Commercial property prices and yields - three trends to tune into

Investors with high equity could see the current market environment as an opening. Zoltan Moricz, Executive Director of Research at CBRE, explains the opportunities arising in late 2022, and provides an investment-perspective forecast for 2023.

Commercial property yields have eased in the first half of 2022, driven by interest rate increases. Following a 10-basis point increase in market yields in Q1, CBRE has recorded a 27-basis point increase in Q2, with upward yield pressure continuing in Q3.

However, we view the downward pricing pressure as transient, likely to ease in 2023, creating opportunities for investors with lower reliance on debt. Significant equity also remains available in the market, although generally sitting on the sidelines for now as most well-capitalised groups run market due diligence and price discovery.

The lower volumes and pricing we are witnessing are primarily influenced by the reduced availability and higher cost of debt. Given this equity is still available and actively looking for opportunities, our view is that the rebound will be faster than we experienced after the GFC, when real estate occupancy conditions played a bigger role in slowing the pricing recovery. Good acquisition timing will be fundamental to securing assets at sensible pricing, and we expect that the optimal buying window could be as short as nine months.

Interest rates will still play a part in determining pricing when transaction volumes rebound. However, with the amount of equity chasing real estate, we anticipate several equity-only deals will transpire, where debt funding is brought in later once debt availability and costs normalise.

Our latest market assessment reveals three trends worth tuning into.

1. Material differences have emerged across sectors, submarkets, and regions

Yields remain resilient in parts of the retail sector. Prime shopping centres, which have been a relatively higher-yielding asset class supported by strong customer catchments and short-term rental growth potential, are the only sector to avoid increasing yields this year.

By contrast, prime office and industrial property, although well supported by occupier demand and rental growth, are proving to be more vulnerable to higher interest rates than previously expected, given the magnitude of interest rate rises relative to their low yields. Industrial rental growth has been strong in recent quarters; prime industrial rents increased by more than 10% in the first half of the year, with secondary industrial rent growth close behind at 8.8%.

Despite this strong growth, prime industrial market yields increased by 27 basis points this year.

Looking regionally, Wellington’s forecasted rental performance and availability rate should insulate owner equity from the more acute effects of inflation. New developments have achieved a significant pre-commitment level, with most occupiers moving towards higher quality space, limiting oversupply of prime market availability. Wellington’s exposure to Government occupiers also promotes core investments to Australasian investors looking for stable income returns in the current phase of the market cycle.

In Christchurch, vacancy rates across all sectors are at record lows, supporting positive rental growth and an emerging new development pipeline, particularly in the prime office sector. New supply is forecast for late 2024 and early 2025, the first of which is nearly all pre-let.

2. Investors are prioritising income growth and certainty-focused investment strategies

With investment liquidity concentrated on property sectors and submarkets that can deliver growth and certainty, they will remain more resilient from a pricing perspective, with higher discounting in sectors and assets that can’t fulfil these requirements. This is reflected in indicative market yields increasing by up to 100 basis points in secondary office submarkets, influenced by higher vacancies, low occupier demand and lack of rental growth.

3. Looking into 2023, we believe that downward pricing pressure from interest rates is transient

While inflation’s impact on property returns is influenced by its balance with GDP growth and supply-demand fundamentals, past cycles indicate a negative relationship between inflation and returns via the link between inflation and interest rates. However, the inflationary hedge nature of property is also starting to come into play, with higher construction costs and CPIbased lease and rent review mechanisms contributing to higher rents in some parts of the market.

Most forecasters see the OCR reaching 4% by late this year and remaining elevated throughout 2023. However, swap and bond rates are likely to peak in late 2022. This interest rate outlook for longer duration rates indicates only modest further upward pressure on fixed rate debt, likely to start easing during 2023, barring adverse moves for lending margins.

In this environment, liquidity may start improving from investors with lower reliance on debt who see the current market as an opening. The current supply-demand outlook generally provides a positive platform for future income growth, except for secondary CBD offices, where CBRE forecasts an extended period of vacancy and rental pressure.

Zoltan Moricz, Executive Director of Research, CBRE