How to pick the top of the real estate market
Strong demand for the broader real estate segment is likely to help prices remain strong for at least another year as the aging population seeks regular annuity in a low interest rate environment, says Luke Dixon, AMP Capital Head of Head of Real Estate Research.
“Real estate is still fairly priced,” Dixon says, a view informed by a detailed analysis published in the latest AMP Capital House View report.
“Record low interest rates and government bond yields has made real estate the asset of choice for yield hungry investors with a lower risk appetite,” he adds.
East Coast prime office yields are over 280 basis points (bps) above the risk free rate, compared to the 20-year average spread of 180bps. Even super prime real estate transactions in the range of 4.50 percent to 5.00 percent are still comfortably above long term average spreads.
What that means is that even though real estate prices are at or near record highs, they are still performing better than government bonds in terms of income, and therefore the aging population is effectively acting as a deflator, says Dixon.
As quantitative easing in the US unwinds, bond yields may rise slightly, though not enough to challenge the attractiveness of property.
“We don’t expect a major disruption to real estate prices on average as we don’t expect a recession, overbuilding, or a sharp inflection upwards in bond yields in the current environment,” he says.
The slow-down in the housing sector, may also keep the heat in the commercial property sector, as it takes the pressure off the Reserve Bank of Australia to raise rates from their current lows. The RBA kept rates on hold at its last meeting on November 7.
“Our modelling suggests that the longer inflation and interest rates are contained, the stronger the chase for yield and the higher prices will go,” says Dixon. “Our view is the cycle could easily extend into 2019.
There are changes on the horizon though.
The AMP Capital House View report also predicts a flight to quality in the office sector as tenants demand flexible workspaces and a contains a general warning about what may happen if interest rates rises in the US, Canada, the UK, and possibly Australia toward the end of 2018.
Since 1987, direct real estate has only suffered four periods of negative total returns, compared to twelve for equities. The long term stable cash flows, and low cost of capital has seen real estate capitalisation rates compress by over 250bps on average in Australia, relative to where they were in the last boom of 2007.
This time around though, AREITS have largely contained debt levels, with leveraging still below 30 percent on average, compared with 55 percent in 2007. This gives investors some flexibility in managing interest rate rises.
However, on the current trajectory, asset prices may rise beyond rental growth.
“Australian commercial property sector still has a little bit left in the tank but investors should be mindful we are in the top quadrant of the property cycle,” says Dixon.
The entrance of e-commerce giants such as Amazon.com and Alibaba Group will drive demand in the industrials space, while second-tier retail centres may see and increase in vacancies, and the office sector may also see a trend toward quality.
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