A turning point for property yields?

The popularity of property investment thisdecade has led to declining yields across the board, with rising prices hittingthe returns available from residential, commercial, industrial, and evenaccommodation buildings.   With lease agreements coming up for their 2-3 yearrenewal, the property sector is now in the midst of a period where landlordsare looking to recover some of the ground lost during the price boom of thelast few years.   Building owners almost always hold the upper hand in thesenegotiations, but current economic conditions suggest they may not have it alltheir own way this time around.

Indices from Quotable Value show a 74%rise in industrial property prices over the four years to June 2006, and a 50% increasein commercial property prices over the same period.   Data from Statistics NZ alsoshows that commercial property rents recorded their largest annual increase in2006 since the series began in 1994.   But the 3.8% average rent rise is stillvery modest given property price movements.

Our graph indicates that a downward trendin property yields has been prevalent since 2002/03.   However, it also showsthat bond yields have tracked a similar course.   Taking the 2016inflation-adjusted government bond as a proxy for the risk-free rate of returnsuggests that the premium commanded by commercial property investment has notshrunk as far as the drop in yields would imply.   The same is true for other propertytypes, including residential.

It may be difficult to see on the graph,but the commercial property premium is smaller than at any time in the lastdecade.   So landlords are looking to restore the premium for investing inproperty.   However, as property price inflation slows, there is also an elementof future-proofing taking place.   The risk-free rate of return is athistorically low levels, and any lift would create significant pressure for anupward correction in property yields.   Such an outcome can only be achievedthrough higher rents or lower prices – the latter being the more likely if asudden correction is required.   And there have been some warning signs frombond rates over the last three months, edging up 0.3 percentage points to theirhighest level since April 2005.

Medium-term prospects for industrialproperty prices seem solid, despite the negative effects of the high New Zealand dollar on manufacturing.   The shortage of vacant industrial land in Auckland and Wellington, in particular, has maintained investor interest.   Increasingdemand for industrial land from non-traditional areas (such as bulk retail) hasalso been a factor behind the surge in prices.   Investors in industrialproperty are likely to be willing to accept relatively low yields if theyexpect the land shortages to persist for some time, pocketing the capital gainsfrom rising property values instead.

Prospects for commercial property areless clear.   Total employment has declined by 0.6% over the last six months,and growth will remain subdued throughout much of 2007.   Demand for commercialspace has stayed robust so far, although if the building is of a lower quality orin the wrong part of town, vacancies have become more of a problem.   Refurbishmentis becoming important for second-tier buildings, and the focus of constructionwork is shifting in this direction following a number of large new projectsover the last couple of years.

Recent improvements in retail salesactivity line up with rebounds in business and consumer confidence.   However,an impending interest rate hike (or two) by the Reserve Bank could yet stuntthis pick-up out of last year’s slowdown.

Retailers’ margins have come underpressure: intense competition and slower spending growth have cramped revenue,while rising labour costs and transport costs have increased overall expenses.   Addin the prospect of hefty rent rises and the squeeze on profits could be toomuch for some businesses.   Retail property owners will need to tread carefullywhen reviewing rents, or a rise in vacancy rates could quickly undermine theboost to yields they are trying to achieve.   The risk of this scenario is thatcommercial property values could give up some of the gains enjoyed over thelast four years.

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