Time to set up for a strong recovery cycle

Frank Gelber From: The Australian June 16, 2011

THE commercial, retail, hotel and industrial property markets have passed the trough of the cycle and begun the long road of recovery. And some players are starting to realise what a recovery it will be.

As we emerge from survival mode, it's time to take stock of our portfolios. Built up during the boom, they were in limbo throughout the global financial crisis when there was no possibility of a sensible sale. Now we need to reshape them, to reposition, to plan refurbishment and development, to work out what to buy, sell and hold.

The numbers don't work now, but they will work later. Now is the time to get into position for the upswing, to reap the rewards in three to five years' time.
Demand from tenants picked up after the GFC and it is becoming evident that we are not building enough to meet that demand.
While the initial collapse in development was a result of a GFC-induced withdrawal of funding, the blowout in yields has left prices below replacement cost levels.

With little likelihood of investment pressure driving a firming of yields, we'll have to wait until tightening leasing markets lead to rents increasing enough to underwrite financial feasibilities. And that's the logic across the board for commercial and industrial markets.

Contrary to the conventional wisdom among investors, these markets are low risk/high return.

 And I include here the super funds, which measure risk/return through the rear-view mirror, looking at past performance as a guide to the future. They are misreading risk. Indeed, it's that excessive caution by investors that, by containing supply, creates the strength of the next upswing.

They'll come back to property -- eventually -- missing first-mover opportunities. They'll come back to both direct and indirect property, the latter including both unlisted funds and the listed property trusts.

The listed property trusts themselves are much more conservative animals now.

All the major players hold portfolios accumulated during the boom which may or may not be appropriate to position themselves for the future.
It's not just which sectors will be better or worse -- in any case, most players tend to specialise. It's also what sorts of property to hold within sectors. Let me give you a quick set of propositions.

Industrial investment property is OK, but not industrial lot production, where there is plenty of land to contain price increases.

Industrial rents will rise -- solidly but not spectacularly. But we can't expect a huge firming of yields through the upswing. Yields were too low and prices too high in the boom. The GFC was a correction, not a shock. Yields will firm a little, but we won't see anything like 2007 yields this decade. Our forecast internal rates of return (IRRs) are solid, not spectacular.

Retail property came through the GFC as the darling of the investment community. While yields and prices corrected, centre incomes held. With the strong dollar underpinning retailer margins, retailing is a much more resilient proposition than it was in the 1980s and 1990s.

People now are worried by the weakness of retail sales growth, but retailers make their money out of margins. We think retail property has been re-rated since the GFC. Nevertheless, we won't see 2007 yields this decade.

To me, the real risk would come from a fall in the dollar, but that doesn't look like happening soon. Again, our forecast IRRs are solid but not spectacular.
Bulky goods centres have been treated as the poor cousin of retail property. They were slaughtered in the GFC. Overvalued in the boom, a large correction was warranted, but we think it was overdone.

Hotels were hit hard during the downturn, by both a fall in income and correction in yields/prices, so development collapsed. Tourism has been thumped by the high dollar, but business travel is recovering strongly. Hotels catering to business already have tight occupancy and the prospect of strong rises in room rates, revenue and hence prices. There is a strong upswing in prospect.

My pick of investments is office property. Not Canberra, which is oversupplied. Adelaide is OK. But Melbourne, Perth, Sydney and then Brisbane will build momentum into a boom. The office markets were hit hard by the GFC. The economic downturn caused a fall in demand and a rise in vacancy rates, pretty much around Australia, and development collapsed.

And now, with demand recovering and constrained supply, we're in for a long period of tightening leasing markets, underwriting rising rents.
We expect a doubling of effective rents and prices in Sydney, Melbourne and Brisbane.

Perth is looking pretty good too. For each of these markets we have forecast IRRs (passive investment, no gearing, market rents each year) between 15 and 20 per cent over a five-year horizon, though the timing is different between markets.

The Melbourne upswing has already begun. Demand in Perth has picked up dramatically, absorbing stock more quickly than expected.

Sydney is the next cab off the rank. Even Brisbane, currently languishing at the tail end of a recession, will pick up strongly as the Queensland economy rebounds.

Meanwhile, markets are mis-priced. Prices were too high in 2007. But now they're too low. In fact, they're below replacement cost levels and inhibiting development.

The economy may be a little weak now but it's really OK and will build momentum over the next three to five years.

Frank Gelber is chief economist for BIS Shrapnel