Property Market Outlook 2004

If history is any guide, Australia is not headed for a massive, widespread property crash although the residential property market will be volatile and far more diverse in 2004. For astute property investors, pockets of opportunities still exist. We expect an increasing shift from residential to indirect investment in non-residential property through Listed Property Trusts (LPTs) and office syndicates over the course of this year in preparation for an office market upswing commencing late 2004 / early 2005.

Residential property

If decades of economic history are to be any guide, Australia's residential property markets are not headed for a massive, across-the-board 'crash' in 2004.

Historically, Australian, United Kingdom, American and Japanese residential property crashes have been typically caused by substantial interest rate hikes that have triggered a jump in unemployment, a dramatic deterioration of migration levels (and underlying demand), falling real house prices and severe recessions. In Sydney, this was the pattern in the property / economic recessions of 1974-76, 1982-83 and 1990-91.

With modest interest rate rises predicted this cycle (one more increase of 0.25% early this year following the two rate rises in late 2003), low inflation, stronger domestic and global economies, unemployment expected to remain around current 14 year lows, and strong overseas migration then a typical recessionary property crash is not on the cards this year. An across-the-board crash under current economic circumstances would represent a dramatic break from history.

Australia's residential property markets are, however, set for a year of volatility and diversity. Our house price models - recently updated to reflect a significant downgrading of overseas migration estimates by the Australian Bureau of Statistics - show that annual house price growth in many capital cities, particularly Sydney, will be flat in 2004. Home owners should expect far more volatility in quarterly median house prices compared to the abnormal market of the last couple of years. Housing markets will also be far more diverse.

Some residential areas will outperform. Others will remain flat. While others still will underperform and experience price falls, as conditions deteriorate in the weak sectors of concern that we have highlighted over the last two to three years.

Further out, interest rates will be the key. This cycle, interest rate rises are expected to be moderate, but the biggest risk for the economy and property markets is that interest rates are increased too far too fast.

So what residential property will outperform?

Established houses close to the CBDs of major capital cities (10km radius) and beach suburbs, particularly those within the more 'affordable' price range, are the sectors most likely to outperform in an overall flat market.

South-east Queensland will continue to experience strong fundamental demand, underpinned by population growth from interstate and overseas migration. But even in Australia's strongest housing market, price growth will not match the strong gains recently experienced. While total migration numbers will remain strong, we believe the rate of growth of inward migration has peaked and will slow in 2004. Investors considering South-east Queensland should look for locations impacted by stronger underlying demand (household formation) and avoid locations where speculative investors, particularly interstate investors, are driving the market.

What residential property will underperform?

Generic units with little differentiation (such as those built in the 1960s, '70s and '80s) will typically underperform, unless in locations where property is scarce, such as harbour-front suburbs.

We expect new investment units in Melbourne's Docklands and Southbank, and parts of South Sydney, Sydney's northern beaches, and Waitara to underperform with a significant volume of supply set to come on stream in 2004. On a positive note, as the economy strengthens tenant demand is rising in those locations, but it may not occur fast enough to absorb supply until later in the year.

Office property

A number of office markets around Australia are set for a solid recovery commencing late 2004. While current leasing demand is weak, giving tenants the upper hand, our research suggests the strengthening domestic and global economies will increase demand for white collar workers late this year - fuelling demand for office space, particularly in Sydney. This scenario should lead to increased capital growth and rental growth in that market commencing early 2005, providing significant gains for investors mid-decade. This is the time to consider taking a position. But note that we refer to significant buildings in prime locations, particularly in the Sydney CBD - for most investors the only opportunity is by way of indirect investment through listed property trusts or property syndicates.

It's little wonder that investors and landlords are absorbed by the here and now in the office markets. The last two to three years have been bleak for most major Australian markets. But this was expected. In most office markets the problems are demand-related, not supply-related: that is they are cyclical not structural. The Melbourne CBD does, however, have some oversupply issues to work through.

Tenants will continue to have the whip hand in lease negotiations for much of this year. But office employment is now in a recovery phase from the worst slump since 1993 and all leading indicators are pointing to a significant recovery in leasing demand commencing late 2004. Business conditions and company profits have picked up strongly, while the global economy looks set to post solid growth in 2004.

Considering the shortage of sites in the traditional prime northern end of the Sydney CBD, buildings with significant cash flows will need to be demolished to make way for the next round of construction, and this will push out the timing of the next development cycle and add to the strength of the investment cycle. As affordability becomes a key issue, tenant demand and construction activity will spread from CBD locations to more affordable suburban office market locations.

Opportunities include Grade B properties in prime locations in the Sydney CBD, prime Sydney CBD offices, and Brisbane CBD offices with long, secure leasing profiles.

Retail Property

User demand for retail property is dependent on retail turnover, which is a factor of population growth, household disposable income and consumer confidence. Year-on-year retail turnover picked up strongly late in 2003 and grew by 8.6% in the 12 months to November, partly due to spending associated with the Rugby World Cup.

Retail turnover is likely to soften over the course of 2004 as interest rate rises, a reduced wealth impact from slower house price growth and competitive discounting impacts on discretionary spending. That said, investors can expect strong previous retail sales growth to flow through to higher rents over the next nine months, particularly in South-east Queensland and Sydney (considering usual lags). Retail property yields continue to firm, however rising bond yields could lead to a softening of retail yields for some secondary-located property assets later in 2004.

We expect solid investor demand to be maintained for sub-regional centres, neighbourhood (including supermarket-based convenience) centres and bulky goods outlets. Food-based centres, which draw most of their income from non-discretionary spending have the lowest exposure to any volatility in spending patterns and are underpinned by long leases. Bulky goods centres, now regarded as an institutional grade asset class, should also be competitively sought, helping to maintain current firm yields in prime, scarce locations.

Industrial property

Investors and developers focusing on the distribution/logistics sector and infrastructure-related opportunities have achieved strong total returns through growth in industrial land values as they have provided cost effective solutions to major corporations.

As development opportunities near new or emerging infrastructure have increased, so have land values. Industrial land values near infrastructure in Western Sydney, North-west Melbourne and South-east Melbourne jumped by between 22% and 67% over the 12 months to September 2003.

As the industrial sector moves from a consolidation phase into an expansionary phase, land banking will continue to be the key to profits. Developers and investors with significant land banking will outperform, particularly those that can leverage off development pipelines and tenant relationships.

Sectors of the industrial property market will outperform, predominantly where there are constraints on land or where improvements to infrastructure are planned. With new supply an issue in some locations, though, there are risks. As industrial companies increase their focus on emerging locations with access to infrastructure, properties in secondary locations will suffer.

In summary

Finding the right property investment this year will certainly be harder than in previous years. But for the astute investor looking at the medium term, certain property sectors will throw up some cyclical investment opportunities. Over the next couple of years, investment returns in differing property markets, sector by sector, will be far more diverse.