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Australian commercial property markets have been one of the standout investment classes since the Global Financial Crisis. The markets have delivered consistently high returns with relatively low volatility. Despite a number of downside risks beginning to emerge, capital sources continue to focus on Australia as an investment destination. With equity markets recording some fragility, a cooling residential sector, and global geopolitical risks becoming more prominent, it is critical that investors have a clear strategy in place to protect investment portfolios.
Investing in commercial real estate can act as a defensive investment class in times of volatility, generally providing a safer and more secure return profile. In this report, our team outlines several key factors solidifying this theory and explores the benefits of rebalancing your portfolio with commercial property.
For a commercial property asset to have a solid foundation for income and capital growth, positive economic indicators are essential. Australia’s 27 years of positive economic growth is a statistic we cannot ignore. This is a highly desirable characteristic, especially from a foreign investment perspective and one of the pillars to the market’s growth. Australia is also a highly transparent market, considered number two out of 100 according to the JLL Transparency Index 2018, ahead of France and Germany.
Significant infrastructure spend is also augmenting the investment proposition. For example in Sydney projects such as the Sydney Light Rail, the Metro Rail Line, the Westconnex Extension and the Western Sydney Airport are providing opportunities for existing areas to evolve but also unlocking new markets with further potential. Parramatta is a good example and a market where Real Estate Investment Trusts (REITs) and Australian property syndicates are targeting office assets with the view of Parramatta establishing itself as the second Sydney CBD.
Melbourne is also recording a buoyant infrastructure spend, with a Deloitte Access Economics report stating that over $100 billion is in the pipeline from both the public and the private sector. Some of the projects include the long-awaited train from the Melbourne CBD to the airport, and the North East link toll road, which has been allocated initial funding from the government. The private sector is also active with the largest project being the proposed third Melbourne airport in Koo Wee Rup 74km South East of Melbourne CBD. This is not only improving established and emerging property markets as mentioned above, but also bolstering the employment sector with 340,000 new jobs being created.
Another key theme supporting the sector is the strong leasing demand prevailing in selected property sectors, mainly along the eastern seaboard. Strong organic occupier growth from finance, technology, education and other business-related industries has driven office markets to record very low vacancy rates, which subsequently has pushed rental growth to record levels. While capitalisation rates over the past 6-8 years have recorded strong compression, the consistent appreciation in rents is countering this, making investment metrics more attractive.
Industrial is also recording growth off the back of the major uplift in e-Commerce and increased need for logistics space. While rental growth is positive for the industrial sector, it is not at record levels that have been recorded in the office market in Sydney and Melbourne.
The retail sector is facing several challenges and for this reason has not experienced as positive markets performance. Current re-leasing spreads are flat or negative for most retail assets which is one of the reasons why the retail investment story is less attractive in the current environment.
With the expectation that a period of greater volatility is ahead, it is important to adopt strategies to reduce risk. Security and sustainability of income are two of the key focuses for investors. Commercial leases are more prolonged than residential and tenant covenants often more superior, which can reduce income stability risk. A longer term lease guarantees return over a certain period unlike other investment classes with similar return profiles. This idiosyncratic nature of commercial property becomes very valuable in times of instability due to the more stable nature of the asset class compared to stocks and commodities. Because the investment class does not trade on the public markets, it can be relatively sheltered from short-term market volatility.
The cornerstone of Modern Portfolio theory incorporates diversification as its key principle with the aim of reducing risk. Commercial property can act as a means to provide diversification in a portfolio given its low correlation to other asset classes. The Australian market is large enough that diversifying across different markets can lower the portfolio risk profile. Each major market has its own economic characteristics and responds to different market drivers. Incorporating diversification into investment strategies can lower the exposure to singular markets and exercise capital preservation.
Risk adjusted returns provide a proxy for comparing investment classes. Commercial property investment has provided some of the highest risk adjusted returns over the last ten years. Considering the GFC was incorporated into this time period highlights the stability of income and capital returns of commercial property assets even through difficult economic periods.
There are many reasons why commercial real estate investment in Australia appeals to a wide range of investors. The strong economic fundamentals that have been underpinning the market for 27 years continue to maintain positive momentum. The major infrastructure pipeline further augments the Australian market and is providing new opportunities for growth and development. Demand for commercial space continues to prosper and drive the investment thesis. In addition, when compared to other asset classes, commercial property provides high risk adjusted returns even through times of global instability.
As the wider economy transitions into a phase of volatility and lower growth expectations, investors focus their attention to the optimal portfolio balance to protect value. Considering the Australian commercial property market is currently positioned well to support secure and stable returns, the team believe it is an essential asset class in any diversified portfolio.
September 19, 2019