost argument is very compelling, I think, in real estate, particularly in sectors with supply constraints. My favourite three sectors right now are regional shopping centres, residential build-to-sell, and student accommodation. I know as parents, we're not allowed to have favourite children, but I like these ones more.
Phil Rowland
All right. Well, I know I bet against you earlier in the year on the timing of rate cuts in Australia, Sameer, but I do think that the wind is shifting a little on that. I'm not giving up on my bet against you-
Sameer Chopra
A photo finish.
Phil Rowland
...on that. If we do see the RBA start the raising process this year, it does bode well for investment activity to recover next year. So particularly for those assets which can't be replicated easily. So, I think that wraps us up. Thank you, Sameer, and thank you to our listeners. I hope you enjoyed this latest edition of The House View. You can send us your feedback and any questions you might have via
[email protected]. We'll be back with The House View next year so make sure to subscribe to Talking Property so you don't miss out on our kickoff episode for 2025. In the meantime, you can tune in to CBRE's fortnightly Talking Property episodes. Until next time.
Sameer Chopra
Beautiful.
