After ongoing interest rate rises during 2022 and into this year, we saw the commercial property market respond with reduced volumes of sales and more caution return to investment transactions. The high competition to secure stock in 2021 and early 2022 by a broad range of buyers, from smaller privates through to offshore and listed trusts, resulted in a rapid decline in average yields and an uptick in capital returns.
Industrial has been the standout performer over this period, with both demand to invest and occupy high causing low vacancies, high rental growth and cap rates reducing to new lows never been tested before. According to the PCA/MSCI All Property Digest, Australian industrial average rates fell to as low as 4 per cent after averaging 6.2 per cent four years earlier. Sydney and Melbourne enjoyed some of the tightest yields as funds actively competed to secure large portfolios of assets during a time where demand for storage and distribution of goods was elevated due to the pandemic.
Further emphasising this demand was the strong growth in income returns for industrial assets during this time, coupled with the high capital growth which peaked at 25.2 per cent in December 2021, resulting in a total return of 30.9 per cent this same period – far from the 15 year average rate of total growth of 11 per cent, highlighting this current historical high.
In comparison we saw office assets hampered by lockdowns, restricting staff and growing the work from home trend, which some cities have yet to be able to shake off. Despite rising vacancies, demand to purchase quality assets did continue, notably by offshore groups, capitalising on the cheap cost of finance and opportunity to secure a trophy CBD asset. This resulted in yields falling across the Australian market to 4.8 per cent in 2022. While capital returns enjoyed positive uplift during this period, high vacancies saw some pressure on income, despite the high inflationary environment, resulting in total returns peaking in March 2022 at 9.2 per cent before returning to their December 2022 level of just 4.8 per cent.
For retail the results are mixed, already in a downswing pre-pandemic, the retail asset class did not enjoy the same strong compression in yields as other property types, despite the availability of finance. As a result we saw cap rates remain somewhat steady between the 2021-22 period, between 4.5 per cent and 5.5 per cent, particularly for shopping centre assets. This explains the strong declines in capital returns fuelled by low occupancy and reduced custom to centres, while this has improved more recently, it’s been supported by income returns often aligned to CPI growth resulting in strong gains in income growth more recently.
Looking ahead, we can see average cap rates across these commercial asset classes have started to record some increase. These rates have grown by 10 basis points in the December quarter of 2022 and are expected to continue their upward trajectory for much of 2023, inline with the increased cost to finance and reduced demand. For returns, these are also expected to continue to decline. With rising yields, capital growth expectations will diminish and fall into negative territory. Rental growth will continue at a subdued rate given inflationary pressures, however, is expected to dissipate mid-year until occupancy levels return to more normalised levels for office and retail, while they’re expected to maintain positive across the industrial asset class.
