By Jason Huljich

Investors haven’t had it easy since the global financial crisis – and real estate has been no different.

A number of both listed and unlisted property trusts undertook highly dilutive equity raisings, collapsed or were frozen as a result of the crisis, leaving investors scarred and wary. Financial markets generally have taken their time to normalise, as volatility became the norm. And to top it off, investment managers have struggled to achieve real diversification in their portfolios as previously uncorrelated asset classes have moved in lockstep, and correlated assets moved apart.

Aggressive quantitative easing (QE) by central banks injected liquidity into global economies as governments attempted to prevent a downward spiral of economic contraction and to stimulate investment and employment. Originally conceived as an ‘emergency measure’, QE has continued for much longer than initially thought, and while it may have succeeded in halting downward momentum after the GFC, whether it has succeeded in reviving real growth is less certain. What it has done is keep interest rates at historic lows - increasing prices for financial assets generally, and punishing savers as bond yields stayed suppressed and investors faced lower real returns and higher volatility than ever before.

The good news for property investors is that against the backdrop of low rates, global volatility and sluggish growth, commercial real estate has been one of the big winners. Falling bond rates and volatile equity markets have driven investors into the stable yields and possibility of upside capital growth of commercial real estate, and in the case of the Sydney office market, offshore money looking for a safe haven has played its part in keeping demand buoyant and prices robust.

So what does the future hold?

Interest rates in the US have now been lifted, and there’s more to come

On 14th December this year, the US Federal Reserve announced a 0.25% interest rate increase, taking official rates from 0.5%-0.75% and calling the move a ‘vote of confidence in the US economy’. In addition, three further rate hikes were predicted for 2017, up from previous expectations of a maximum of two. There was no explicit comment on the US Presidential election, but there is widespread expectation that if Mr Trump follows through on his promise of massive tax cuts and huge infrastructure investment, this could well be catalyst for a more sustained economic recovery in the US, putting further upward pressure on rates.

If rates go up here, will commercial property markets in Australia suffer?

The short answer is probably not. If we look back at what happened in 2013 when the US Federal Reserve Chairman, Ben Bernanke, made the first direct suggestion that the Fed might pull back on its bond-buying program, what resulted was the so-called ‘taper tantrum’. US Treasury yields rose by over 100 basis points in four months which would normally have a negative effect on commercial property markets, but in fact, the effect was negligible. The same was true here.

There is certainly strong long-term relationships between long-term interest rates and real estate capitalisation rates, but there are other, more specific market-based factors at play, not the least of which is supply and demand. High institutional demand, for example, in the face of limited supply plays a very significant role, even in a rising interest rate environment, and this is what we have seen to some extent supporting commercial real estate in the major markets of Australia as well.

Commercial property faces some global headwinds – but they may be to our advantage

Global economic and political uncertainty does present challenges for commercial property managers – because it can mean lower growth generally. And, in fact, the IMF downgraded global growth twice last year, never a positive sign. On the other hand, the impact of global uncertainty can be positive for markets such as Australia, as foreign flows move into markets which are largely viewed as safe haven options.

And as returns from other investment assets struggle, funds which have not been in real estate before are starting to invest. For example, at the end of 2015, after posting huge losses, Japan’s Government Pension Investment Fund announced a move into real estate for the first time – to the tune of US$65 billion. There’s no question that this massive wall of money will provide a boost to some of the larger, or ‘gateway’ real estate cities globally, as it seeks a home in quality commercial real estate. Markets in the US will no doubt be the big winners, but Australia may profit as well.

Sydney and Melbourne could be on the receiving end of significant flows

Our expectation, not surprisingly, is that the most significant flows (both from onshore and offshore) will move into the strongest markets – Sydney and Melbourne.

In Sydney, demand across the board for commercial property has been strong, and as supply has been constrained due to withdrawal of stock for residential conversion, fundamentals have improved. Centuria’s property at 10 Spring Street in the Sydney CBD is a case in point. The property was purchased for $91.6 million three years ago, rented at that time for an average of $620 per sqm. The space is now attracting rents in the order of $1050 per sqm, due to the withdrawal of similar stock and was recently valued at $164 million.

Looking forward, if rates do rise more quickly than anticipated, cap rates could become squeezed, but in our view they are starting to stabilise after a number of years of decreasing significantly.

Commercial property ticks plenty of investment boxes

The bottom line is that the right commercial property investment can tick plenty of boxes. Residential properties are lucky to be making a return of between 2.5-3%, so without some serious capital gains, returns are looking pretty low. This is partly because residential property owners are responsible for outgoings, including council rates, water rates, repairs and maintenance.

By comparison, in commercial property, tenants are responsible for the majority of all outgoings. As a result, yields from quality commercial property can be in the order of 6-8% and when combined with capital growth, total returns are much higher, often 12-13%, or more. For example, Centuria unlisted property trusts over the past 18 years have offered investors, on average, total returns of 13.2%.

Needless to say, a higher return doesn’t come without some risk, and in commercial property, one of the biggest risks is vacancy. But that’s where it’s important to look at the track record of the property manager you are investing with – how well they have managed vacancy across their portfolio in the past, and how competent they are at maximising both rents, and capital gain.

But if these factors are covered, and despite some global economic malaise and the prospect of rising rates, the right commercial property will continue to perform strongly in 2017.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.