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Investors ignoring property fundamentals in insatiable quest for yield

HARRY ROSENBERG
APN Online
4 NOVEMBER 2015

The combination of historically low interest rates mixed with a commodity price collapse, volatile equity markets and a weakening Australian dollar, has contributed to record amounts of money in the Australian investment property market.

As Sydney’s and Melbourne’s residential markets have grown, investment levels in the commercial and industrial property sectors have also risen to their highest point since the 2008 Global Financial Crisis.

Domestic and international investors continue to flood the buoyant local property markets in an attempt to secure yields through commercial and industrial properties that currently appear unattainable in cash or equity markets. Funnelling money into traditional bricks-and-mortar is seen as a financial “no-brainer” for an investment community eager to maximise its investments and reap instant rewards.

But have the buyers taken into account the current property fundamentals and the risks that have always existed in commercial property?

The very tight sale yields currently being achieved are at odds with the soft leasing demand and high vacancy levels being experienced across most CBD office and industrial property markets. This situation is illustrated by the significant office incentives currently being offered to potential tenants  –  approximately 50 per cent in Perth and Brisbane, 30 to 35 per cent in Sydney and Melbourne and 20 to 25 per cent in Adelaide and Canberra. Industrial incentives are currently running at approximately 15 per cent.

In these market conditions, allowance needs to be made for a letting-up period with no income should a tenant decide to leave. Consideration also needs to be made for the CAPEX requirements of a building that may be necessary to retain existing tenants and attract new ones.

Conservatively, these “forgotten” normal expenditures in a commercial building will reduce the already tight face yield on which the property was purchased by at least 30 per cent  –  effective yield rates are therefore often far removed from the initially quoted face yields.

Is this being considered when assessing the property’s returns and the question of capital preservation?

Somewhat unaffected by this reality are non-yield-seeking Asian buyers. Motivated less by yields and more by the opportunity to invest their capital in a perceived “safe haven” economy as well as their longer term investment horizon, the demand from Asian buyers for Australian commercial and industrial property is likely to continue for the foreseeable future, fuelling continued high prices and defying current market fundamentals. Another factor that’s fuelling the demand is the current low debt interest rate environment.

The big question we must now ask ourselves is for how long will interest rates remain as low as they are? Are low interest rates, in fact, now the “new norm”?

This question is the great imponderable currently faced by property investors, as an increase in interest rates has the potential to adversely affect both the appetite of buyers and the prices achieved across the market.

And then there are the questions being asked about the economic conditions both in Australia and overseas. I think it’s safe to say that all is not rosy in this regard  –  what impact will that have on property in the short to medium term?

Accordingly, in my opinion, property investors should stick to a disciplined approach when acquiring property. Each investment opportunity must be assessed and evaluated on its own individual merits, while also taking into account property fundamentals.

This discipline includes buying well under replacement cost, performing a thorough due diligence process on the property being considered, ascertaining the short-, medium- and long-term required CAPEX and, most importantly, employing conservative assumptions around rental income when determining future cash flows.

Investors should only proceed in acquiring the property if the due diligence doesn’t throw up any “deal breakers” that can’t be resolved and the projected returns are still acceptable after taking the conservative assumptions into consideration.

Most importantly, capital preservation cannot be overlooked in the insatiable quest for yield. If the property doesn’t pass the due diligence process and acceptable returns can’t be projected using conservative assumptions, then don’t buy the property. Wait for one that does. After all, the quest for yield can lead to long-term pain.

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