Savills Weekly Cut: Volume 2

It’s been a busy week with Australian economic data highlighting a still benign economy, supporting low for longer interest rate settings. Globally, similar conditions exist, also supporting central banks willingness to keep rates low for an extended period. Global financial markets remained orderly through the week, albeit were sold off. China will come back from their New Year celebratory week on Monday and we could see some market correction. The contagion of the coronavirus will also temper global GDP growth and in particular it could impact Australia given China is our number one export destination. 

Market economists have suggested the virus could have a negative impact on Australia’s GDP or 0.1-0.2% over the next 2 quarters. This coupled with the negative economic impact of the bushfires of circa -0.2 to -0.5%, could actually push 1H/2020 GDP into negative territory, prompting some doomsayers to shout recession. We don’t think such a data print correctly encapsulates the economy, as the economic benefits from the bushfire rebuild and fantastic generosity of donors will have positive impacts later in 2020…so a lag effect will be evident.

What does this mean for real estate? We expect further cap rate compression to occur in 2020, supported by historically low funding costs and prudent access to capital from providers (banks, institutions and non-traditional providers as well as international providers and investors), businesses maintaining to marginally growing to support lease space demand. 

We continue to prefer: 

-Office, in particular Sydney and Melbourne with fringe markets such as North Sydney and Parramatta continuing to play catch up. Melbourne’s fringe markets of Cremorne, Southbank and Boroondara (Hawthorn, Hawthorn East and Camberwell) will also play catch-up up to their CBD cousin. As with Sydney’s South Sydney precinct (South of the CBD to Green Square), Boroondara is emerging as a viable fringe market with developers and tenants seeking locations. The difficulty will be the lot accumulation to obtain economies of scale, but this will support price and compress cap rates. Perth is proving to be stabilising and at the right price deals will be done - see Chevron Perth transaction below. Brisbane could remain problematic if vacancies increase due to supply, however quality and price will always win out.

-Industrial thematic remains driven by electronic economy and logistics requirements. Australia’s population density to the capital cities continues to support firm prices, although the national economy is perhaps not supporting demand push for higher than average rent growth. 

-Retail will continue to be difficult, although we prefer exposure to non-discretionary (large exposure to supermarkets and daily living requirements) spending over discretionary (large weighting to fashion, consumer goods and the like). We are seeing transactions occur, again proving that there is always a price.

This week’s eye catchers and comments

Aussie CPI up +0.7% in 4Q19 and +1.8%yoy to Dec 2019

Aussie CPI beat market expectations of +0.6%, but still remains below the RBA target range of 2-3%. Core CPI rose 0.4% qoq and +1.6% yoy, highlighting underlying inflation is still benign in the economy. The ABS noted that the “most significant price rises … were tobacco (+8.4%), domestic holidays, travel and accommodation (+7.3%), automotive fuel (+4.4%) and fruit (+6.8%)” and “the most significant falls were international holidays, travel and accommodation (-2.9%) and women's garments (-2.5%)”. Drought did affect prices for food increasing +1.3% driven by pork, dairy and fruit products. Annual inflation remains benign despite record low interest rates, again highlighting monetary policy is no longer working to boost economic turnover and supply.

Debt and Equity Funding continues to support Cap Rate Compression and Highlights Retails Potential Mispricing

The Centuria capital raising this week (more detail below) highlights the ability to positively fund from a debt and equity perspective, highlights our underlying thematic that real estate cap rates can continue to compress in 2020, especially from an Office and Industrial asset class perspective. Both asset classes are supported by positive yield dynamics as well as underlying annual rental escalations of between 3%-4% (above the 5yr all-in cost of debt yield of 2.50%). The potential arbitrage that could emerge is Office Fringe markets, where the rising tide will lift all boats as we have seen with North Sydney and Parramatta markets playing catch-up to Sydney CBD. Retail is a tougher asset class, however with the right mix exposed to non-discretionary spending, we can see investors discriminate pricing and cap rates also compress from a current circa 6.3% (see below).

Another example of cheap funding was Dexus’ announcement Wednesday that it raised AUD$500m 12yr debt finance via a medium term note (MTN) facility at 1.7% over the swap rate (I estimate the margin over swap in the below curve has the 12yr at +1.75% margin) with a coupon of 3$. According to the AFR report circa 60% of the MTN investors were from outside Australia, highlighting the demand for income, and also supporting our view that passive income assets such as Office (in particular) by extension have more compression potential in 2020/21.

So should the RBA cut rates further?

Recent data perhaps gives further weight by some for another rate cut by the RBA, however I disagree, arguing that rates are now no longer working and any cut from 0.75% is meaningless; if the economy can’t kick start at 0.75%, why would it at 0.50%? If rates were closer to the US levels of 1.5%-1.75%, then yes the RBA should ease. But they aren’t, they are effectively at zero plus borrowing margins, that are circa double current monetary policy settings.

Fiscal Policy loosening is required to kick start an economy weighed down by policy inaction and tight tax policy. Employment (full time) growth is required to address the high underemployment rate of 8.3% and boost economic activity. The interesting aspect to the employment numbers is that part time is growing, exacerbating the underemployment rate, and the participation rate is also growing, soaking up jobs, keeping the overall unemployment rate somewhat constant above 5% (5.1% Dec 2019). Consumer confidence and hence retail sales by association remains weak.

The only true winner from the 2019 interest rate cuts has been the housing market, where price growth has become again abnormal. For me, this unintended consequence will be a concern to the RBA and APRA, fearing another asset price blowout and the potential for looser lending requirements for the banks to write business.

US Fed and the BOE keep rates on hold

As expected the US Fed kept rates on hold at 1.5%-1.75%, reiterating that economic growth was growing at a “moderate rate” with a strong labour market. They noted that while “household spending has been rising at a moderate pace, business fixed investment and exports remain weak”. The Fed believes “keeping rates steady will support sustained expansion of economic activity, strong labour market conditions, and inflation returning to the Committee’s symmetric 2 percent objective”. A response by Fed Chair Powell on his thoughts of the coronavirus impact was interesting, with him acknowledging that the epidemic in China introduces “uncertainty” into the outlook for global growth.

The Bank of England kept rates on hold at 0.75%, citing a general improvement in business sentiment since the general election, however did downgrade the outlook for the economy as the UK BREXITs today and it transitions. Growth is forecast at 1.1% over the next 3 years with inflation in check. 

Centuria Capital raising

Centuria came to the equity market to raise $80m (upsized from $60m indicating strong demand from investors) to part fund its AUD$174m acquisition of NZ listed property group Augusta Capital. CNI is raising equity at a discount to last ($2.41) of 2.9%, an earnings yield of 5.3% ($0.125/$2.34) and a distribution yield of 4.1% ($0.097/$2.34). The current Aussie cost of debt curve suggests a 5yr all in cost would be circa 2.50%, highlighting debt being an advantageous tool for asset creation (albeit I am not recommending 100% debt funding is prudent, thus congratulating Centuria on their structuring and ability to tap equity markets appropriately).

Invesco buys 50% of Perth’s $800m Chevron building

Invesco buys 50% of Perth’s One The Esplanade developed by Brookfield and anchored by Chevron (42,000sq m on 15yr lease). The premium grade office is 57,000sq m over 29 levels and Savills believes it has traded at a yield of circa 5.25% or $15,000/sq m with a 5yr rent guarantee from Brookfield for unrented space.

Mirvac unveils Darling Harbour AUD$1bn redevelopment

Mirvac plans to transform the shopping centre into mixed use incorporating office, luxury apartments (Lendlease and Crown across the bay will inspire where they were getting circa $60,000-$70,000/sq m pre-Christmas) and retail…this whole project will walk out the door. This is part of a major revamp of Pyrmont/Darling Harbour that includes “The Ribbon project by Grocon, backed by Chinese company ¬Greaton, and the International Convention Centre, the centrepiece of the $3.4bn redevelopment of Darling Harbour undertaken by a Lendlease consortium.” While across from “Darling Harbour, plans for a $2bn office tower over Cockle Bay Wharf, led by the owners of the Darling Park complex, were approved last year. The government is considering a metro station in the area.” 

NAB Business Survey sees confidence down

The NAB monthly business confidence index fell 1pt in Dec, with confidence down 2pts to -2 index points, the lowest since 2013. Forward orders remain weak and capacity utilisation is below average. 

NSW Ratings tool for developers, builders and certifiers

The AFR is reporting that the NSW Building Commissioner is developing a ratings tool to measure developers, builders and certifiers “on their record of building failures, finances, complaints, insurance claims and other such factors”. This is on the back of recent building failures in Homebush and Mascot, as well as others. The NSW Building Commissioner David Chandler noted that “in a construction industry where he estimated 20% of players account for 80% of the problems, the tool will flag the riskier projects in advance and allow regulators to keep an eye on them as they progress, rather than reacting after problems arise.”

Coronavirus update

The WHO has declared the coronavirus a public health emergency of international concern. This is only the 6th time the WHO has declared an international emergency. The disease has killed 170 people (contained to China only at this point) with Chinese authorities citing 7,818 cases and it spreading to 18 counties now. 

It is reported a cruise ship off the Italian coast has been put into lock down, quarantining ~7,000 passengers, on a suspected coronavirus case. 

Outside the square

Lego has collaborated with NASA to produce a 864-piece International Space Station set. The 20cm high, 31cm long and 49cm wide set includes a scale space shuttle with 3 mini-cargo spacecraft and 2 astronauts. You can even rotate the solar panels. No mention of a Darth Vader or his son Luke Skywalker.

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