A year ago, just about everything looked like an investment opportunity. There was a carnival atmosphere in many world real estate markets due to an unprecedented combination of factors, including the strongest global economy since the early 1970s, low interest rates, cheap debt, a global stock market bull run and the sheer volume of liquidity.
But since August 2007, there has been a shift in some fundamentals because of the unfolding US sub-prime mortgage crisis and ensuing credit squeeze.
As a result, we expect rental growth rates across several major office markets to moderate.
Australia and Asia stand out as the non-residential markets least impacted, while the US and UK office markets have been the most affected by the credit crunch.
Clearly, despite some lessening in its influence with the rise of Asia, the US economy is still important globally.
Stock market volatility is a key risk to the global office cycle due to the flow-on effect through financial and business services. But despite current market volatility, it has typically taken a significant and sustained downturn in equity market performance in the past to flow through to a downturn in office performance.
Macquarie Research Economics believe the US will be in a slowdown rather than a sustained recession, with gross domestic product growth of between 1.5 per cent and 2 per cent in 2008.
However, the world’s largest economy is still a risk factor for office markets, partly due to the link with global financial markets.
Real estate investment trusts (REITs), similar to listed property trusts in Australia, are feeling the impact of financial market volatility in the short term, due to their link with the broader share market.
For instance, in Singapore, REIT pricing has suffered in November despite strong growth in the direct real estate markets, with rents rising solidly.
But, in Australia, Japan and the rest of Asia, the fundamentals of the direct office real estate markets should remain solid unless the US economy and financial markets experience a persistent downturn.
Show of strength from Australia
Since the credit squeeze, Australian office markets have displayed strength and business conditions are at near-record levels.
The Sydney office market continues to improve, with vacancy rates falling and rents strengthening. It is shedding its laggard tag as it plays catch-up with Brisbane and Perth. With little prime space available and limited potential for new construction, further rental growth is likely.
Brisbane and Perth have seen exceptional growth, with office rents soaring 194 per cent and 180 per cent respectively in the past three years.
Vacancy rates are the lowest in 25 years, but are likely to see increases over the next few years as new supply is completed.
The medium-term outlook will depend on just how many new buildings beyond those already started get up and running. In the next 18 months, the forecast is for subdued rental growth.
Melbourne looks affordable for corporations, with rents well below those in Brisbane and Perth for the first time.
The supply coming on stream is attracting a high degree of pre-commitment and, while limiting rental growth now and in the next 12 months, we believe there is an opportunity for further growth in that market.
More life in Japan
Japan’s office market has sprung to life in the past 18 months. Vacancies have fallen to 2.5 per cent — levels not seen since 1991 — which is translating into higher rents and land values. Office land values are up 20 per cent in Tokyo in the past year (the strongest growth of all real estate sectors in Japan).
Despite the economy showing signs of flattening in the past six months, Japan appears to be on track for sustained growth, leading to further growth in rents and values.
While office yield spreads (which represent the difference between real estate yields and long-term government bond yields) aren’t as high as residential and industrial property in Japan, they are still buoyant at 180 basis points and certainly favourable by international standards.
As a result, these markets are attracting increased attention from large institutional investors in the US, Europe and Australia.
Strong office cycle across Asia
Other parts of Asia have enjoyed an exceptional cycle. We are expecting solid growth through 2008-09 but not at the same level.
Singapore is a good example where, despite the strength of the office cycle (prime office rents have increased 286 per cent over the past three years), further growth is expected — albeit at a much more moderate pace — particularly as there is virtually no supply until 2010.
US leading indicators point to moderation
In the US, leading indicators point to more moderate conditions.
We have already seen leasing demand slow in response to the sluggish US economy and volatility in financial markets, although the impact on rents and yields isn’t uniform across the US.
Those markets with supply and high vacancies or cities where employment has been hit hard by the sub-prime fallout have been most affected.
In the UK, too, London rental growth is moderating.
Europe appears quite exposed to the credit correction, which makes for a more muted outlook.
Asia and Australia hold the most appeal
For global investors, Asia and Australia hold the most appeal, which is why we are seeing a shift in focus and funds to these areas.
Our outlook for office markets is highly dependent on the performance of global share markets.
Typically, equity markets affect office markets, although it takes a significant and sustained fall in global equity markets to have a major impact on office rents and values.
Rod Cornish is the head of property research at Macquarie Real Estate. Note: Some facts and opinions presented in this article may change on the basis of changing market conditions and actual results may vary from any forecasts provided.
