Capitalising on the COVID-19 recovery

Australia’s strong economic recovery has certainly been interrupted by lockdowns across the country, but despite this short-term pain, we believe the economic momentum following the re-opening will bode well for commercial real estate and those investors able to find value from both traditional and alternative real estate sectors.

It may feel like a surprising statement with many still in lockdown and case numbers stubbornly high, but we believe the time is right for investors to be considering the construction of their for real estate portfolios, with the long-term implications of COVID-19 and the ‘new normal’ after the pandemic in mind.

As we emerge from lockdowns into a majority-vaccinated environment, we believe it is likely Australia will continue to enjoy the current, very low levels of unemployment and very high levels of economic activity, underpinned by ongoing fiscal stimulus in the form of infrastructure spending¹.

So how will this kind of strong and resilient recovery play out for real estate investors? And what is the best way to play the post-COVID economy?

To be sure, the economic drivers of real estate investing look uniquely aligned. Central banks have indicated that low interest rates will remain policy for the foreseeable future and while inflationary risks are emerging, they are likely to be a short-term effect. On a five-to-10-year timeframe, the inflation environment looks very benign with traditional inflation triggers like labour scarcity and oil shocks absent.

Meanwhile, employment at 4.9 per cent is at its lowest level since 2010²  and the Reserve Bank expects this rate to drop even further to 4.5 per cent by June 2022³.

For consumers, higher employment generally means more money for households and more discretionary spending. For businesses, it translates to more workspace to accommodate extra staff to support growth.

Continued global demand for real assets

Another factor underpinning the strong outlook for real estate is the continuing strong demand for real assets by global investors.

One of the big structural changes of the last 20 years has been the shift towards investment in the real estate sector by large superannuation funds, insurance groups and other institutional investors as well as self-managed super fund investors.

In our opinion, the push towards owning real assets is being driven by the search for higher income yield and better overall returns compared to equities and other asset classes.

While past performance is not a reliable indicator of future performance, the figures show that real estate has been strong performer over the last decade compared to equities delivering 5-7% average income returns⁴  and we believe that should continue in the 2020s.

Sources: Bloomberg, MSCI/IPD, ASX, Deloitte Access Economics (12 months to September 2020). Past performance is not a reliable indicator of future performance.

Investment demand typically returns quicker than business demand after a market downturn and we are seeing this playing out post-COVID.

We believe there remains very strong investment demand for quality office assets in particular, as demonstrated by transactions resulting in sale prices well above book values as high levels of investment capital chase a scarcity of high-quality assets.

Australian real estate has become a much more global asset class than what it was a decade or so ago, meaning domestic funds are now competing with capital from Singapore, Europe and the US.

So how will individual sectors perform?

Office

There is no doubt the office market has been bruised from pandemic lockdowns and the rise of working from home.

Coming into COVID, occupancy rates around the country averaged 90 per cent, but according to Property Council figures this has fallen to an average of 60 to 65 per cent through the peak periods of COVID and as low as zero to 5 per cent during hard lockdowns in Sydney and Melbourne. Perth has seen the highest consistent occupancy levels, averaging over 70%+ since the first lockdowns of 2020.⁵

The other positive that’s going to support the office market is a slowdown in supply.

Supply of office space tends to move in big, slow cycles and in Sydney and Melbourne, the outlook for supply increases is more muted than it has been in recent years.

Notwithstanding the working from home phenomenon that will be likely be with us for some time to come, higher employment has traditionally been a key indicator of upside in demand for office space in our opinion.

There was evidence of this at the end of 2020 as the consulting, law and finance industries started to lift their headcount. This is an indicator they are confident of their revenue projections and business growth is likely to be positive.⁶

These service firms are critical. In Sydney, more than 60 per cent of the base demand for offices comes from banks, financial services, investment banks, advisory firms, law firms and tech firms. As a group, they are expanding and increasing their headcount.

We believe this should translate into vacancy rates dropping sharply for established office markets as we enter 2022 and 2023.

As business feels more confident about profitability and the growth outlook, they are more likely to lift their spending and expand balance sheets. This can translate to higher demand for office, logistics and retail space.

Retail

In retail, one of the key attractions is the diversified income available from large shopping centre investments.

Typically, a large shopping centre will have 150-plus tenants across a range of retail categories, which helps investors manage risk through cycles.

In recent years, the rise of e-commerce has started to change consumer behaviour which is affecting the way people access big shopping centres.

But as COVID ends, as we’ve seen before the COVID pandemic, and certainly will expect to continue to see coming out of it, the shopping centres are adapting.

One big change is the rise of the shopping centre as a service provider – offering services like cinema and dining precincts.

As an example, neighbourhood centres anchored by supermarkets that provide the daily needs of their communities have been priced very aggressively and remain highly sought after because their perceived stable income.

However, this adaptation will be even more pronounced at the biggest malls and super regional centres.

We predict that one big structural change coming is likely to be build-to-rent apartment towers on top of shopping centres, providing investors with an alternative income stream and valuation source.
This could in our opinion, offer retail real estate investors considerable upside through greater portfolio diversification and relatively stable, long term stable returns.

Logistics

Moving to logistics and industrial, we believe the sector is set to be the strongest performing real estate market for the next three to five years.

There are solid reasons underpinning this – not least that there is more demand for space than there is supply.

The pandemic accelerated the uptake of online shopping, which rose from 7 per cent to 12 per cent of consumption during COVID. Over the next 10 years, we forecast this number to hit 30 per cent.⁷

More online shopping means more demand for fulfilment facilities.

Still, investors need to be picky choosing logistics assets as it is a big and diverse market and not all assets are going to deliver the best return, especially as pricing has reached new highs as investors scramble to increase their allocations.

Finding value from real estate

We believe the best value will lie in inner metropolitan and middle metropolitan markets with scarce land availability and the ability to grow rents.

Investors should also consider alternative investments like build to rent, which we expect should have a strong future in Australia. It is the largest asset sector in the US and looks likely to follow that performance here, where approximately 30 per cent of the population rents in Australia.

Data centres are another alternative real estate market that looks promising as increasing demand for mobile phones and corporate data services drives demand.

All in all, investors who are prepared to think beyond COVID now, should be positioned well to take advantage of the economic momentum we expect to see coming out of these lockdowns. Investors will also be rewarded by taking a thematic approach that rides the underlying trends driving the real estate market and aligns portfolios with long-term growth.

1.  https://budget.gov.au/2021-22/content/jobs.htm#eighteen
2. Australian Bureau of Statistics, Labour Force, June 2021: https://www.abs.gov.au/media-centre/media-releases/unemployment-rate-falls-49
3. Reserve Bank of Australia, Statement on Monetary Policy – August 2021: https://www.rba.gov.au/publications/smp/2021/aug/economic-outlook.html
4. MSCI/IPD
5. Property Council of Australia
6. https://www.afr.com/companies/professional-services/ey-posts-amazing-result-amid-tightest-job-market-in-25-years-20210802-p58f6p 
7. ABS
8. https://www.abs.gov.au/statistics/people/housing/housing-occupancy-and-costs/latest-release

 © AMP Capital Investors Limited 2021

 

Milestone Financial Services Pty Ltd

(ABN 68 100 591 508) is an Authorised Representative and Credit Representative of AMP Financial Planning AFSL 232706