“Commercial & industrial property: creaky foundations or pillars of support?” ANZ Bank economist Cameron Bagrie asked in a market commentary this week. The material below is taken from his paper, but isn’t the whole paper.
“Economic barometers are giving no clear signal on commercial & industrial property prices. Higher interest rates have shifted valuations into the overvalued zone, but the magnitude is small. With no apparent supply-demand mismatch, and economic prospects remaining sound, commercial & industrial property remains a solid but unspectacular asset class for portfolios,” Mr Bagrie said.
“The market is awash with liquidity looking for a home. With the residential market looking extended, migration receding, yet economic prospects remaining sound, attention is turning to the commercial & industrial sector.”
In his research article, he checked the foundations underpinning the commercial & industrial sector:
Commercial & industrial rental growth has averaged a meagre 1%/year since 1991. With inflation averaging 2% over the period, real rents have been in decline. Stripping out the period of declining rents from 1991-1993 – a period where the commercial & industrial sector suffered from excess supply – raises annual rent growth to 1.5%, but it has still not kept pace with inflation.
Rents have fallen behind construction costs (the replacement cost of the building). Non-residential construction costs have broadly mirrored the rate of inflation. However, they have risen sharply recently (more than 10%) and this development is yet to be reflected in rents.
On a conventional price:earnings (p:e) ratio – the ratio of property prices to rents – commercial & residential property is looking expensive. The ratio has increased by 50% since 1991.
Lower interest rates imply a higher p:e. Easing inflation & a slightly lower real component to New Zealand interest rates has lowered average borrowing costs by around 40% since the early 1990s. This has improved affordability and lowered the yield required to cover the cost of capital.
But yields have fallen below the cost of capital. Commercial & industrial yields are sitting around 7-9%. Yields are at the lower end in strong-performing regions and where land & property is in scarce supply. The weighted average cost of capital for publicly listed property firms sits closer to 10%. Financing rates on commercial & industrial developments generally sit north of 8%.
Further capital gains and/or higher gross yields are being banked upon and the market needs to perform above average going forward. Given where interest rates sit, associated property expenses & the risk associated with property investment, the market is implicitly banking on annual capital gains in the order of 5% over the next 2 years.
To put this in perspective, in the long run commercial property prices should increase somewhere between the rate of inflation (2% on average) & real economic growth. The former should be the long-run driver of construction costs, while the value of land as a scarce resource is more likely to increase in line with the rate of real economic growth (the economy’s trend capacity sits around 3%).
Historically, nominal gains have easily surpassed 5% on average (although real gains have averaged 2.5%/year). Inflation is expected to settle around 2% on average going forward, and it is difficult to foresee a further structural decline in borrowing costs.
Our baseline models suggest the market is mildly overvalued. However, the degree of overvaluation is mild (5%) relative to the residential market, which is generally thought to be 5-10% overvalued.
But sound economic prospects and the lack of pending supply-demand mismatch imply prospects remain sound. Vacancy rates are low and we suspect there is an element of catch-up from the rental side of the equation pending. A positive output gap (demand) will persist well into 2005. The ratio of non-residential building consents to gdp (a measure of supply-demand mismatch) has remained static for the past 5 years. Given the historical relationship with the output gap, and stage in the cycle, our baseline model anticipates real price gains of just below 1%/quarter over the coming year.
But don’t go betting on further double-digit gains. Economic barometers are currently giving a mildly bearish view on commercial & industrial property prices and we are mindful of a degree of spillover into other property segments if aspects of the residential market pull back.
Higher interest rates have shifted valuations into the overvalued zone. However the degree of disequilibrium is small relative to history. With no apparent supply-demand mismatch (in contrast to the residential market), and economic prospects remaining sound, commercial & industrial property will remain a solid yet unspectacular asset class for portfolios.
Bob Dey Report