Talking Property | What Commercial Property Investors are Prioritising in 2023

KH:

Hello and welcome to Talking Property, our CBRE podcast series where our team of experts, our clients, and industry specialists share insights into the way we live, work, and invest through the lens of commercial real estate. I'm Kathryn House, CBRE's Australian Communications Director and I'm your host for this latest Talking Property episode. Today, we'll be talking about commercial property investment activity and what the outlook is for the year ahead after a challenging 2022. This was one of the key topics in our recently released Pacific Market Outlook report, and it's great to have the opportunity to do more of a deep dive. Today, we'll discuss the funding environment and how that's challenged deal flow, not just in Australia but globally, and examine the major drivers and trends that will shape the market and influence investor decision making this year. To talk us through this, I'm joined by three of CBRE's market experts, Stuart McCann, Head of International Capital for Pacific and Southeast Asia, Andrew McCasker, our Pacific Managing Director of Debt and Structured Finance, and Tom Broderick, CBRE's, Australian Head of Capital Markets Research. Thanks for joining me today. 

TB:

Hi Kathryn. 

SM:

Hey Kathryn. 

AM:

Hi Kathryn. Good to be on this podcast. Look, it's certainly going to be an interesting year for us going ahead. 

KH:

Nice to have you here. So, look Tom, to set the scene, you recently crunched the numbers on 2022 investment activity in Australia. Can you talk us through the key outtakes and just give us a sense of why you think activity's stalled in the second half? 

TB:

Yes, sure. So, I guess from a 2022 perspective, we saw deal activity slow a fair bit. Overall volumes across the major sectors reached 33 billion dollars' worth of transaction activity. That was about 40% off 2021 levels, but through the course of the year it changed quite a bit. So, the first half of 2022 was largely in line with kind of 10-year averages, but it was really the second half of the year that dropped off, in particular Q4, which is in general the most active period of any calendar year. But we saw 7 billion worth of transactions in Q4 2022, which was the lowest result that we've seen in a decade in the Australian commercial property market. In terms of sectors, the industrial sector saw the largest decline from about 22 billion in 2021 down to 8 billion in 2022. That was partly the fact that there was some really large portfolio deals in 2021 in that sector. In terms of why that was, clearly interest rates were the biggest impact and it kind of brought uncertainty to the market. There was a discrepancy in what vendors wanted and what buyers were willing to pay and that resulted in a fairly significant drop in activity. 

KH:

And I guess you talk about interest rates, so really the cost of funding has been one of the real major market challenges. Andrew, what's your outlook for this year and do you think we're going to see the market shift in the short term? 

AM:

We've seen the RBA, 7th of March, raise the cash rate for the 10th time in a row, which is a record for Australia and has our cash rate at 3.6%. And when you consider we've come out of a record low interest rate environment as a result of that, we've seen the property market and the debt market really get a spur along and everyone participating with their ears pinned back to get as much of what they can. What we saw, as Tom mentioned with the statistics around sales and trading, what we saw was a slowdown in last year as interest rates rose. And we will continue to see that through the best part of this year until such time that people have confidence in where the interest rates are going to sit and then what the impact of that cost of debt is going to be in relation to the asset that they're either looking to purchase or looking to sell. And obviously all that flows through into value through cap rates and market acceptance. Our view is we're probably at the point where we're going to see some stabilisation in interest rates over the next couple of months and the commentary that we're looking at is saying the back end of 2023, beginning of 2024, we'll start to see a softening in the cash rate which will flow through into not only commercial lending but also residential housing loans. But as I keep saying to all of our clients, we are not going to get back to that sub 2% all up interest cost for debt unless we roll into another global impact or global pandemic. So, we will sort of stabilise around that cash rate of somewhere between 2.8% and 3.1% is our view. 

KH:

Yes, let's hope we definitely don't have another pandemic. So, Stuart, in your role, you've got this real helicopter view of what's happening in the market. So, tell us a little bit about what you're seeing at the moment and where the capital's heading. 

SM:

Yeah, it's an interesting one, Kathryn. Listening to Tom saying that volumes across Australia were down 40%. If you actually compare that to volumes across the US, Europe and then Asia-Pacific, over that 2022 same period, volumes are actually only down by between 15 and 20%. So, Australia actually was more impacted over that same period. What we put it down to is clearly the tightening by the central banks around the world has impacted pricing. It's impacted transaction volumes because of that disconnect between where vendors and purchasers were meeting in terms of transactions. So, if you look across what happened into the UK and the US over the same period, the central banks lifted by between circa 400 and 450 points, versus where the Reserve Bank lifted by 300 basis points. So, if you think about what that's meant for real estate markets is that your big markets in the US and UK actually re-priced much more aggressively over the course of 2022. And as a result, we saw global capital get allocated more so into those markets that re-priced quicker and that's why we saw volumes in Australia, you know, sit well below I guess the other regions around the world. Look, as we move into 2023, clearly the RBA movement has caught up to some of these other central banks around the world. We're seeing vendors become more realistic in terms of where re-basing of pricing needs to be in order to get transactions across the line. And given the general economic and the underlying real estate outlook of Australia relative to some of these other markets around the world, you know, we think that Australia is really well placed to outperform. So, as we go into 2023 and throughout 2024 where you start to see some stabilisation in interest rates, you know, we think Australia's really well placed to be a good beneficiary of an uptick in capital inflows from overseas markets going forward over the next 12 to 18 months. 

AM:

Stuart, with those investors, you mentioned they focus back into the US and UK based on returns, how quickly can they change their investment strategies to move the allocations? 

SM:

Look, some of these big investors can move very, very quickly around that. And so, we think, as my comments earlier, Australia's benchmarking incredibly well from a rental growth standpoint actually across all sectors. And so, my view is that some of these bigger global investors will be opportunity-led like they were in 2022 and will continue to be so going forward. 

KH:

Are they looking at particular opportunities, Stuart? Like in particular sectors? 

SM:

Absolutely, they are generally, and when we're talking about this, we're talking about the bigger institutions that are allocating across various markets across various sectors. Ultimately what we're finding is that the capital that's been allocated is really trying to focus on cash flows and cash flows that have been really well supported by strong dynamics of demand supply, economic growth, et cetera. And so really these allocations of capital are trying to pursue sectors where they see the ability to outperform on rents and obviously grow your yield through the investment period as well. And look, clearly across, you know, Australia, if we looked across inner city and CBD locations, we think those markets from an Australian standpoint are incredibly well-placed to outperform over the next 12 to 24 months. Clearly, we're seeing, you know, a return to work from workers, which is driving the performance particularly of our super prime premium grade assets. We're seeing residential vacancy rates in and around the CBDs compress rapidly to record lows, which is fuelling incredible demand and rental growth from a residential standpoint. And clearly, we do start to see an uptick in tourism back into the country and overseas students back into the sector, into the country to drive, you know, the student accommodation sector as well. So, our view is that capital will get allocated where they're confident that you can outperform on rental growth. 

KH:

So, it's probably a good segue back to you, Tom. I mean in our market outlook report, you know, I know you've made some predictions for 2023 and 2024 in terms of capital flows. Can you talk us through those and you know, what you're expecting this year and next? 

TB: 

Yes, so I think our expectations for 2023 are probably the reverse of last year, where the start of the year is most likely going to be relatively slow and then activity will pick up in the back end of the year. To Andrew's point, the expectation from financial markets is that interest rates will peak somewhere in the middle of this year and that'll give investors more confidence about what the terminal rate is. On top of that, I think to Stuart's point, there's been probably a lack of evidence of the new pricing metrics for Australian real estate as opposed to the likes of the UK and the US. That evidence should start to come through in the first half of the year. So that'll give buyers and vendors more confidence around where the new pricing benchmarks are at and that should unlock more activity. Beyond that, we expect activity to rebound in 2024. Our base case is for about a 20% increase in transaction volumes. 

KH:

That's good to know that things are getting a lot more positive. Stuart, can you give us a feel for which market sectors are top of investor buy lists? 

SM: 

For sure. So, look, the best basis really is the Australian Investor Intention Survey, which CBRE released early January and that surveyed, you know, a number of the large big fund managers, private equity groups, Asian REITs, around what their priorities were for investments into Australia over the course of 2023. The three big sectors that have come through very strongly in that surveying is super-prime office followed by logistics and build-to-rent. If we think about why super-prime office has really been top of the list for some of these bigger investors, I think it comes down to the fact that the supply side is coming under pressure into our big CBDs. It's just getting harder to build and bring on new stock and that sits well for rental growth and also super-prime offices are being supported by a really strong return to the office and increasing utilisation rates, which we think is attractive for the sector together with some ability for this segment of the asset class to really outperform from some pretty attractive and strong flight to quality trends that are playing out across the office markets. Logistics continues to be well bid and well pursued, particularly by the overseas investors. At this point in time, we're starting to see a number of JV and club style of transactions getting funded over the course of 2023 by groups that have struggled to get set in the sector previously given the level of competition for the sector, and residential in the form of build-to-rent. We see that as a, you know, a really attractive asset class at the moment where you've got national vacancy sub 1 % and again, incredible challenges on bringing on new stock as well. So, we think there's a pathway over the next sort of short to medium term for above trend rental growth as well. So, speaking to the groups, these seem to be the sort of top three peaks in terms of asset classes that they're looking to get exposure to. 

AM:

And Kathryn, not surprisingly in the debt market, we follow exactly the same suite of products that Stuart just spoke to. So, super prime office, industrial logistic distribution and built-to-rent multifamily. If we could give our lenders a wish list, they would definitely tick those three as their top three to participate in. And more around the risk side of things, so because the yields are so tight on industrial and super prime, the gearing levels are quite low because the interest cover ratio that's generated out of the asset with the debt overlaid onto it, determines how much money the owner can borrow at that point in time. In the build-to-rent space, we've definitely seen a lot of appetite move into that purely on the back of the demand for, in the Australian market, residential requirement under the rental and purchasing side of things. So, those three are a no-brainer. The one I'm calling out which we are getting more and more appetite for is the retail market. So, we saw the retail assets be quite defensive during covid and quite well supported and I think a lot of the financial institutions have got confidence back for those retail shopping centre assets as well. 

KH:

Well, the retail team are going to be very pleased to hear that. Andrew. Another thing while I've got you on the line, I'm really interested in ESG and how that's playing into investor decision making at the moment. You know, it's increasingly top of mind I think for investors and lenders. So, Stuart, what sort of feedback are you getting from clients on and how this is shaping their investor decision making? And Andrew, how much is it factoring into lender strategies as well? 

SM:

Yes, it's something that's building enormous momentum and we just cannot see it reversing in any shape or form. So, we think it's here to stay. Interestingly, and probably one of the most compelling reasons why it's so important that it's coming across in our surveying is that if you do look at the recent survey we did as part of that prior report around investor intentions, what we've found is that 62% of corporates are already moving or are considering moving into green buildings going forward. So, if your occupier markets are transitioning to assets that suit this criteria, it's pretty incredible to see how assets that don't have appropriate ESG and environmental credentials could start to really underperform. So, it's not just important from your own internal requirements to adopt more ESG credentials as part of your investment strategy, but you also think that over time it's going to start to impact the overall performance of your investment as well. So, we think it's going to continue to build momentum and it's certainly here to stay, and we think that's a good thing. 

AM:

Stuart, just on that, do you sense that we may move to a point where we've got office buildings which become obsolete because they can't be retrofitted and they're just not going to be compliant? 

SM:

Of course, it's definitely a risk, but one thing I'd say is that Australia's been one of the earlier movers in terms of, certainly from an office perspective, by introducing the NABERS rating sector many, many years ago. So, on a global basis I think Australia is really ahead of the curve and so a lot of the assets that are being developed today, refurbished today, have already been built up their credentials from an ESG and environmental standpoint. And so, we are fortunate in the Australian market that a lot of the work has been done by particularly a number of the larger institutions across their assets, whether it's the older assets or some of the newer assets as well. So yes, it's a risk on the horizon, but we think that Australia's well protected given the investment into the ESG credentials across the institutionally owned real estate over the last 10 to 15 years. 

KH:

And then Andrew, I'd love to hear where the major debt providers are looking to increase their allocations. 

AM:

In the banking space. It's quite interesting. We've seen the evolution of ESG certainly in investment committee papers where it used to be an annexure and a one line or two. Now it's the first or second topic spoken about when financiers are looking at deploying capital in loans for assets. We had been talking to a number of groups around green lending and what qualifies and what the benefit of green lending is. And the thought has moved from giving a discount to debt costs for compliant or soon to be compliant assets to actually charging a premium for those assets which aren't compliant or won't get to compliance in a certain period of time. So, rather than offering a benefit to be compliant, it's offering effectively a penalty for not being compliant. 

KH:

It's really good to see that it's not just lip service anymore. I know it's been talked about for a long time, but the fact that, you know, it really is becoming that people will actually walk away from deals if they can't satisfy those ESG credentials. 

AM:

Well, the banks are actually now tracking it on the basis. If we do syndicated lending, there's always a bank that's a lead and there's a lead ladder table which says which banks led the most syndicates. We're now talking about green leads as well. So, banks are very interested and keen to put their hand up to be the green lead across syndicate loans to ensure that the assets and the groups that we're lending into are compliant as much as possible in the ESG space. 

KH:

That's fantastic. Now I just had a bit of a fun question to finish up on. So, if you had, and I'm going to go for Tom first, if you had $500 million to invest, where would you park your money and why? 

TB:

Start with the conservative researcher. So, I think from a fundamentals perspective, residential looks really attractive in Australia at the moment. Very low vacancy, high rental growth and the versive supply situation, I can't see getting rectified in the short term. It takes a while, we know about high construction costs, et cetera. So, I think that rental story is going to continue and so I think that's where I'd probably park my money and I think there's a lot of capital out there that is responding to those low vacancy rates and looking at things like build-to-rent and student accommodation. 

KH:

Excellent. Stuart, where would you put your dollars? 

SM:

Look, it'd be a great position to be in to have $500 million to play with, but look, I think fundamentally I'd look at it from a point in time perspective together with an occupier market perspective too. And right now, I'd see the opportunity to get set in super prime office into big gateway markets like Sydney and Melbourne as a great opportunity. You know, these markets have been incredibly tightly held over the past 10 to 15 years and right now there is a great availability of product and the opportunity to buy some of the best quality office buildings in these core markets that just haven't been available for investment over the last 10 to 15 years. So, at the same time, to my point earlier, from an occupier standpoint, rental growth standpoint, we saw the market see 4% rental growth in Sydney for prime office in the last 12 months. We are downgrading our supply outlook for office going forward and we just think that the markets have got some good runway to continue to leverage off improving utilisation rates as well as the flight to quality trends which are playing out not just in Australia but globally. 

KH:

So, Andrew, lucky last. $500 million. 

AM:

Yes, well I get to take a hedge 50/50 because I'm in absolute agreeance with Tom in that residential space and would be pinning my ears back across there but would also split my investment into the super prime for all the reasons that Stuart mentioned. There's certainly assets there which are once in a lifetime opportunity to acquire. So, if I certainly had the fortune of being able to spend that amount of money, I'd be placing across residential and super prime and potentially a good size boat for myself for the weekend 

KH: 

I think we'd all like that. Alright, well thank you so much for your time. I really enjoyed the conversation. If only we all had $500 million to test out your investment theories. So, thanks very much, Stuart, Andrew and Tom. It's clearly going to be a dynamic year in the capital markets space and there's a lot to consider. So, I hope we've given you some food for thought today. Thanks for tuning in to this latest episode of Talking Property with CBRE. If you like the show and want to check out more, visit www.cbre.com.au/talking-property, or you can subscribe through Spotify and Apple Podcasts. You can also read our Pacific Market Outlook report by clicking on the link in our show notes. Until next time.