anz australian commercial property outlook...anz australian commercial property outlook commercial...

Inside:

Economic Overview................... 2

Commercial Property Overview... 3

Office Property ......................... 6

Retail Property ......................... 8

Industrial Property...................11

Tourist Accommodation ............12

Contacts.................................15

Authors:

Paul Braddick Head of Property and Financial System Research +61 3 9273 5987 [email protected]

Mr. Ange Montalti Senior Economist, Property and Financial System Research +61 3 9273 6288 [email protected]

Jasmine Robinson Senior Economist, Foreign Exchange and International Economics Research +61 3 9273 6289 [email protected]

Dr. Alex Joiner Economist, Australian Economics andInterest Rates Research/Property and Financial System Research +61 3 9273 6123 [email protected]

Stephanie Wayne Research Analyst, Property and Financial System Research +61 3 9273 4075 [email protected]

29 April 2008

ANZ Australian Commercial Property Outlook

Solid foundation to prevail

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Inside The economy still supportive While the downside risks from financial market turmoil have clearly risen, the Australian economy retains considerable momentum and is well placed to weather the global downturn. A surge in Australia’s terms of trade, continued strength in Asian economies and booming domestic incomes will provide a supportive backdrop to commercial property markets helping to offset heightened risk aversion and interest rates.

Commercial property fundamentals are sound Despite some very high profile ‘disturbances’ to key investors in Australia’s commercial property market in recent months, direct property so far remains relatively unscathed compared to the performance of some financial asset markets, particularly equities.

Poor sentiment stemming from the generalised lift in risk aversion however, will drive property market outcomes that belie fundamentals. A softening in income yields is expected over 2008 (0-25bp for prime assets and 25-100bp for secondary grade assets) but will be short-lived as current market reticence makes way for quiet confidence.

The secular decline in capitalisation rates over the decade has not been excessive and can be fully ‘explained’ by movements in benchmark returns. With real risk-free yields expected to remain low over the medium-term, there is little case for expecting any structural or sustained reversion in property yields over this period. Furthermore, with the Australian economy holding firm, property fundamentals remaining sound and depth in equity-based investment sources (superannuation and offshore), the risk of a significant collapse in commercial property values is remote. Indeed, any softening in yields over 2008 will be largely countered by continued healthy growth in rentals, supported by good affordability and a fairly measured addition to supply capacity.

There’s no comparison

Sources: ABS, PCA, IPD, ANZ Economics

0

20

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60

80

100

120

140

160

CorporateGearing

%

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

Constructionlevels

% of GDP

0

50

100

150

200

250

300

350

400

450

PropertyRisk

Premium

basis points

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5

10

15

20

25

OfficeVacancy

Rate

% of stock

-400

-300

-200

-100

0

100

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300

400

EmploymentChange

'000

‘90 to ‘92

‘08 to ’10(f)1990

2008

1990

2008

1990

2008 1992

2010(f)


Economic overview Global turmoil impacting sentiment…

Following boom conditions in recent years, domestic economic and property market sentiment has plummeted in the past 6 months in the wake of the US sub-prime meltdown. The subsequent credit crisis has been described by the IMF as “the largest financial shock since the Great Depression” and has seen investor risk aversion rise sharply. This, along with constrained funding and tightened lending criteria will clearly restrict business investment and property sales activity in 2008.

Risk aversion back with a vengeance

Source: Thomson Financial Datastream.

Indicators of investors’ appetite for risk

0

50

100

150

200

250

300

350

400

97 98 99 00 01 02 03 04 05 06 07 080

5

10

15

20

25

30

35

40

45

50Basispoints

VIX index(volatility ofS&P 500futures contracts;right scale)

Spread betweencorporate bond yield

and 10-year USbond yields(left scale)

Index

In addition, domestic borrowers have been hit with a sharp rise in interest rates as the RBA attempts to rein in increasing inflationary pressures. Many commentators foresee a marked slowdown in Australian economy in 2008 and have even drawn (misguided) parallels with the late 1980s.

…but Australia remains well placed…

But while the downside risks have clearly risen the Australian economy retains considerable momentum and is well placed to deal with the global downturn. Solid underlying fundamentals in the household and corporate sectors suggest comparisons with the 1980s are unfounded and several key factors will insulate Australia from the global turmoil.

Despite widespread concerns regarding increased household debt, household balance sheets remain well placed as household assets have expanded. Some households will, however, experience tightened cash flow in the year ahead as rising debt service costs coincide with increased food and fuel prices. Nonetheless, a tight labour market is driving solid employment gains and placing upward pressure on wages, which combined with ongoing tax cuts ($11bn in 2008-09), will support further strong growth in aggregate household incomes.

The starkest point of difference to the late 1980s is the state of corporate balance sheets. The corporate gearing ratio blew out to 170% in 1990, but has since fallen sharply to multi-decade lows below 70%, suggesting the corporate sector is very

well placed to absorb the impact of increased funding costs.

Solid property market fundamentals themselves also provide a degree of insurance as the present turmoil has hit when both residential and commercial property markets are experiencing record low vacancy rates.

…supported by solid Asian growth

Over recent decades we have become far less dependent on our traditional export markets in US and Europe and far more integrated with Asia where despite the turmoil in the developed world, economic growth continues apace.

This is evidenced most starkly in commodity markets where rampant Chinese demand has driven commodity prices sharply higher and lifted Australia’s terms of trade to record highs providing a significant boost to incomes, investment and employment.

Commodity prices continue to boom

60

65

70

75

80

85

90

95

100

105

110

115

120

125

60 65 70 75 80 85 90 95 00 05

Index

"Second leg” of boom driven by increases bulk commodity prices

Sources: ABS

Terms of trade*

*ratio of export prices to import prices

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1

2

3

4

5

6

7

01 02 03 04 05 06 07 08

ann. % change

Gross domestic income

Gross domestic product

'potential' economic growth

Economic growth

Further remarkable gains in bulk commodity prices (iron ore and coal) in 2008 will alone boost domestic income by an additional $54 billion in the year ahead or a massive 5% of GDP!

Clearly Australia is not entirely immune from the global turmoil as equity markets have weakened sharply which combined with rising interest rates has seen consumer and business sentiment collapse in recent months. After solid growth of 3.9% in 2007, real GDP is expected to slow to 2½% in 2008 as domestic demand growth moderates.

However, an 18% surge in the terms of trade will see real gross domestic income accelerate to just below 7% in 2008 and will drive a significant improvement in the current account deficit. Queensland and Western Australia will benefit most from the additional boost and we expect a further widening of the growth differential with the non-commodity states that will have less protection from weakened sentiment and increased funding costs.

Paul Braddick


Commercial property overviewCommercial property prices buoyant

We’re only getting a hint of the property market response to the effects of heightened financial market risk aversion and higher funding costs. As 2008 progresses, market reticence will gradually make way for quiet confidence. While there have been some quite visible casualties and still some cleaning up to do, in many respects it will be “business as usual” for property markets with slightly higher hurdle rates of return for stakeholders.

Commercial property values growth held up well through all of 2007. At first glance, the run-up in values in recent years might appear excessive but it comes on the heels of an extended period (around a decade) of relatively mediocre price outcomes. While the retail and industrial property sectors have been recording healthy gains since 2003, the office sector has had a recent and belated spurt in values.

There does appear to be widespread agreement among property market commentators that 2008 will be much tougher for commercial property markets with some even predicting a major collapse in values.

Commercial property prices doing OK

Source: IPD/PCA, Economics@ANZ

-2

0

2

4

6

8

10

12

14

16

97 98 99 00 01 02 03 04 05 06 07

% p.a.

Retail

Office

Industrial

Commercial property capital returns

While there certainly are headwinds the commercial property market needs to contend with, these are likely to present as tempering influences on what are sound fundamental drivers still offering good support for property markets.

That said, the power of sentiment can overwhelm and indeed trigger outcomes at odds with these fundamentals. To date, the generally unfavourable sentiment in financial markets has not spread to the property market although some have argued the sell off in LPT stocks in 2008 is a sure signal the physical market is next ‘cab off the rank’. We’re not convinced and early signs from bellwether sales in some capitals are encouraging.

While the listed sector traditionally had been a useful barometer of the performance of underlying

property assets, the evolution of the LPT sector from “rent collector” to a more highly geared, complex funds management and property development model suggests the recent sell downs have everything to do with the greater risk embodied in these entities (e.g. weaknesses in financial and management structures) and little to do with the physical property market. This does not mean property market outcomes will not be affected by the actions of these players and/or their lenders but that an important distinction needs to be made between the financial performance of the investors in this sector and the performance of the investments themselves.

Yields continued to firm to end-2007

The secular decline in income yields and capitalisation rates recorded over much of the past decade has been substantial but in many respects has merely lagged the compression in other market yields.

One key benchmark used for assessing property valuations is the 10 year bond rate. However, while intuitively many would compare the nominal bond yield to the measured property income yield, such a comparison overlooks the inbuilt escalation and market review clauses in commercial leases that do not figure in a government bond.1 To overcome this, at the very least we should deflate the nominal bond yield by inflation.2

Property yields finally respond to bonds

0

1

2

3

4

5

6

7

8

9

10

11

97 98 99 00 01 02 03 04 05 06 07 08 09

% p.a.

Retail

Office

Industrial

Real gov't bond yield('risk free' rate)

90s average (5.2%)

average since Mar. 2000 (2.8%)

Source: IPD/PCA, Economics@ANZ

Commercial property yields

Comparing movements in property yields with movements in the real 10-year bond rate (see chart) reveals that yield compression in property markets can generally be fully explained by shifts in the real risk-free rate. That the current premium between property yields and the real risk-free rate (risk premium) is sitting around its long-term

1 The coupon interest on a bond does not change over the life of the bond and when the bond matures, the initial principle sum is returned. 2 Ideally we should be deflating by average rental growth on commercial property or alternatively, we can compare the nominal bond yield to “property income yield + average rental growth”.


suggests that on investment fundamentals at least, there is no hint of overvaluation.

More importantly, to the extent that the real long term risk-free interest rate is expected to stay low, there is a compelling case against expecting any structural and sustained reversion in yields.

No hint of overvaluation

28

Source: Property Council/IPD, RBA, ABS, Economics@ANZ

-1

0

1

2

3

4

5

6

7

85 87 89 91 93 95 97 99 01 03 05 07

% p.a.

# Property 'risk premium' = cap rate less real risk free rate

* includes office, retail and industrial

Australian composite* ‘property risk premium’#

But what about the higher cost of debt?

The US sub-prime debacle and associated fallout has been a prime catalyst for financial markets to set about re-pricing all kinds of securities but more importantly, it is the availability of funding that has been more problematic for some. There have been some failures, bailouts and restructures. In stark contrast to the financial stresses of the early 1990s, these stresses have generally not arisen from the debt-servicing implications of higher funding cost but more from the inability of highly-geared operators with questionable strategies and business models to rollover debt or access finance. For others and for the bulk of Australia’s corporate sector who remain conservatively geared, debt-servicing is a second-order issue.

The recent lift in funding cost needs to be put into perspective. The nominal cost of funds (measured using 5-year swap rate) has risen from 6.94% to 7.56% in the past six months. The burden of this increase has been buffered by continued healthy growth in rentals, arguably more than fully offset in some sectors enjoying relatively tight market conditions. A sensible but still conservative way of capturing the inbuilt escalation into most commercial lease arrangements is to deflate the cost of funding by CPI. In real terms, the 5-year swap rate has moved back to below its 4-year average and remains quite low compared to its longer-term average. And while the gap between income yields and real funding costs is narrowing, it remains high by historical standards. The implication is that some market adjustment will probably occur but there is little justification for a wholesale shift.

Cost of funding has lifted a bit….

29


4

8

12

16

20

86 88 90 92 94 96 98 00 02 04 06 08

% p.a.

Australian commercial property yields and funding costs

Nominal 5 year swap rate

Commercial property cap

rate*

* Used ‘income yield’ prior to 1995

90-day bill rate

….but in real terms, it’s hardly moved

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1

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4

5

6

7

8

9

10

86 88 90 92 94 96 98 00 02 04 06 08

% p.a.


Australian commercial property yields versus real interest rate

Real 5-year swap rate

Commercial property cap

rate*

* income yield prior 1995

Will yields ‘soften’?

With valuation tools suggesting commercial property markets are not over-valued, physical demand/supply fundamentals in good shape and the economy maintaining positive growth, any negativity towards property will stem from the transfer of poorer sentiment in financial markets generally (i.e. heightened risk aversion), from a slight increase in funding costs and the impact of any ‘stressed’ sales. We believe the incidence of such sales will rise over the course of 2008 but will not be sufficient to significantly taint direct property market sentiment. The depth of investor demand including from equity-based funding sources e.g. domestic super funds and offshore institutions will offer considerable support to market outcomes, acting as an effective buffer against the market consequences of any up-tick in the incidence of stressed sales.

Our expectation is that average prime income yields will rise marginally over 2008 (0-25bp) with a relatively greater ‘softening’ in secondary grade stock (25 to 100bp along the quality curve). With rentals already growing at 5.5% over the year to December 2007 and tightness in key markets persisting over 2008, good growth in rentals can be expected over this period. As a consequence,


capital values will fall proportionally less than implied by the yield adjustment. Indeed, on an average 40bp softening in yields and estimated rental growth of 5%, capital values are likely to fall only marginally (0 to -5%) over 2008. This ‘breather’ is largely sentiment driven and belies the strong fundamentals in place.

The “blow out” in the last recession


4

8

12

16

20

88 89 90 91 92 93 94

% p.a.

Commercial property income yield

90-day bill rate

Softest (8.4%)

Tightest (6.6%)

-100 0 100 200 300 400 500

Office "A"

Office"B"

Office "C&D"

Super &Major Regn

Regional

Sub-regional

Neighborhood

Industrial

basis points

Total office +208

Total retail +30

+310

Income yield change between 1990 and 1994

Composite income yield

Supply is not a problem

Yield outcomes beyond this period will be increasingly determined by how demand and supply play out. We consider the supply-side to pose the greatest leverage over the medium-term balance in the medium-term. Despite headline data suggesting Australia has been experiencing a commercial sector construction boom, there is little justification for characterising this healthy level of activity as excessive.

As a percentage of GDP, real construction levels are still running at around half the peak level of the late 1980s/early 1990s boom. While there is a healthy level of new projects already committed and mooted, there is every likelihood that development pipelines will be curtailed as tighter funding conditions work through, particularly through the LPT sector.

No boom!

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

% p.a.

Source: ABS, Economics@ANZ

Real non-residential building as share of real GDP

Commencements

Value of work doneApprovals

In other words the upside is likely to be limited as both borrowers and lenders take a more cautious approach to development. This contrasts markedly with the lending and interest rate environment that drove the previous supply cycle to unsustainable levels and to the subsequent bust. The heightening in risk aversion among investors, focus on re-capitalising balance sheets and more difficult funding conditions should tame the development pipeline, thereby minimising the risk of chronic oversupply emerging.

Mr. Ange Montalti


Office marketsOffice fundamentals are sound CBD office markets performed strongly through 2007, with capital values rising 15% over the year and income yields firming from 7.1% to 6.5%. Rentals growth has been solid with exceptional growth in resource-related capitals being recorded. Underpinning this solid outcome has been a continued tightening in the physical demand/supply balance. CBD office vacancies have fallen to their lowest level in almost two decades from a cycle high of around 10% in 2004 to 3.2% in January 2008. The prospect of a slowing in white-collar employment over the next year or so will reduce absorption from 372,000 square metres per annum to 284,000 square metres per annum and while this will alleviate pressure in the market, the sluggish supply response, particularly in the fast-growing economies will avert a significant up-tick in the overall vacancy rate over 2008. These strong fundamentals will continue to provide a solid underpinning to sentiment, rentals and values over a period that presents challenges for the broader financial community and the more highly-geared players in the commercial property sector.

Despite very good fundamentals, we expect a mild softening in CBD office market yields over 2008, reflecting the sentiment effects of heightened risk aversion, rising funding costs and the incidence of some stressed sales weighing down on the market. Generally, prime stock which is experiencing the tightest conditions will hardly notice the softening in conditions but lower grade stock is more likely to reflect these negative influences.

Over 2008/09, there is every likelihood of a consolidation in yields as nervousness about underlying values recedes and some confidence returns. Beyond this period, fundamentals will play out differently across the capitals. There is little evidence yet that construction levels are rising to unsustainable levels. Indeed, as a percentage of GDP, office construction is way below levels that were recorded in the late 1980s/early 1990s. Committed and mooted developments point to further growth but our expectation is for the supply side to remain largely in check for the time being given the market uncertainties.

Despite the NSW economy languishing in recent years, Sydney CBD office market has performed well with capital values rising 13.4% over the year. The shortage of infill development opportunities provides a structural support to the Sydney property values, whereas economic underperformance has compounded market tightness by keeping new developments at low levels. Vacancy rates have tightened substantially and are set to fall to an effective ‘zero’ as the supply pipeline remains subdued. Medium-term fundamentals remain intact

with little likelihood of a construction boom to undermine rental and values.

Fundamentals in the Melbourne CBD office market are sound with vacancies at below average levels. A robust economic performance to date has set in train a healthy supply pipeline, a considerable part of which is earmarked for the Docklands precinct. A key risk for the Melbourne market is an overzealous development sector failing to take heed of the likely fall in absorption. We expect vacancies to lift gradually from 4.4% currently to around 9% by 2010. This should not destabilise the market but suggests rental and capital growth may be more difficult to achieve later in the cycle.

Brisbane and Perth CBD markets are both experiencing acute tightness with vacancy rates effectively at zero. Market values have correspondingly shot up with capital returns lifting by 22% in Brisbane and 41% in Perth over 2007. While the development sector is finally up and running, long lead times imply continued tightness in these markets for much of the next year with ongoing rental and capital growth expected and being supported by a strong economy and investor demand. The out-years do present some vulnerability however, with existing return prospects encouraging potential over-development. Momentum in rents and values is likely to continue for much of 2008 but will ease substantially as the weight of new supply and lease renewals at lower effective rents encourage tenant mobility. This will remove some support to capital returns next year. However, a solid medium-term outlook for these resource-driven economies does suggest the fundamental imbalances and associated market vulnerabilities will not translate into a severe contraction in values but a more moderate correction further out the cycle.

Office market to remain tight

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90 92 94 96 98 00 02 04 06 08 10 12

%

Brisbane

Melbourne

Sydney

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5

10

15

20

25

30

35

90 92 94 96 98 00 02 04 06 08 10

%

Perth

Hobart

Sources: Property Council of Australia, Economics@ANZ

CBD Office vacancy rates

Adelaide

Adelaide ‘core’ office market is in a sound position with a strong economy and solid employment growth lifting absorption levels over 2007. While we expect some slowing in economic growth this year


and in the consequent take-up of office space, the supply pipeline remains manageable and is unlikely to destabilise fundamentals. Capital values in Adelaide CBD office market rose 10.2% over the year to December 2007, a more modest performance compared to most other capitals. After softening over 2006 (against the national trend), Adelaide income yields tightened in the past year but still remain more attractive than other capitals. This should in conjunction with a relatively solid economic outlook for the South Australian economy provide some insurance to yields and to capital values over 2008 while the broader market ponders the challenges.

Mr. Ange Montalti

Resource capitals tight across the board

Source: Property Council of Australia, Office market report

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9

10

Syd Melb Bris Perth

PremiumA GradeB GradeC GradeD Grade

CBD Office vacancy rates%


Retail property Uncertainty brought on by the dislocation in global credit markets, domestic interest rate hikes and escalating food and fuel costs have dampened consumer sentiment in recent months and this has translated into lower discretionary spend. The first two months of this year saw nominal retail sales growth ease to an average rate of 6.4% in annual terms after expanding by a strong 7.3% in 2007.

Looking forward, low unemployment, solid wages growth and the expectation of tax cuts are likely to cap the downside risks to growth in retail turnover. Real household disposable income is forecast to rise a further 5% in 2008 from 6½% in 2007.

Nevertheless, retailers will be operating under tougher conditions as inflation, driven largely by non-discretionary items such as higher rents, food and fuel prices, as well as higher mortgage costs, prompt consumers to re-adjust their household budgets. In addition, equity price falls will also factor into consumer sentiment and could impact spending.

While we have seen a narrowing in the difference in nominal retail sales growth across states in recent months, we are likely to see a gap re-emerge as states exposed to the resources sector, i.e. Queensland, the Northern Territory, Western Australia and South Australia, receive an added boost to incomes.

Our forecast is for nominal retail sales growth to ease to 4-5% in 2008 and 2009 to be below the 15-year average of 5.8% with discretionary spending being hardest hit. When adjusted for inflation, retail turnover is projected to moderate to 2-2½% from 4.8% in 2007 - the slowest pace of expansion since 2005.

Retail sales forecasts and underlying macro assumptions

06 07f 08f 09f

Retail sales (nominal) 6.0 7.3 5.0 4.3

Retail sales (volume) 3.6 4.8 2.6 2.1

Real GDP growth 2.8 3.9 2.5 2.4

Employment 2.1 2.8 2.4 1.4

Wages (real) 0.4 1.2 -0.2 1.1

Wages (nominal) 4.0 4.1 4.3 4.1

CPI 3.5 2.3 3.4 2.8

Real HDI 3.3 6.6 4.2 2.9

HH consumption 2.9 4.5 3.0 2.2

Source: Economics@ANZ

Data on retail profits cover a wider range of spending (including car purchases & repair and household equipment repair services etc) than what is included in the retail sales data. Nevertheless, we use this retail profits data as a proxy for trends in the narrower definition of the retail sector. Growth in real retail

profits ticked up over the past year thanks to robust retail turnover. However, the trend in household consumption suggests that growth in real retail profits could soften over the next couple of years which, in turn, is likely to limit the pace of rental growth.

Retail profit growth likely to moderate

Sources: ABS, Economics@ANZ

-60

-40

-20

0

20

40

60

80

91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09-3

-2

-1

0

1

2

3

4

5

6

74 qtr mvg avg, % yy 4 qtr mvg avg, % yy

Retail profits – EBT (real) (lhs)

HH consumption (real) (rhs)

Adjusted forbreak in series

On the supply side, several large-scale projects are well underway and the lack of new major ones coming on stream, especially against the difficult credit market environment and prospects for slower growth in retail turnover, is likely to result in some softness in retail construction activity ahead. Nominal shop-building approvals data suggest that activity is likely to slow in coming months. This follows a sharp run-up in 2007, reflecting the expansion/refurbishment of suburban shopping centres as well as regional retail development.

Shopbuilding activity expected to soften

1500

2000

2500

3000

3500

4000

4500

5000

00 01 02 03 04 05 06 07

Real value of shopbuilding work done (4-qtr mvg totals)

Real value of shopbuildingapproved (4-qtr mvg totals)


$ mn2005-06

1500

2000

2500

3000

3500

4000

4500

5000

5500

00 01 02 03 04 05 06 07

Nominal value of shopbuilding approved (12-mth mvg totals)

$ mn

Despite some softening in turnover over the next couple of years, the fundamentals supporting retail property remain sound with tenant demand still expected to keep vacancy rates tight, particularly for prime assets. Overall, a rebalancing of supply and demand is likely to support rental growth, albeit on a reduced scale.

A breakdown by retail type has shown a steady decline in yields over recent years, underpinned by


strong investment demand for retail assets. They have now reached a point where the yield gap or relative risk across the different asset groups is minimal. What are the implications for the future? Against the headwinds facing investors, and a softer retail trade outlook, scope for further yield compression is likely to be limited. We expect some divergence in trends as capitalisation rates adjust upwards, possibly by 0-25 bps for prime assets and 25-100 bps for secondary buildings over the next 6-18 months. Positive rental growth will, however, help to minimise price declines over this period.

Retail yield compression most marked at smaller end of market

Source: Property Council, Economics@ANZ

5

6

7

8

9

10

11

12

13

96 97 98 99 00 01 02 03 04 05 06 07

% p.a.

Super and Major Regional

RegionalSub Regional

Neighbourhood

Australian Retail by Size - Yield

Retail “property risk premium”, as measured by the capitalisation rate relative to the real risk free rate (i.e. the 10-year bond rate), has held around its long-term average of close to 4%. Adjusting to the new environment of tighter liquidity and a re-pricing of risk lifts the potential for a further move back to the long-term average.

Retail risk premium hovers around benchmark

Source: Property Council, Economics@ANZ

0

1

2

3

4

5

6

7

85 87 89 91 93 95 97 99 01 03 05 07

% p.a.

* Property 'risk premium' = sector cap rate less real risk free rate

Australian retail ‘property risk premium’*

New South Wales

Limited stock in the pipeline is likely to keep yields tight in the Sydney CBD area and prime retail strips with vacancy rates expected to stay below 1.8%. For the first two months of this year, nominal retail sales averaged 6.6% in annual terms, higher than the average over the past five years of 4.8% per annum. However, retailers are likely to face softer

demand conditions as consumers tighten spending on discretionary items. The impact of the current financial environment is likely to be felt more keenly in the bulky goods segment with rents expected to consolidate after improving in recent years as a higher interest rate environment postpones a recovery in the housing market and the coming on stream of new, higher quality stock, puts downward pressure on rents for older centres.

Nominal retail sales growth across states


0

2

4

6

8

10

12

NSW VIC QLD SA WA NT TAS ACT

2003-07 (average per year)Jan-Feb 08

Annual % change

Victoria

After a strong spurt in retail construction over the past year, activity is likely to moderate in response to a softening in retail spending. Additional new supply coming into the market as major projects, such as Westfield Doncaster and Chadstone shopping centre extensions, are completed later this year will have a limited impact on retail indicators such as vacancy rates and rental growth as tenant demand is likely to remain healthy. Nevertheless, scope for stronger rental outcomes is likely to be weighed down by a slowdown in growth in retail turnover.

Queensland

Southeast Queensland saw the largest increase in retail floorspace in 2007, accounting for around 38% or 228,200 sqm of new space. Despite the additional supply, vacancy rates have fared relatively well, with only a mild uptick, thanks to strong tenant demand. Brisbane CBD yields have firmed, ranging between 5.5-6.5% for prime properties and 6.75-7.5% for secondary assets in late 2007. Retail sales growth so far this year, has kept pace with its 5-year average. Notwithstanding tighter liquidity conditions, continued strength in the resources sector, growing inner city residential living and low office vacancy rates are likely to support growth in retail turnover in Brisbane CBD although the retail sector is likely to face some softening in growth in international visitor arrivals.

South Australia

South Australia has recorded robust retail sales growth, up 9.9% in the first two months of this


Western Australia year, compared with the corresponding period in 2007. This is well above its five-year average of 4.7% per annum and it was the strongest performing state after the Northern Territory. The mining boom and recovery from the drought has lifted growth prospects for the South Australian economy and, together with a pick-up in the housing sector, will keep retail demand relatively healthy. With investor demand expected to stay strong, yields are likely to compress further. The bulky goods sector has seen rents firm with yields ranging between 7-7.5% in late 2007 from over 9% in 2002 while indicative yields for prime CBD properties have tightened to around 5%.

Growth in retail sales in WA has slipped markedly this year to be the worst-performing state. This partly reflects a high base as well as a maturing of the market. However, forward indicators suggest a pick-up in domestic activity brought on by renewed strength in the mining sector. This bodes well for the outlook for retail sales and, together with limited new supply, is expected to keep Perth CBD retail vacancy rates low. Building approvals for the twelve months to February 2008 are down slightly from the corresponding period a year earlier.

Jasmine Robinson


Industrial PropertyThe ongoing stability of the Australian economy is expected to continue to provide a positive backdrop for the industrial property sector in the coming year. This is despite ongoing pressures in the manufacturing sector due to intense import competition and the high local currency capping any significant increase export demand. As a result the additional demand for factory space has been in steady decline for some years. Conversely, the demand for warehouse space has increased dramatically. The strong $A continues to encourage imports which are still relatively high at 35% of total domestic sales. The demand for warehousing space also comes amidst significant improvement in logistical efficiency with the inventories to sales ratio hovering around a record low of just under 70%. Market reports suggest that demand has been strong across the country, sufficient to absorb the estimated 3 million square metres per annum of additional capacity in recent years.

The strength of demand has also been reflected in a consistent firming of capitalisation rates since the recession of the early 1990’s. In the past 5 years, the firming of cap rates has accelerated due to; a structural lowering of the risk free rate (real 10-year bond yields); a relatively subdued level of risk aversion; and the weight of institutional money flowing into commercial property and into industrial property in particular. However, cap rates in the industrial sector still retain a significant risk premium over other sectors of commercial property.

Supply attracted by firming cap rates

Source: ABS, Economics@ANZ

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

84 86 88 90 92 94 96 98 00 02 04 06

7.0

8.0

9.0

10.0

11.0

12.0

13.0

$bn, rolling annual sum

Industrial property cap rates, rhs(lagged 3-quarters)

Real value of approvals - warehouses etc, lhs

capitalisation rates (inverted), %

Real value of approvals - factories, lhs

Real value of building approvals & cap rates

The market has moved to meet greater demand with the real value of building approvals in the industrial property sector surging to exceed $5.0bn for the first time last year. The significant disparity in the value of approvals of the warehouse and factory sub-sectors reflects the shift in economic fundamentals from manufacturing to warehousing and logistics that has underpinned the divergent demand within the industrial sector market.

A consequence of adequate industrial property supply coming on stream is that capital returns in

the industrial sector remained consistently solid over an extended period of time. As such industrial property returns have avoided much of the cyclical behaviour experienced in the retail and office sectors over the past 10-15 years. Over the past decade both capital and rental growth has been solid, yet over the past 12-18 months aggregate rents have softened and have been patchy especially due to the availability of additional supply and competition in the pre-lease market.

However, strong demand especially in the resources states of WA, QLD and increasingly SA, combined with relative low vacancy rates should keep rents well supported, especially in the primary warehouse sector. According to IPD data, industrial property vacancy rates across the country have reached 0.8%, the lowest of all commercial property sectors. Distribution and warehousing space has been particularly scarce with vacancies at 0.4% and 0.9% respectively. As a result the total returns for warehousing and distribution space have remained stronger than other industrial sectors over the past three years.

Returns strongest in faster growth states

0 5 10 15 20

Australia

Rest of Aust.

Sydney

Melb

Brisbane

State

Unit estates

Hi-Tech

Warehouses

Distribution

Sub-sector

Income CapitalState

Sector

% growth p.a.Australian

average

Sources: IPD/PCA

Composition of total return by type of industrial propertyAverage annual return, 3-years to December 2007

Despite the threat of a slowing local economy in the coming year the industrial property sector remains vibrant in Melbourne. The Melbourne market continues to add industrial space in spades with another 1.6 million square metres completed in 2007 with the expectation of further 1½ million square metres in 2008. Growth corridors in the west of Melbourne and along the EastLink arterial have been the centres for a significant proportion of this new construction. Approvals for warehouse space in Victoria remains the highest in the country at $923mn in the year to February, but rapidly expanding approvals in QLD, at just over $903mn, look poised to pass Victoria in the next few months. NSW is also expected to add around 1.3 million square metres of industrial space, predominantly along the transport corridors through western Sydney.

Dr. Alex Joiner


Tourist AccommodationThe tourist accommodation sector continues to perform strongly, with room rates reaching record highs after several years of sluggish growth. Improved conditions reflect, in part, a slowdown in room supply in recent years after strong building activity in 1998-1999 and again in 2004-2005. Inbound travel has also picked up, generating solid demand for tourist accommodation.

Demand and supply more evenly balanced

Short-term overseasvisitor arrivals


4.0

4.2

4.4

4.6

4.8

5.0

5.2

5.4

5.6

5.8

97 98 99 00 01 02 03 04 05 06 07

mn (12-mth moving total)

55

57

59

61

63

65

67

97 98 99 00 01 02 03 04 05 06 07

% (4-qtr mvg avg)

Room occupancy rates

Growth in visitor arrivals set to slow

In 2007, total visitor arrivals rose by 2.2%, up from 0.8% in the previous year. Over the first two months of this year, performance in the inbound travel market has been mixed, having fallen in January, in annual terms, but rebounding in February. Collectively, visitor arrivals fell by 0.4% from the same period in 2007. Under the current difficult global economic environment, our forecast is for growth to slow to less than 1% this year.

The next two years are likely to see the world economy expand at a below-trend rate of growth after expanding by more than 4% per year between 2003 and 2007. Australia’s major tourist-generating markets, namely New Zealand, UK, Japan and the US, which collectively account for 50% of total visitor arrivals, could see real GDP growth halved in 2008 and the impact on discretionary household spending will become more evident over the next 12 months or so.

Economic growth outlook for traditional markets

Visitor arrivals

Real GDP growth

% share 2007 2008f 2009f

NZ 20.1 3.1 1.4 1.5

UK 12.2 3.1 1.3 1.9

Japan 10.1 2.1 0.6 0.9

US 8.2 2.2 0.7 0.8


Nevertheless, it has been encouraging to see aggressive growth in visitors coming from

developing economies such as China, India and Vietnam as well as resource-rich countries, such as Russia and the UAE. While these markets may be relatively small (apart from China which accounts for 6.4%, the rest mostly represent less than 1% of the total share). Rapid wealth accumulation in these countries offers vast opportunities to grow the market significantly over the medium term. The Chinese and Indian economies, in particular, are forecast to grow by more than 7½% per annum over the next few years, offering strong potential for overseas travel as their middle-class population expands. China is now among Australia’s top ten tourist-generating markets and India is fast gaining ground to becoming among the top ten markets for Australia. Other markets such as the UAE and Vietnam grew by a strong 39.4% and 40.7% respectively in 2007 and have continued to grow at a solid pace so far this year.

Domestic visitor nights by accommodation type

Sources: Tourism Research Australia, Economics@ANZ

0

2

4

6

8

10

12

14

16

18

20

NSW VIC QLD SA WA NT TAS ACT

year ending Dec 07

Total

Annual % change

Domestic visitor nights in hotel, motel, guest house, B&B, apt, rented house

Domestic visitor nights by accommodation type

Other(14%)

Friends’ or relatives’Property (37%)

Guest house, B&B (1%)Hotel, resort, motel,motor inn (27%)

Caravanpark,

Campingground

(11%)

Rented house, apt, flat, unit (10%)

The domestic travel market is expected to hold up relatively well given the challenge of a moderation in growth in the domestic economy. In the year ended December 2007, domestic visitor nights in hotels, motels, bed & breakfast and rented houses or apartments were up 9.2% compared with the corresponding period of the previous year.

Some winding back of business travel could be on the cards as investment intentions over the next 12 months adjust to softening demand and higher funding costs. Nevertheless, corporate travel associated with the resources sector is expected to hold firm. Relatively low unemployment and a net boost to household incomes after taking into account the expected fiscal stimulus should continue to support domestic leisure travel. This segment is also likely to benefit from more competitive air-fares and the expansion of routes serviced by domestic airlines. Nevertheless, higher mortgage costs and inflation’s impact on discretionary spending could weigh on domestic travel plans. In addition, the


relatively strong Australian dollar is expected to keep outbound travel attractive.

Trading performance expected to hold up well

On the supply side, building approvals data suggest that construction activity should pick up strongly in coming months. For the twelve months to February 2008, building approvals have climbed 33% against the corresponding period of a year earlier. This, however, follows a period of consolidation in recent years. In addition, much of the increase in approvals is attributed to activity in Victoria, which is expected to be absorbed, with the other states only recording a mild upturn.

Building activity picks up

Building approvals –accommodation sector


0

200

400

600

800

1000

1200

1400

1600

1800

2000

98 99 00 01 02 03 04 05 06 07

$mn (12-mth moving total), nominal

Approvals, by state

0

100

200

300

400

500

600

700

800

900

1000

01 02 03 04 05 06 07

$mn (12-mth moving total), nominal

SA

VIC

NSW

QLD

WA

The trading performance across most tourist accommodation segments has improved. Tightening room availability has lifted average room takings to record levels.

Tighter room availability lifts rates

55

60

65

70

75

80

85

90

95

100

89 91 93 95 97 99 01 03 05 0745

50

55

60

65

70Real $/available room, 4-qtr mvg avg

room occupancy rate(rhs)

%, 4-qtr mvg avg

average takings per available room

(lhs)

Occupancy rates vs. average takingsTotal establishments


In the hotel segment, room supply increased by just 1% in 2007, and with room occupancy rates averaging 71%, average takings per available room increased by a further 7.7% after an 8.6% rise in 2006. The serviced apartments segment also saw a similar rise in occupancy rates, averaging 69.2% in 2007 and average takings per available room breached A$100 for the first time. Despite the

growth in outbound travel, demand for motels & guesthouses, which largely cater to domestic travellers, has also improved, with average takings per available room rising by 8% in 2007 on the back of a 1.2 percentage point increase in the room occupancy rate to close to 59%.

Further improvement in trading performance


0

1

2

3

4

5

6

7

8

9

10

Room occupancy rate(% pt diff)

Avg takings peravailable room night (%

ch)

Guest arrivals (% ch)

HotelsMotels & guesthousesServiced Apartments

2007 vs 2006

Overall, the outlook for the tourist accommodation sector remains positive as demand and supply conditions are more evenly balanced. This is likely to underpin strength in occupancy levels and room rates over the coming year. Notwithstanding higher funding costs, investor interest, particularly from offshore, is expected to remain positive as buyers compete for high quality assets against favourable trading expectations. According to a report by Jones Lang LaSalle, Asian buyers accounted for 35% of total hotel transactions last year, up from just 4% in the previous year.

New South Wales

The tourist accommodation market in New South Wales is experiencing one of the strongest gains in room and occupancy rates with the outlook staying positive especially as Sydney remains a key destination. In 2007, hotel occupancy rates reached 73.9% and growth in average takings per available room, at 7.9%, was the strongest increase after Western Australia. A strong events calendar such as World Youth Day, to be held in Sydney from in July, as well as corporate demand is expected to sustain growth in revenue indicators. Construction activity will largely reflect strategic development in growth areas such as the Olympic Park precinct and greater western Sydney area, and to meet demand for top-end accommodation.

Victoria

Despite the expected surge in tourist accommodation in Victoria, it is well-positioned to absorb the increase in room supply. This is partly driven by the expected increase in visitor traffic once the 5000-seat convention centre is ready in 2009. In addition, a strong events calendar will help to keep demand firm. Developments underway include the makeover of the Rialto hotel, development of Crown Casino’s third hotel and the


construction of the Hilton hotel in the convention centre site.

Building approvals data suggest a strong pipeline of work ahead, supported in part by the improvement in trading conditions. This increase in supply is likely to be comfortably absorbed. Average takings per available hotel room have stayed above A$85 compared with A$74 in 2005 as room occupancy rates have climbed above 65%. The relatively healthy domestic economy is also likely to prompt more travel within the state, lifting prospects for regional accommodation operators.

Queensland

Growth in international visitor traffic could slow in response to the downturn in the global economy but cheap airfares, with the expansion of budget airline networks, will help to mitigate this situation. Domestic corporate travel is likely to remain firm, backed by the resources sector. While domestic leisure travel to southeast Queensland is likely to hold up well, occupancy and revenue data for the tropical North are likely to be adversely affected by the declining trend in the Japanese visitor arrivals. Hotel room occupancy levels in Queensland have held steady at 69% over the past two years with a 4.8% rise in average takings per available room in 2007.

Western Australia

Western Australia was the top performing market with average hotel takings per available room rising by a strong 17.5% in 2007 to over A$105 as occupancy levels surpassed 70%. The resources sector will continue to underpin demand for tourist accommodation. Western Australia also benefits from competitive air services to and from Asia, drawing repeat visitors from the region. Improving development fundamentals (i.e. against rising construction costs) have prompted renewed interest in building activity as reflected by the approvals data, which show an increase of 89% for the twelve months to February 2008 against the same period from a year earlier, albeit from a low base. Steady demand is expected to lift scope for a further improvement in revenue indicators.

South Australia

South Australia is likely to see strong growth in demand for tourist accommodation as it benefits from the mining boom, with the development of major resource deposits such as BHP Billiton’s Olympic Dam copper and uranium mine expansion and Oxiana’s Prominent Hill gold and copper mine project.

Jasmine Robinson


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