Commercial property not immune to interest rate pressure

Serviceability challenges expected, says valuations firm

Commercial property not immune to interest rate pressure

While the current property market downturn is expected to start to level out late in 2023, the commercial property market has not been spared the effects of rising interest rates, the latest Herron Todd White data shows.

Releasing its Month In Review February 2023 report on Monday, the property valuation and advisory group captures the current sentiment within the commercial (industrial) sector, including the major markets and the movement in 2023, along with the residential and rural sectors.

Herron Todd White CEO Gary Brinkworth said interest rate rises were the primary reason for a softening in real estate prices over 2022, noting that as a rule of thumb, for each 50-basis point rise in the official cash rate, borrowing capacity drops by around 5%.

Commenting on the Month in Review report, Herron Todd White Brisbane commercial director David Walsh (pictured above) noted that yields had compressed by around 50 to 100 basis points in his service area, following the nine official cash rate movements.

Ahead of aggressive monetary policy tightening from the Reserve Bank of Australia, prime yields in the institutional space were sitting around 3.75% to 4.50%, and middle market yields were in the vicinity of 4.25% to 5.25%, he said.

Since interest rates began to rise, Walsh said that discussions with agents in the Brisbane industrial market revealed yields had compressed “circa 50 to 100 basis points across all markets”.

“Demand in the institutional space has also begun to deteriorate with industrial funds, REITs and property syndicates retreating somewhat due to the difficulty of cash flow forecasting and predicting accurate target returns for investors,” Walsh said.

Assets located within prime industrial locations have demonstrated strong leasing results and continue to be well-received by the market, he said. 

Opportunities for industrial owner-occupiers

Overall, Walsh said demand for industrial assets was still strong, noting the owner-occupier market was an outstanding performer in the sub-$10million market.

“Now that industrial funds, REITs and property syndicates have retreated, opportunities for owner-occupiers have arisen to purchase either vacant assets or buildings with imminent lease expiries,” Walsh said.

Demand for vacant assets remains strong

Due to strong leasing conditions and the investment market over the last 24 months, Walsh said there was a shortage of vacant assets, with many assets that were acquired having been leased.

“Demand for vacant assets has therefore remained strong which is somewhat counterintuitive with the rising cost of debt, yet the evidence demonstrates that owner-occupiers are still very active within a declining market,” he said.

Affordability a key theme for 2023

Given the rising cost of debt, coupled with inflationary pressures, Walsh said he expected affordability to be an important theme this year. 

He said that he expected the premiums owner-occupiers have and would likely need to pay for vacant assets, coupled with high interest rates would put pressure on debt repayments, presenting serviceability challenges for some businesses.

“For investors, it will be about identifying properties that offer value-add opportunities, primarily via income growth,” Walsh said.

“Whilst we are currently in a high inflationary environment, lease structures indexed to CPI will provide solid income growth in the short term and those with a short lease term certain/WALE will provide reversion upside at lease renewal due to the strong evidence of rental growth in the past 12 months.”

Walsh said he anticipated significant new industrial development this year, namely in Brisbane and Melbourne.  This was unlikely to alleviate the supply shortage however, meaning there was a probability that rents would continue to rise.

NSW transactions slow, rental rates expected to rise

While capital value growth and rents increased over 2022, Walsh said the effects of interest rate rises were starting to show.  Feedback from agents showed a lack of sales in late 2022 and early 2023.

However, agents reported an uplift in industrial rental values and demand, which Walsh said was potentially due to reduced purchasing power as a result of interest rate rises.  Inflationary pressures were also considered to be a factor in increasing rental rates, he said.

“Our outlook for 2023 is further growth in rental rates and we forecast this trend to continue over the next few years. Location is considered to be a prime factor.”

Victoria’s undersupply could be corrected in 2023

Rising interest rates and higher construction costs have led to a slowdown in sales volumes in Victoria, Walsh said. 

Walsh noted that much of the available industrial warehouse space was still under construction, resulting in some leasing deals being negotiated as far as 6 to 18 months in advance.

While strength of demand had seen investors paying a premium over the past two years, the market is set to welcome an influx of development completions in 2023. This could mean the imbalance is  corrected, resulting in a softening of capital values as demand reduces.

“We can expect to see more surging rental growth throughout 2023 which has provided an offset for the outward yield shifts since interest rates began increasing and has been the reason capital values have stayed so steady,” Walsh said.

He recommended that investors avoid assets within the secondary industrial sector, such as assets with access issues, poor ingress or egress, poor clearance, and properties with high office to warehouse ratios in markets with no such requirement.

Outlook for South Australia, Western Australia and Northern Territory

In South Australia (Adelaide) interest rate rises have resulted in a “broad softening of yields” across all asset classes, Walsh said. Due to higher construction costs, historically low industrial vacancy rates in Adelaide look set to continue in 2023.

Leasing demand for industrial premises in Western Australia (Perth) continued to strengthen last year, particularly for new build, high specification facilities, Walsh said.  With limited new land to be released, Walsh said he expected land values to continue to reflect positive market movement.

In Northern Territory (Darwin), he said the industrial market would have an important part to play in the state government’s plan to transform the Territory. Many major projects had run into difficulties, however other projects were pushing ahead. Defence projects continue to be an important employer and creator of demand for industrial accommodation, Walsh said.