If you thought Australia's residential property market could be too hot to handle, show a little empathy for commercial property investors.
Take a look at the share prices of GPT Group (ASX: GPT), Cromwell Group (ASX: CMW) and Charter Hall Group (ASX: CHC).
Over the past six months, the S&P/ASX 200 (INDEX: ^AXJO) (ASX: XJO) has returned just 2.75%. But shares in these three major commercial property owners have fallen more than 10%.
Ouch!
What's going on?
While it could technically be called a 'market correction' we couldn't extrapolate those numbers into a long-term trend, in my opinion.
But looking a little closer at the property market it is easy to see why investors in Australia's commercial property market could be in for a very tough 2017.
Firstly, incentives, which are a mechanism to get tenants into properties, remain high, especially in cities outside of Melbourne and Sydney. For example, a landlord may offer you three months free rent if you sign a five-year rental contract for office space. In 2016, incentives in Sydney CBD were believed to have fallen a little but were still as high as 20%.
Furthermore, capitalisation rates are compressed. Capitalisation rates are effectively what you would receive from buying a property using cash. Obviously, the lower the capitalisation rate, the lower your return. Capitalisation rates were heavily compressed in 2016 as the hunt for yield pushed more money in already expensive property markets.
Importantly, the spread between long-term interest rates (used for financing) and the cap rate was squeezed. That makes it unviable for new buyers to enter the market.
Oh, boy.
So far, we have:
- Higher incentives, and
- Lower capitalisation rates
Vacancy rates are the other part of the equation. If vacancy rates increase, everything starts to unwind. Once again, Melbourne and Sydney are doing better than other cities but that may not be saying much.
Basically, if interest rates in the United States (and locally) begin to increase, capitalisation rates must increase to make it viable for landlords. That could mean higher rates for tenants, more vacant offices, less income and lower property prices.
Foolish Takeaway
Property markets are cyclical and like any asset they are only 'defensive' so long as they are defensive. That may sound obvious but if you overpay for any asset you are virtually guaranteed to make a sub-optimal return. As a general statement, I believe the odds are currently stacked against investors in real estate investment trusts (REITs) and commercial property funds. If they go higher it won't be a sustainable rally, in my opinion.
So that's not to say I think they'll crash and burn, just that you should be really picky and expect lower returns from the majority of property funds.
