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18 February 2010

BIS Shrapnel says, "Get ready for the next investment boom: Property"

Article from The Australian today:

I KNOW we're barely out of the office market downturn, but I can't help thinking that the preconditions are being set for an investment boom this decade.

The current setback, plus risk-averse debt and equity markets, will continue to impede office development, setting up stock shortages and strong rises in rents and property values. It won't take long to forget the global crisis and the recent disaster in the property markets.

Meanwhile, the feeling of relief that the worst is over is giving way to cautious optimism. The yield correction that hit property prices is largely over. Attention is turning to leasing markets and tenant demand.

In Australia, the economic downturn was mainly financially driven rather than a real side investment-driven downturn.

Unlike other developed economies, we had a credit and equity squeeze rather than a financial crisis. Banks and investors ran from risk after the excesses of the financial engineering boom. Equity prices corrected. The downturn in the economy hit operating profits. But the financial system remained sound.

Property investment markets were hit hard, with the GFC triggering an unwinding of the preceding financial engineering-driven phase of gearing up and yield compression. And leasing markets faced reduced demand just as new supply was coming on. The extreme pressure we all felt early last year has now passed, with the damage not nearly as bad as most feared.

The economy is now clearly emerging from the recession that never was and the recovery has already begun. Confidence has picked up with a run of good news. Retail sales are still patchy since the household handouts, but consumption expenditure has passed its trough.

Strong infrastructure spending is cushioning weak business investment. Businesses have raised equity to reduce gearing, positioning them to start investing again.

Residential property has already rebounded and that will flow on to construction.

But it's not all sweetness and light. The high Australian dollar is damaging the competitiveness and viability of domestically produced tradeables industries, particularly manufacturing, tourism and other tradeable services. But mining, health, wholesale and retail trade, and professional and financial services are already picking up.

GDP growth is recovering from last calendar year's 0.8 per cent to an expected 2.6 per cent this year on the way to growth averaging between 3 and 4 per cent over the subsequent three years. Fortuitously, with pressure to reduce government budget deficits, private investment will take over from public investment as the engine of growth.

The Australian economy is on the threshold of a major cyclical upswing and the next five years will be strong. Underlying inflation remains stubbornly high, but is coming down slowly.

Our forecast is that cash rates will reach 6.5 per cent by the time the cycle matures.

Getting back to office markets, tenant demand is not an issue in a strong economy. Having stalled last year, employment has rebounded over the past five months, with growth of about 1.7 per cent through the year to January. Last year the impact of the downturn on unemployment was softened by companies reducing working hours rather than jobs. We expect employment to recover slowly as employers increase working hours before taking on new staff.

Improved confidence among tenants has led to some withdrawal of sub-lease space. Office leasing demand will improve from here. In some cities, there is still residual pre-GFC supply coming on. But new development has stopped.

The real point is that rents are too low to underwrite new development. While there is a logic for owner-occupiers to build while costs are low, irrespective of current financials, developers need a pretty good reason to build now even if they can get the finance. Some can build, but most won't.

Given lead times, supply will remain constrained for another three to four years at least. That means that improving demand will quickly absorb excess stock, leading to tightening vacancy rates and a shortage of stock.

Will we forget the lessons of the GFC? It won't take long. I can't help a comparison with the sharemarket collapse of 1987. The subsequent inflow of funds into property drove the 1989 boom. Low vacancy, tightening leasing markets, strongly rising rents, firming yields and strong property returns through the middle of this decade will attract investment capital. At BIS Shrapnel, we're looking at internal rates of return of about 20 per cent for Sydney and Melbourne commercial property over the next five years. That's extraordinary.

Frank Gelber is chief economist for BIS Shrapnel

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