A lot of noise but the facts are singing a different tune

The current challenges facing the commercial property markets remain vast. Throughout 2023 the significant increase in the cost of debt alone would have been an adequate reason for property owners to sense a level of heightened pressure. Adding to this was one of the most volatile years experienced in over a decade effecting arguably every advanced country and their respective economy. Inflation, geopolitical tensions and active warfare in Ukraine and the Middle East made conditions even harder for commercial property owners, buyers, and valuers to navigate.

For commercial property, added impacts stemming from COVID-19 made the landscape furthermore unpredictable especially within the commercial office building sector which is experiencing occupancy conditions not seen in Australia since the early to mid-1990’s recession. It would be fair to conclude that irrespective of the markets transition towards providing higher leasing incentives to prospective tenants, net absorption of office space was flat with most new leasing transactions simply being tenants moving from one space to another and likely taking advantage of the timing of their lease expiry and building owners that were understandably keen to secure some form of leasing activity for assets under their ownership.

I have long held the view that the way in which the Australian commercial property market is analysed and reported on in a mainstream sense provides at times an opportunity for more thorough analysis namely on a sector-by-sector basis. To this point, it would be fair to conclude that the industrial, hotel, retail and several of the ‘alternative’ asset sectors performed a lot better than what say commercial office buildings did throughout the year.

Of the transactions that did occur across all sectors and even more so as the year evolved, one thing that can be fairly concluded is that capitalisation rates were significantly impacted if for no other reason than the higher costs associated with asset funding.

We believe that whilst the conditions for commercial property transactions in 2023 were subdued, the outlook may not be totally gloomy for owners of assets with an appetite to divest. Unlike the capital market conditions that we saw between 2008 and 2010, there is a visible deep pool of active capital that seems to (at this stage of the cycle) be simply waiting to be deployed into the market at a time at which it deems provides more normalised returns that have traditionally been associated with commercial property investment.

In most of my interactions with private investors and family offices throughout 2023, there was a strong underlying level of interest for investment into the commercial property sector. The general sense from speaking with these investors is that whilst their appetite is present, uncertainty towards which sectors to invest into and timing of when to invest remains prevalent in their thinking.

There is little doubt that a consistent theme of thinking from those that are capable to purchase commercial real estate is that many investors who continued to acquire properties at prices that reflected tighter and tighter initial capitalisation rates (likely driven on mass by the falling costs of asset funding) will need to be held to account for their decisions. Throughout the year, many conversations referenced the activity of investors whom they deemed had paid too much to acquire properties and whom they felt would likely be facing significant issues with what they do with those assets in the short to medium term.

My personal view is that it is likely that buyers who are capable for capital deployment into the commercial property sector at present are likely to remain highly cautious until a point in the cycle is reached where there is a general view held that capitalisation rates have settled at a level that takes into accurate account the range of factors that constitute the overall risk profile of the sector.

Additionally, and as a final point, there is a strong level of interest from investors to understand in more detail opportunities that exist within the residential sector mainly driven by the clear demand / supply issues, the impacts of the Build to Rent (BTR) sector and how all levels of government plan to solve for the housing crisis that is playing out across all of Australia at present.

It would be fair to conclude that sentiment of owners of commercial real estate has been one of uncertainty and heightened concern when compared to many previous years over the last decade. No doubt many owners who purchased commercial real estate over the last few years at prices that needed to be paid to secure assets are now facing increased scrutiny from investors, financiers, and valuers. We believe that the majority of 2023 for these owners would have been spent on protecting cashflows of existing assets as well as communicating with their shareholders and working with financiers and valuers.

We are of the view that many owners would be willing to trade assets that a couple of years ago they would not have considered selling, however their willingness to publicly offer assets for sale has been subdued due to their concerns around how active buyers would price their assets in a public process. This view from many owners is likely to contribute at some point in the next 6-18 months to an oversupply of assets being publicly offered to the market for sale, this will result in further softening of values of which buyers are willing to pay to purchase properties, and likely at this point we will see the establishment of the ‘new’ values for commercial properties being defined.

The big question that we are asking within our company is what will occur with ‘debt’ relating to commercial property in 2024. We are already seeing advanced deterioration of asset values in the United States of America which has always and will for the foreseeable future remain a key indicator of what is likely to occur in the Asia Pacific commercial property markets.

As loans for commercial properties purchased in 2017, 2018 and 2019 likely come due for refinancing, what impact will the significant increase in the cost of debt have on the borrower’s ability to obtain refinance, service new loans and arguably most importantly do this at a lower valuation on the asset than when the asset was purchased.

We anticipate that whilst conditions may continue as we saw in 2023 with lower transactional volumes, this will only occur for the first few months in the new year. A major unknown piece of the puzzle will be to understand just how much exposure to commercial property non-bank lenders have. Clearly the non-bank sector has seen significant overall growth over the past 5 years and whilst they in essence provide the same function as a traditional bank (predominantly debt), they do it on far different terms when it comes to reporting, visibility and transparency of loans that have been made.

In my personal market experience working in the commercial property asset class for the last 18 years, the components which make up ‘asset value’ is very fickle in Australia. I believe that when 4 assets in the same class (for example 4 Victorian neighbourhood shopping centres) are offered for sale at the same time in market conditions that are not rampant with buyer demand that this is the catalyst for a significant softening of asset values as the market swings very much towards a ‘buyers market’ landscape. The process commences with the properties being offered for sale, not transacting at the end of the public sales process, each of the assets remain on the market for sale as owners become a bit keener to see their asset divested as they can see the rising volume of assets they deem as comparable to theirs being offered to the market by other sellers. At some point their patience runs out and they start to consider if they should meet the market (best price offered), for a multitude of different reasons one or more owners of the assets being offered for sale may decide that it is in their best interests to meet the market and divest. As soon as this occurs it begins the cycle of asset class repricing which in turn has wider spread impacts across the board on commercial property asset pricing.

Whilst we saw in 2023 some assets starting to sell on yields that were softer than through the 2015 and 2021 period, most of these sales occurred at the price for a reason pertaining to the specific asset itself. The softening of prices has not been widespread as there simply has not yet been the funding pressure to trigger such market movements. It is difficult to see how any asset that has limited rental growth that was purchased on a yield of under 5.25% and within the time bracket mentioned above will not encounter some type of difficulty in the coming 24 months. For private investors and families that either borrowed conservatively and/or can provide additional equity required due to softer valuations this will not be a major problem. For those that purchased the same type of assets with different capital structures, return requirements and share/unit holder commitments, it may not be as smooth sailing.