It’s far too early to invest in the Brisbane and Perth office markets.
A number of investors are looking at these markets as a countercyclical proposition. To me, that’s a classic case of leap before you look. They need to understand how long the market will remain weak.
Certainly, we’re near the tail end of a significant downturn. A number of commentators have been calling the bottom of the market. (Mind you, that’s been happening for a few years.) They are looking for a rebound to boost returns, but will be disappointed.
These markets are substantially oversupplied. It will take a long time to absorb the excess capacity created during the boom. We’ll be bumping around the bottom of the cycle with rents and property values remaining weak, and significant difficulty in leasing space, until well into next decade. On our forecasts, five-year expected returns are dismal.
Other investors have taken a longer view yield-play logic. For overseas investors looking for Australian office market exposure (and some Australian investors who should know better), Brisbane and Perth provide higher yields. Some acknowledge that the market will be weak for some time, but look to long leases to ride through the period of weakness. That won’t work either.
With office cycles out of synch, you can’t judge returns on yield alone. That was a better investment logic in the period where falling bond rates drove firming yields and prices, boosting returns. But the prospect of rising bond rates and softening yields and prices (from that source) means strong expected returns will need to be driven by rising rents. And rents won’t rise much while the leasing market remains oversupplied.
In fact, I regard the strength of yields in Brisbane and Perth as an anomaly in that a developer can underwrite a new project by taking tenants from expiring leases, paying incentives and getting rents high enough to underwrite the financial feasibility of projects. Usually, property values fall below development cost when the market is oversupplied, preventing development. The strength of investor demand this time has kept prices high. Any projects that are developed will lengthen the period of oversupply and delay a recovery. That’s a real danger now with a number of projects mooted.
The Brisbane and Perth office cycles have been driven by the resources investment boom and bust. In the boom, both markets were caught short of space, leading to a dramatic escalation of rents, property prices and then development. We estimate that, during the boom, a quarter of Brisbane office space was occupied by people servicing mining. In Perth it was half. The current oversupply arose as building kept going at boomtime levels while demand fell.
In Brisbane, vacancy rates rose to 17 per cent. Prime effective rents have halved since the heady days of the boom, with incentives of around 35 per cent (though we’ve heard examples of much higher), softening the impact on face rents and prices. In fact, yields have firmed, with the weight of investment driven by falling bond rates.
Vacancy rates have fallen a little with the completion of three major CBD towers and a strengthening of demand. Certainly, the negative impact on the Brisbane economy of falling mining investment has run its course. But much of that impact was rerouted into an inner-city apartments boom, which will now bust. Moreover, some of the improvement in office demand has been associated with staging space for the relocation of state government employees into a new building — which will reverse. Demand will strengthen eventually, but the current improvement in demand could turn out to be a false dawn.
It will take a long time to absorb the excess office space created during the boom. Worse, there are two major office towers vying for precommitment, which, if they proceed, will further delay recovery.
Perth was hit even harder by the end of the mining investment boom. And there’s further to fall. Vacancy rates are around 22 per cent and will rise a little further before this is over. The fall in effective rents has been dramatic, with incentives, now around 50 per cent, softening the impact on face rents. Despite this, yields have firmed, leaving property prices vulnerable to rising interest rates.
The real problem is demand will stay soft. On our forecasts, the vacancy rate won’t fall below 10 per cent until the middle of next decade. Recovery is a long way off.
For investors in Brisbane and Perth, this will be a long, hard haul — plenty of time for them to become disillusioned, particularly if they have to lease out space this decade.
That’s not to say we shouldn’t invest in Brisbane or Perth. Their time will come. But before that, we’ll have to navigate a long and difficult period of weakness. On a five-year horizon, expected returns in both of these markets are dismal. But this is just another cycle and 10-year returns look better. Leasing markets drive everything and oversupply suppresses recovery. It’s only when the oversupply is absorbed and markets tighten that property rebounds. And that’s not for a long time yet.
There’s plenty of time before counter-cyclic investors should invest.
Frank Gelber is chief economist at BIS Oxford Economics.
Originally Published: http://www.theaustralian.com.au/