Higher interest rates have made commercial & industrial property slightly overvalued, but they remain solid portfolio asset classes because there’s no mismatch between supply & demand, ANZ Bank’s economists said in their weekly Market focus today.
“The combination of low interest rates, strong economic growth, increasing globalisation in the property market & investor preference for bricks & mortar following carnage in the US equity market in 2002, has pushed property prices up strongly.
“Accentuating the move has been significant pent-up demand through little commercial & industrial investment from 1998.”
The economists said the residential, commercial & industrial property cycles were historically well correlated, as they’re generally influenced by the same economic influences such as interest rates, expected capital gain, yield & economic growth.
The ANZ economists said there was consensus that the residential market was 5-10% overvalued, begging the question: Are the commercial sectors similarly vulnerable to a correction?
Economic growth and the output gap
In the long run, the economists said, commercial property prices should grow in a range somewhere between the inflation rate (average 2%) & real economic growth. The inflation rate should be the long-run driver of construction costs, while land as a scarce resource was more likely to increase in value in line with the rate of real economic growth.
Commercial & industrial property prices are closely correlated with the economy’s spare capacity, so if demand in the economy exceeds supply (a positive output gap), commercial & industrial property prices tend to be on an upwards trajectory.
The ANZ economists said a simple model showed both industrial & commercial property prices were within “a hair’s breadth” of fair value. As economic prospects remained sound, the output gap should stay positive into 2005, so asset growth should continue.
Prices to rents (a p:e ratio)
Looked at this way, the economists found commercial & residential property expensive.
“Property prices have surged over the past decade across all property classes, particularly in relation to sombre rental growth. This partially reflects a period of catch-up following weak declining property prices (a lower p:e) during the late 80s & early 90s.
“But augmenting the p:e ratio for movements in real interest rates implies a p:e that has just
risen above its 15-year average.
“Property prices have taken a level shift upwards over the past decade as interest rates have moved to a structurally lower average over each economic cycle.
“Our augmented p:e ratio implies both commercial & industrial prices are mildly in the expensive zone, largely on the back of recent rises in interest rates, although the magnitude of overvaluation is within the margin of error.
“There is little evidence of a pending supply-demand mismatch.”
The economists said the ratio of non-residential investment to gdp had been broadly stable for 5 years. Typically a cyclical driver of economic prospects, the sector had shown a very muted response to strong economic conditions.
“A key reason for falling yields within the commercial & industrial sector in relation to the cost of capital is scarce supply in some market segments, which has encouraged investors to accept rentals below the cost of capital in the expectation of capital gains.”
The economists said commercial & industrial rents should continue to lag behind rising asset prices. In sharp contrast, they said a swathe of supply would enter the residential market in 2005.
“Yields in most asset classes â€“ residential, commercial & industrial – have now fallen below the cost of capital. But sound economic prospects, a rebalancing of growth & no major supply-demand mismatch imply commercial & industrial property are the relatively better bet for property investors.”
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