Commercial property set to ride out rising rate era

Inflation has become a hot-button issue over the past few months. The annual inflation rate in Australia was sitting at 3.5 per cent in the December 2021 quarter, before surpassing market estimates of 4.6 per cent by spiking to 5.1 per cent in the March 2022 quarter. The underlying measure also increased from 2.6 per cent to 3.7 per cent year on year, in comparison to the Reserve Bank of Australia’s target range of 2 to 3 per cent. Whilst concerning, this increase is minor in comparison to other developed countries such as the United States, United Kingdom, and China.

The RBA noted in its most recent Monetary Policy Decision that inflation is expected to increase further. RBA governor Philip Lowe stated in the April decision that higher prices for commodities, including petrol, would result in a further increase in inflation. It is expected the RBA will act with haste to quell this surge.

Economists at the four major banks were correct in deducing that rate rises could be expected as early as June 2022, being the first rise in official interest rates in over 11 years. In early June, the RBA increased the cash rate target by 50 basis points to 85 basis points and increased the interest rate on Exchange Settlement balances by 50 basis points to 75 basis points.

The changes to inflation and interest rates have caused many investors to reconsider their position and ability to expand their portfolios.

With rising interest rates and inflationary pressures evident across the country, we can expect all forms of property investment to be impacted. In its most recent Financial Stability Review, the RBA noted that debt levels are currently high relative to income for many businesses and households, and an increase in interest rates will affect the ability of households to meet their debt repayments. They warned that loan performance could worsen significantly if incomes are not increased along with higher interest rates. However, the RBA noted that many households are in a better position to make higher debt payments, as historically low interest rates have enabled them to make excess mortgage payments in recent years.

So, how will these conditions impact Australia’s commercial property market? With the broader economy set to grow post-pandemic, the impact on the commercial property market will be complex. Many sectors of the market are likely to see increased demand, with budget forecasts anticipating real GDP growth by 4.25 per cent in the 2021-2022 financial year and 2.25 per cent the following year. Commercial property yields have been compressed to record lows as a result of strong investor demand during COVID, particularly for industrial property, which has increased values to record highs. At the conclusion of 2021, the Australian average weighted prime industrial yield fell below the prime central business district office yield for the first time, at 3.71 per cent and 4.53 per cent, respectively.

The rise of debt funding costs in the coming months and years will also have an impact on commercial property. The Commonwealth Bank of Australia stated that this might result in investors having less money to borrow and therefore bid on properties with. The reduced competition amongst bidders may result in the easing of price growth and trading activity. However, CBA also anticipated that various factors, including increased inflation and reduced vacancy rates, would enable property income to increase in the short-to-medium term.

Luckily, there are some safeguards for commercial property owners against the effects of rising inflation. Commercial property leases generally contain “inflation-proof clauses” whereby annual rent reviews are conducted, and rent subsequently adjusted, in accordance with CPI or CPI+. These reviews act as inbuilt protection by providing rising income throughout a lease. This protective measure can be described as an “inflation hedge”, something that is of great comfort to commercial property owners during times of increased inflation and the pressures that come with it.

An analysis by BNP Paribas Real Estate states that there was a highly variable and modest correlation between property yields and interest rates in Eurozone economies. They noted that investors should be accepting of lower initial yields on their real estate assets, given that higher interest rates generally relate to higher growth rates and, therefore, faster income growth. Additionally, Charter Hall found that during periods of increased inflation, annual returns for commercial property tend to increase along with it. This means that, in previous periods of inflation increase, commercial property has provided a “hedge” and continued to perform well.

In this economic environment, one option that may be appealing to investors is the commercial real estate debt market. It is anticipated that this market will provide positive results during the looming era of economic expansion and higher rates. These debt yields are made up of the standard base rate as well as a margin on the loans to account for the level of risk. As long as margins remain stable, investors can expect higher returns from any increase in the base rate caused by a jump in official rates.

There is no doubt the commercial property market is facing major change. Given that the increase in interest rates is occurring alongside a period of higher growth rates, investors can still expect increased income growth for their real estate assets. With the economy rapidly bouncing back from the pandemic and interest in commercial property remaining high, commercial property is nicely placed to ride out further changes. There are many exciting and rewarding options for those looking to invest in the shifting commercial property market.

Andrew Turner is the chief executive of Banner Asset Management.