Rental's short slide is over - analyst

Industrial property cycles have proven simpler to predict than CBD office trends. Photo / Bruce Clarke

Records suggest the scale of commercial property rental decline has slowed in Auckland and, "in terms of year-on-year growth as a measure of cyclical change, we have reached the trough," says Alan McMahon, Colliers International's director of research.

"If this proves to be correct, then like the last cycle, we have had a very quick downhill run as it was only three short years ago that rental growth peaked," McMahon says.

Writing in Colliers' latest National Portfolio, McMahon predicts that, weighing a number of industry factors including previous market patterns, "we must conclude that a trough-to-peak recovery period, of a longer duration than the short peak-to-trough period we have just experienced, is inevitable".

McMahon says the extended growth cycle, which ended abruptly with the onset of the global financial crisis, underlined how difficult cycle predicting is.

"If the last big peak was in 1987 and was brought to an end by the global financial crisis of its day; and the last deep trough was in 1992 with the next real peak not until 2007, we can see how wobbly the cycle has become," McMahon says.

"That's five years to the bottom of the trough, but 15 years back to the top again."

He says that in New Zealand, cycles have been harder to detect than in larger countries, partly because good research was not established here until quite recently. It took the spreading of institutional property ownership in the 1980s, which was previously confined to AMP and one or two other large property companies, to stimulate the setting up of research expertise into CBD office trends, either directly by these institutions or by the international property services firms who followed in their wake.

"However, our research suggests that industrial property cycles are somewhat more predictable than CBD office cycles. This has something to do with simplicity of construction and development of industrial property, and the fact that they are typically built to order.

"In normal times, a CBD office building might have to be 50 per cent to 60 per cent pre-leased before commencing construction. If it is a 30,000sq m tower in total, that might leave more than 10,000sq m to be leased 'on spec'.

"With numbers like that in a small market such as Auckland or Wellington, each of which have less than 400,000sq m of prime CBD office stock, the construction of a large new tower can throw the market into disarray for some years," McMahon says.

"It's not just the uncommitted 10,000sq m, it's the 20,000sq m vacated by the anchor tenant that adds to the vacant stock. One way or another, the equivalent area of the new building has to be absorbed. In a market which has periods of contraction like now when net absorption is negative, as well as periods of expansion when net absorption is positive, it can take years for this absorption to be completed."

McMahon says one of the much-vaunted attributes of property investment has been its usefulness as a hedge against inflation.

"In New Zealand however, the passing of the Reserve Bank of New Zealand Act in 1989 required the Reserve Bank to tame inflation, then running at around 7.5 per cent, which it has achieved very successfully. This was a matter of some regret among property professionals at the time as they looked on inflation as a friend of property."

Rents tended to increase at the rate of inflation and big rental increases at reviews, which were entirely due to inflation, would often hide the fact that properties were not being managed optimally. "But with the defeat of inflation, asset managers had no place left to hide," McMahon says.

"Now we find ourselves again defending property as a hedge against inflation, not because inflation has taken off again, but because rents have stagnated or declined since the onset of the global financial crisis. The fervent hope of property managers now is that rental increases in the properties they manage will match inflation, even if it is only 2 per cent per annum."

McMahon said direct property investment traditionally sat towards the higher end of the risk-return spectrum in comparison with other asset classes and typically provided higher returns than cash or bonds but with more volatility.

He said returns from direct commercial property were made up of income or rental returns, plus a return component based on change in capital value. While the capital value component had been highly volatile recently, it was worth remembering that income returns had been quite stable and over time had been very good.

The Property Council of New Zealand and Investment Property Databank (PCNZ/IPD) index, for the 15-year period from December 1994 to December 2009, showed that income return overall across all commercial properties in the database had been slightly over 9 per cent per annum.

McMahon said the general sentiment in residential property was to accept a modest initial rental return and hope for a capital value increase. But the sentiment in commercial property investments was to secure a decent income return and not rely on capital growth.

"In the interests of balance we'd have to comment that not relying on capital growth in commercial property is a sound assumption, as the same PCNZ/IPD data demonstrates a paltry 1.5 per cent per annum capital growth over the same period."

The 9 per cent income yearly return and 1.5 per cent capital return over the 15-year period for all classes of commercial property, gave a combined per annum return of 10.5 per cent "which is pretty damn good," McMahon said. "The NZX all-equities would have given you 7.6 per cent total return, and bonds would have provided an overall total return of 7 per cent per annum."

Turning to another subject which tended to impact on markets, McMahon, warned about paying too much attention to business confidence surveys.

"In our experience, confidence surveys, whether property-specific or broader economic or consumer surveys, tend to amplify or exaggerate sentiment.

"For example, both our June and September 2009 investor confidence surveys showed a significant increase in confidence from the previous quarter. Now the overall level of optimism has drifted back down and this sentiment was reflected in other surveys carried out around the same period."

In retrospect what respondents were saying was more like "thank goodness it's not going to be as bad as we feared" rather than "things will be better next year".

McMahon said that "stable readings" over the period September 2009 to March 2010 showed a cautious attitude. The euphoria of avoiding an economic depression had been replaced by a more thoughtful assessment by investors of the year ahead.