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Commercial & industrial property expensive, but not as expensive as residential, bank economist finds

“Commercial & industrial property: creaky foundations or pillars of support?” ANZ Bank economist Cameron Bagrie asked in a market commentary this week. The material below is taken from his paper, but isn’t the whole paper.


“Economic barometers are giving no clear signal on commercial & industrial property prices. Higher interest rates have shifted valuations into the overvalued zone, but the magnitude is small. With no apparent supply-demand mismatch, and economic prospects remaining sound, commercial & industrial property remains a solid but unspectacular asset class for portfolios,” Mr Bagrie said.


“The market is awash with liquidity looking for a home. With the residential market looking extended, migration receding, yet economic prospects remaining sound, attention is turning to the commercial & industrial sector.”


In his research article, he checked the foundations underpinning the commercial & industrial sector:


Commercial & industrial rental growth has averaged a meagre 1%/year since 1991. With inflation averaging 2% over the period, real rents have been in decline. Stripping out the period of declining rents from 1991-1993 – a period where the commercial & industrial sector suffered from excess supply – raises annual rent growth to 1.5%, but it has still not kept pace with inflation.


Rents have fallen behind construction costs (the replacement cost of the building). Non-residential construction costs have broadly mirrored the rate of inflation. However, they have risen sharply recently (more than 10%) and this development is yet to be reflected in rents.


Price:earnings ratios


On a conventional price:earnings (p:e) ratio – the ratio of property prices to rents – commercial & residential property is looking expensive. The ratio has increased by 50% since 1991.


Lower interest rates imply a higher p:e. Easing inflation & a slightly lower real component to New Zealand interest rates has lowered average borrowing costs by around 40% since the early 1990s. This has improved affordability and lowered the yield required to cover the cost of capital.


But yields have fallen below the cost of capital. Commercial & industrial yields are sitting around 7-9%. Yields are at the lower end in strong-performing regions and where land & property is in scarce supply. The weighted average cost of capital for publicly listed property firms sits closer to 10%. Financing rates on commercial & industrial developments generally sit north of 8%.


Further capital gains and/or higher gross yields are being banked upon and the market needs to perform above average going forward. Given where interest rates sit, associated property expenses &  the risk associated with property investment, the market is implicitly banking on annual capital gains in the order of 5% over the next 2 years.


To put this in perspective, in the long run commercial property prices should increase somewhere between the rate of inflation (2% on average) & real economic growth. The former should be the long-run driver of construction costs, while the value of land as a scarce resource is more likely to increase in line with the rate of real economic growth (the economy’s trend capacity sits around 3%).


Historically, nominal gains have easily surpassed 5% on average (although real gains have averaged 2.5%/year). Inflation is expected to settle around 2% on average going forward, and it is difficult to foresee a further structural decline in borrowing costs.


Our baseline models suggest the market is mildly overvalued. However, the degree of overvaluation is mild (5%) relative to the residential market, which is generally thought to be 5-10% overvalued.


But sound economic prospects and the lack of pending supply-demand mismatch imply prospects remain sound. Vacancy rates are low and we suspect there is an element of catch-up from the rental side of the equation pending. A positive output gap (demand) will persist well into 2005. The ratio of non-residential building consents to gdp (a measure of supply-demand mismatch) has remained static for the past 5 years. Given the historical relationship with the output gap, and stage in the cycle, our baseline model anticipates real price gains of just below 1%/quarter over the coming year.


But don’t go betting on further double-digit gains. Economic barometers are currently giving a mildly bearish view on commercial & industrial property prices and we are mindful of a degree of spillover into other property segments if aspects of the residential market pull back.


Higher interest rates have shifted valuations into the overvalued zone. However the degree of disequilibrium is small relative to history. With no apparent supply-demand mismatch (in contrast to the residential market), and economic prospects remaining sound, commercial & industrial property will remain a solid yet unspectacular asset class for portfolios.


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ANZ economists find commercial & industrial property still a solid investment

Higher interest rates have made commercial & industrial property slightly overvalued, but they remain solid portfolio asset classes because there’s no mismatch between supply & demand, ANZ Bank’s economists said in their weekly Market focus today.


“The combination of low interest rates, strong economic growth, increasing globalisation in the property market & investor preference for bricks & mortar following carnage in the US equity market in 2002, has pushed property prices up strongly.


“Accentuating the move has been significant pent-up demand through little commercial & industrial investment from 1998.”


The economists said the residential, commercial & industrial property cycles were historically well correlated, as they’re generally influenced by the same economic influences such as interest rates, expected capital gain, yield & economic growth.


The ANZ economists said there was consensus that the residential market was 5-10% overvalued, begging the question: Are the commercial sectors similarly vulnerable to a correction?


Economic growth and the output gap


In the long run, the economists said, commercial property prices should grow in a range somewhere between the inflation rate (average 2%) & real economic growth. The inflation rate should be the long-run driver of construction costs, while land as a scarce resource was more likely to increase in value in line with the rate of real economic growth.


Commercial & industrial property prices are closely correlated with the economy’s spare capacity, so if demand in the economy exceeds supply (a positive output gap), commercial & industrial property prices tend to be on an upwards trajectory.


The ANZ economists said a simple model showed both industrial & commercial property prices were within “a hair’s breadth” of fair value. As economic prospects remained sound, the output gap should stay positive into 2005, so asset growth should continue.


Prices to rents (a p:e ratio)


Looked at this way, the economists found commercial & residential property expensive.


“Property prices have surged over the past decade across all property classes, particularly in relation to sombre rental growth. This partially reflects a period of catch-up following weak declining property prices (a lower p:e) during the late 80s & early 90s.


“But augmenting the p:e ratio for movements in real interest rates implies a p:e that has just


risen above its 15-year average.


“Property prices have taken a level shift upwards over the past decade as interest rates have moved to a structurally lower average over each economic cycle.


“Our augmented p:e ratio implies both commercial & industrial prices are mildly in the expensive zone, largely on the back of recent rises in interest rates, although the magnitude of overvaluation is within the margin of error.


“There is little evidence of a pending supply-demand mismatch.”


The economists said the ratio of non-residential investment to gdp had been broadly stable for 5 years. Typically a cyclical driver of economic prospects, the sector had shown a very muted response to strong economic conditions.


“A key reason for falling yields within the commercial & industrial sector in relation to the cost of capital is scarce supply in some market segments, which has encouraged investors to accept rentals below the cost of capital in the expectation of capital gains.”


The economists said commercial & industrial rents should continue to lag behind rising asset prices. In sharp contrast, they said a swathe of supply would enter the residential market in 2005.


The upshot


“Yields in most asset classes – residential, commercial & industrial – have now fallen below the cost of capital. But sound economic prospects, a rebalancing of growth & no major supply-demand mismatch imply commercial & industrial property are the relatively better bet for property investors.”


Website: ANZ Bank

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