[+] Rising inflation is not bad news for the real estate sector
Higher inflation figures should help support the commercial real estate sector, with demand from local and foreign investors likely to continue pushing up asset prices.
Although construction costs also increase with inflation, this can delay some projects, which can have a positive effect on supply and demand dynamics.
The real estate sector is preparing for a market correction. The cash rate remains at historically low levels and RBA Governor Philip Lowe has acknowledged there is room for rate hikes over the medium term to bring inflation back within the RBA target band.
The CPI is now at 3.5%, above the RBA inflation target range of 2.0% to 3.0%.
Construction costs rise to highest in 16 years
Rising inflation means the cost of debt is also rising, which is a dynamic the real estate sector has avoided as interest rates have remained at historic lows.
“It is only just beginning to be felt. Given that interest rates are expected to rise, we believe the current cycle of yield compression will begin to stabilize in most sectors this year,” says Tom broderick, CBRE associate director of research.
“But over the long term, rents for commercial properties will rise with inflation, driving returns for investors. The industrial sector is likely to outperform other sectors in terms of rent growth in 2022, given the strong rental demand across the country.”
However, asset holders who have locked in funding since interest rates hit historic lows will continue to benefit from lower costs.
“Developers who have built properties in recent years will have a lower cost base than any new development under construction or about to start,” says KPMG chief economist Brendan Rynne.
▲ Projects stalled before the interest rate hike will continue to receive this benefit.
They will receive a performance bonus if they are able to achieve market rents. Or, if they’re still comfortable with their return targets, they’re going to keep demand strong for those assets because their rents might be slightly cheaper than whatever comes up.
Counterintuitively, higher construction costs are likely to be positive for some subsectors. Indeed, developers could potentially delay some projects, which will create a supply gap and contribute to lower vacancy rates in the medium term.
New developments moving forward will require higher rents to offset the higher cost of construction. of Alceon Todd Pepper estimates that a 15-20% increase will be needed to cover commensurate cost increases.
The Australian Bureau of Statistics’ implicit price deflator is a useful way to understand construction cost trends in the commercial real estate industry, in the absence of a formal construction input price index. It is a measure of inflation which is a ratio of the value of goods and services for the current period to the base period.
The most recent data available from the ABS shows for the September 2021 quarter, the implicit price deflator for non-residential construction, new engineering construction was up 4.3% from the previous quarter, when this measure was up 2.7%.
Supply chain constraints and a construction boom in the residential sector supported by government stimulus packages have driven up the prices of inputs such as wood and steel during the pandemic. Rynne says developers will now start to feel the pinch of end products such as faucets and toilets.
“Prices will continue to rise as China has already indicated that items like these will be more expensive over the next 12 months.”
Inflation is expected to head towards 4.0% this year, before receding in 2023 and stabilizing at above-average levels for the rest of the decade.
“So what you’re going to see are commercial rents going up in nominal terms every year over the next decade at faster rates than what we’ve seen in the previous decade,” says Rynne.
There are a variety of other reasons why rents are likely to rise in commercial real estate over the medium term.
▲ A stronger financial situation will allow many companies pay more rent.
One reason, says Joanne Henderson, national research director at Colliers, is that companies are in a stronger financial position to pay higher rents than in previous cycles.
“Rents have the ability to absorb inflationary pressures, especially given tenant incentives in recent years. Rentals across Australia CBD markets are also lower than those of most global gateway cities. So any rent increases would be met with limited resistance from large global occupiers,” she says.
“Australian office markets are recovering, with vacancy rates set to peak in the first half of 2022. Any inflationary knock-on effect on rents would be part of a rising interest rate cycle.”
Rising rents should support investor demand for projects. broderick expects investor demand to remain buoyant as commercial real estate income rises with inflation.
“Capital inflows from pension funds, due to the current under-allocation to real estate, should ensure solid buyer depth. Australia also remains very attractive to overseas buyers, with record volumes of offshore groups registered in 2021,” says broderick.
Adam Woodward, head of desktop capital markets at Colliers, said rising interest rates will put upward pressure on yields. But he doesn’t expect that scenario to seriously materialize this year due to the wide spread between base yields and interest rates.
“This allows yields to stabilize if interest rates rise,” he says.
▲ Although a rate hike will put pressure on yields, it should not be dramatic.
The good news for real estate markets is that they tend to be relatively resilient to inflationary pressures.
“Returns on commercial real estate have exceeded the rate of inflation, so relative returns are generally positive, even taking into account any decline in asset values due to the rise in interest rates induced by the crisis. ‘inflation,’ says Woodward.
He notes that the CPI has increased by 21.5% over the past 10 years. In contrast, the values of prime office assets increased by 105% and the values of prime industrial assets increased by 133% over the same period.
In addition to inflation, the macroeconomic outlook and supply and demand dynamics will also drive the performance of the commercial real estate sector this year.
Continuing Covid uncertainties will cloud the near-term outlook. But overall, the future looks reasonably secure for the sector, despite unforeseen shocks.
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