Commercial property sectors face vastly different challenges moving forward

While the office sector was heavily affected by COVID-19, other sectors, particularly logistics, have benefitted.

Office

Unsurprisingly, vacancy in Australia’s CBD office markets rose throughout 2020. As at January 2021, the Australian CBD vacancy rate had risen 3.1% year-on-year to 11.1%. Sydney and Melbourne saw their year-on-year vacancy more than double to 8.6% and 8.2% respectively. Brisbane was more subdued, increasing 0.9% to 13.6%.

Despite short-term challenges and much media speculation, the office is here to stay. While landlords supported tenant-customers through the government-mandated Code of Conduct, these measures have now mostly ceased.

A preference for high-quality, technology-enabled and wellness-focused buildings will be of increasing appeal to most potential occupiers. As such, building owners must continue to overhaul workplace design and configurations, strengthen health and safety protocols, adopt smart building technology as well as generally enhance the overall tenant-customer experience. These trends were relevant pre-COVID-19, but have been accelerated over the past year.

A defining theme in 2021 may lie in these value-add opportunities. According to JLL estimates, as much as 40% of existing office stock needs some form of upkeep and investment in order to stay relevant. Consequently, investor appetite for value-add investments is likely to increase.

Although organisations have generally now returned to the office, many have adopted a hybrid model, in which employees split their time between working in the office and working remotely.

A survey conducted by CBRE across Asia Pacific found that more than 70% of managers would prefer to have office-based staff. This infers a disconnect between organisations and their employees, however, the rapid urbanisation and infrastructure improvements across CBD fringe locations have resulted in the emergence of decentralised business hubs which might be able to bridge this gap.

JLL’s ‘Future of the Office’ survey found a hub-and-spoke model might be a suitable compromise between remote working and a lengthy commute to the office. Across Asia Pacific, 31% of companies are contemplating adopting this model, with a further 30% of respondents stating the pandemic has made it less important to maintain large headquarters in CBD locations.

Retail

The shift to e-commerce has accelerated changes in shopping behaviour, pushing retailers to reconsider their sales and distribution strategies and landlords towards experiential offerings, particularly for shopping centres or malls.

Given consumers can buy almost anything, anywhere, shopping centres and the brick-and-mortar stores within them must therefore shift focus to incorporate experiential offerings, rather than the simple, traditional procedure of purchasing things.

Retail success now depends on a sound omni-channel strategy, whereby retailers use their store networks for customer acquisition, brand experience, online order fulfilment, returns and data gathering.

An unforeseen but positive outcome experienced throughout COVID-19 has been the boom to certain discretionary sectors. Hardware, home appliances, electronics and household goods have boomed, first as Australians began working from home, and then as lockdowns lifted, home improvement and hobby goods moved to the fore.

The extent of this was evidenced by JB Hi-Fi reporting a HY21 net profit after tax of $317.7 million, an 86.2% increase on HY20, with online sales up 161.7%, representing 13.7% of total sales for the half. Similarly, Super Retail Group, which owns BCF, Rebel and Supercheap Auto, reported net profit after tax up 201% to $172.8 million, with online sales up 87.3%, representing 13.3% of total first half sales.

Separately and unsurprisingly, non-discretionary retail has so far performed as strongly as anticipated throughout the pandemic, with properties substantially weighted towards grocery and other ‘essentials’ always in demand.

Logistics

The logistics sector has largely benefitted from the challenges facing the retail sector, both prior to and as a result of COVID-19. The pandemic has accelerated many of the longer-term trends that have facilitated record levels of investment into the sector, such as increased internet penetration rates and the aforementioned omni-channel retailing.

Supply chain resilience will come under scrutiny as companies defend against disruption. Efficiency and evolution will drive the future of logistics assets, particularly through automation and multi-storey facilities. Logistics capital growth is shaping up to be considerably stronger than rental growth in 2021, with yields compressing further in what is a popular and increasingly overcrowded sector.

Summary

The road to recovery will have its challenges. Investors must work hard to find good investment opportunities, particularly on the back of trends that have been accelerated by COVID-19. These include assets with value-add potential in the office sector and logistics assets that will continue to benefit from a sharp uptick in e-commerce

Investment overview

Investment volumes have been rising steadily since the last market trough in 2009, when just €6.9 billion worth of logistics transacted across Europe. In 2017, a peak year that was boosted by some large deals, trading volumes hit €40.4 billion. Interest in the sector has continued at very robust levels over the last couple of years, with €35.8 billion transacting in 2019 with the UK, France, Germany and the Netherlands consistently amongst the most active markets in Europe, also recording some of the highest penetration of online retailing.

There is, of course, the much talked about slowdown to the European economy hitting markets hard, although there has been a much swifter reaction by Central Banks than was seen during the GFC which, it is hoped, will go some way to supporting the weakening economic situation. But there are still a lot of unknowns: the main factors being the length of lockdowns, the impact of the gradual lifting of measures being seen across a number of European countries, the possible resurgence of the virus and when and how much consumer demand will be impacted, with the acceptance that a proportion will be permanently lost.

While the market drivers are there, real estate fundamentals underpinning the sector are healthy, capital is waiting on the sidelines to deploy when appropriate opportunities present themselves, the full-year 2020 trading volumes are expected to be subdued. While Q1 numbers are looking relatively healthy with €7.6 billion changing hands and above the long-term quarterly average of €6.2 billion. Activity levels are largely reflecting the conclusion of deals already in the pipeline pre-COVID-19 and a truer picture is likely to emerge as Q2 progresses. Indications thus far are for a much slower quarter as less product is openly marketed – stymied, for now at least, by the inability to view potential assets, conduct technical due diligence and the gap between buyer and seller expectations on pricing.

Once a new pricing benchmark has been established, capital is likely to react quickly, but during times of uncertainty, investors will favour core assets in strong locations. These will include assets close to infrastructure hubs as carbon emission regulations bear down and are now higher up the agenda and/or gateway cities, which service the growing demand for last-mile logistics. In addition, the wall of global capital headed to Europe is expected to ease, at least temporarily, providing a buying window for domestic institutions and cross-border European capital familiar with their local markets to take a larger share.

What next for occupiers?

COVID-19 has been a shock on both the supply and demand sides. One of the interesting questions this throws up is what occupiers are doing with their supply chains. Historically, companies have minimised supply chain inventories, keeping them flowing at low, but continuous levels, so they can remain competitive.

An additional consideration if there are ongoing shortages to disruptions in global supply chains is a potential shift to re-shoring or near sourcing, as companies bring their supply chains closer to home. This could translate into demand for more warehouse space near ports and airports, and rising demand for distribution hubs along the supply chain.

In summary, COVID-19 is expected to result in higher inventory volumes and a reassessment of business continuity plans, which will create stronger demand for warehouse space. Whatever the outcome of the COVID-19 pandemic, and despite current economic demand side pressures which has suppressed economic activity, when the risk subsides, the expectation is for a rebound in activity.

Firstly, the quote. Originating from Donald Horne’s 1964 book, ‘The Lucky Country’, the entire phrase states, ‘Australia is a lucky country run mainly by second rate people who share its luck. It lives on other people’s ideas, and although its ordinary people are adaptable, most of its leaders (in all fields) so lack curiosity about the events that surround them, that they are often taken by surprise.’

Horne’s quote has long been twisted to fit a specific context. A similar argument can be made that this is also the case for Australia’s economic growth as measured by its GDP numbers.

How economic growth is measured

Economic growth is typically measured in terms of gross domestic product (GDP), a measure of the value of all goods and services produced in a given country, across a given timeframe.

The equation to calculate GDP is private consumption + gross investment + government investment + government spending + (exports – imports). Each component is explained below.

A recession refers to two consecutive quarters of negative GDP growth.

Is GDP per capita a better measure?

GDP per capita is a measure of a country’s economic output that accounts for its number of people. It simply divides the country’s GDP by its total population. Growth in GDP per capita demonstrates how much economic growth is exceeding population growth, which can be used as an indication of improvement, or decline, of living standards.

Australia recorded relatively strong growth in annual GDP per capita between 1992 and 2017, but did not outperform other OECD countries to the same extent as overall GDP. This underscores the importance of population growth, and the sometimes-controversial role of immigration in particular, in accounting for the resilience of Australia’s economy since the 1991 recession.

Effectively, where GDP is the ‘lucky country’ part of Donald Horne’s quote, GDP per capita paints a more nuanced picture.

What is build-to-rent?

Build-to-rent refers to a residential development in which all of the units are retained by an owner or developer and leased out, as opposed to being sold off to multiple owners as per the traditional build-to-sell model. The developer owns and manages the units as long-term income generating assets, typically benefitting from economies of scale when it comes to maintenance, repairs and other general upkeep.

As Australia continues to urbanise and inner-city land values increase, owning a house can suddenly become a more distant dream for many. Confronted with this reality, there is a new generation prepared to rent for longer in order to continue to access the lifestyle, location and amenity-rich environment that they are attracted to, and that build-to-rent can provide.

A new asset class for investors

For institutional investors, build-to-rent provides diversification from traditional asset classes by providing a secure revenue stream with a new and growing customer base. Institutions deploy capital into the build-to-rent sector overseas in order to diversify their portfolios and achieve a low-risk, stable, long-term income return for their investors.

Growth in the sector will be underscored by build-to-rent helping address Australia’s housing supply deficit as the population continues to grow. Unlike other commercial assets, which are generally comprised of a small number of long-term leases, build-to-rent developments are comprised of hundreds of diversely structured rental agreements that turn over on a rolling basis.

The appeal of the sector is based in long-term returns similar to aged care and hotels, which compare favourably with both equity market and commercial returns, along with providing lower volatility. As demonstrated across the US build-to-rent sector, during an economic downturn, rents are more resilient, decline less and improve more rapidly than other commercial sectors.

Where build-to-rent differs from traditional rental accommodation

Similar to commercial assets, profit from a build-to-rent development is derived through rental income. High tenant turnover and long vacancy periods are therefore detrimental to income, and as a result, build-to-rent developments incorporate elements designed to attract and retain tenants.

An (im)practical example

Matthew Cridland, a tax lawyer and Partner at K&L Gates provided an example of how build-to-rent taxes would rack up in New South Wales.

Firstly, duty applies at a premium of 7% for vacant land purchases above $3 million. If the party acquiring the land is foreign, an 8% ‘Surcharge Purchaser Duty’ also applies, lifting the total duty to 15%.

An MIT is considered a ‘foreign person’ if an overseas company holds a 20% or more interest. On a $20 million vacant residential development site, total duty costs – including premium rate and surcharges – would be $2,940,490, or 14.5%

NSW also imposes a land tax surcharge of 2% on residential land owned by a foreign person, wherein no thresholds apply. Australian-based, foreign-owned developers are exempt from these surcharges, but only if they are developing new homes or residential lots for sale. The exemptions do not apply to foreign institutional investment in new residential developments which will be held for lease – regardless of the economic benefits such projects may provide.

Beyond the aforementioned surcharges, the existing land tax rules also work against institutional investment. In NSW, a premium land tax of 2% is applied to a site with an unimproved land value above $4,231,000. As such, for build-to-rent projects, it is reasonable to anticipate the 2% tax will be applicable.

For an unimproved $20 million development site, land tax would be $372,104. Surcharges would likely increase this by $400,000 to $772,104. However, unlike duty, this is an annual expense that varies as land values fluctuate.

By this point in the example, it should come as no surprise that GST also works against the build-to-rent sector. For a build-to-rent project involving total costs of $110 million, no credit is available for the $10 million of GST. However, an identical project, differing only through the intention to sell rather than lease upon completion, would allow the developer to claim a $10 million credit and have a net cost of $100 million.

These surcharges and taxes may vary on a state level, but the impact they have, in addition to the 30% withholding tax rate, means the sector faces substantial headwinds.

Success in the US

Over a third of the US population lives in private rental accommodation, and of this, 36%, or approximately 10% of the total US population live in multi-unit rental communities. As such, the build-to-rent, or as it is known locally, ‘multi-family’ sector is large, well established and liquid.

According to the National Multi-family Housing Council, the sector is worth a total of US$3.3 trillion, with the majority of this capital provided by banks, life insurance companies, commercial mortgage-backed securities or government-backed lending programmes.

The sector also has a significant economic impact. In 2016, the most recent year comprehensive figures are available, multi-family apartment construction generated over US$150 billion in economic activity, as well as over 750,000 jobs.

Hotel service classifications

Hotels are categorised in numerous different ways, including star ratings, size of hotel and number of rooms, location, ownership and affiliation, and also the type of hotel which is aligned to its offering.

The most common types of hotel markets include business, airport, resort or leisure, casino, convention and conference hotels.

Hotel dynamics

The hotel asset class possesses a number of key differences when compared to some other real estate sectors.

Owner or operator

All hotels require an operator, but whilst the operator and underlying investor (or owner) can be one and the same, particularly for boutique hotels, this is not necessarily always the case.

Many larger branded or chain hotels tend to have a mix of several ownership types including direct ownership, management contracts or franchise arrangements. For example, just because the name says Hilton, does not mean the Hilton Company owns the property.

Hotel rooms are perishable goods

A hotel room, like an airline seat, is a perishable good. That is, once a specific date occurs, every room not booked for that night perishes. Similar to airline seats, there is no market for yesterday’s rooms.

This presents a challenge as every hotel obviously wants as many rooms as possible booked each night, albeit the temptation is often to discount the room. Ongoing discounting, however, can damage a hotel’s brand and lead to other challenges.

Pricing fluctuates greatly

Hotel prices are put through a rigorous prediction process. Pricing rooms is not as simple as knowing when peak and off-peak seasons are. Rather, the hotel looks at the past year’s demand and compares it to larger trends correlating with the wider hotel industry. These include the economy of the country in which the hotel is situated, competitors’ prices for similar rooms, and even weather patterns.

A hotel will also look at its booking history. In doing so, the hotel seeks to identify the ‘booking curve’ in order to understand the optimal number of rooms that should be booked at certain intervals in advance (generally one, two and/or three months).

The overarching goal for every hotel is to ensure the most rooms are booked per night, at the highest price possible. As such, during stretches of lower demand or if actual bookings are lower than projected, room prices can be decreased to incentivise last-minute booking. On the other hand, prices are generally raised when demand is high.

Booking platforms are important

Online booking platforms have become an important tool to ensure the greatest possible number of rooms are occupied on a nightly basis, particularly when demand is low during off-peak times.

Third party agency sites such as Booking.com act as an intermediary between guests wanting to make a reservation and a hotel. These platforms also have a broader reach compared to a hotel’s own website, so while they can direct additional bookings to a hotel, they also charge for the privilege. This, in turn, eats into the hotel’s profit – hence why hotels usually advertise that the best rate is obtained by booking direct.

Loyalty programmes

Almost every major hotel chain has a loyalty programme to encourage travellers to stay with their chain wherever they travel across the globe. Similar to airline loyalty schemes, their hotel counterparts offer varying levels of membership and rewards for staying with a particular chain, or group of hotels.

Key growth drivers and future trends

Mixed-use: Work, stay, play

Mixed-use buildings, combining hotel, residential, office and/or retail space in a single building or precinct have gained increased traction in recent years. Mixed-use buildings increase diversification for investors and allow them to blend their offerings to meet the increasing demands of their guests.

Millennials moving in

Demographics are a major consideration for all hotel investors and operators. In Australia, millennials on average spend the most on accommodation per night. This gives rise to an emerging challenge, particularly given the growing rise of Airbnb amongst this demographic. Hotels must create a point of difference to ensure they continue to attract customers in the face of this popularity.

Rise of the global middle class

The rise of the global middle class also shows no signs of slowing, increasing from 1.8 billion people in 2009, to a forecast 3.2 billion in 2020 and 4.9 billion in 2030. The bulk of this growth comes from Asia, which will represent two-thirds of the global middle-class population by 2030. As a result of this rapid rise, the sheer number of people looking to travel, and stay at a hotel, is growing quickly.

The experience economy

Consumers are also placing less emphasis on acquiring material goods, and more on seeking out experiences. This is particularly evident in the global luxury travel market, which is forecast to reach US$1.1 trillion by 2025, representing a compound growth rate of 4.3% between 2017 and 2025.

This growth is driving demand for hotel stays and investors are looking to capitalise. In 2018, the US saw luxury hotel transactions rise by 76% year-on-year. In Europe, investors are looking to deploy capital to meet this demand in key destination cities such as Paris, Rome and Florence.

Investor diversification

Investors are also seeking alternative options to the traditional real estate sectors of office, industrial and retail to diversify their returns. As pressure mounts to deploy capital, the positive longer-term dynamics continue to heighten the appeal of hotel assets. Across the five years to 2018, 70% of hotel investments were made by investors looking to diversify, rather than those seeking hotel-specific funds.

Hotels, like any other asset class, have positives and negatives as an investment option. However, there is a lot to like about the sector, including its ability to diversify investor portfolios and sustained medium-term growth in demand off the back of the experience economy, tourism boom and continued rise of the global middle class.

However, in 2016, the International Monetary Fund called the Chinese economy the world’s largest when adjusted for purchasing power parity (which allows you to compare how much your money can buy in relative terms).

Perhaps a more telling statistic is that per capita disposable income is US$39,513 in the US and just US$2,993 in China. This more aptly illustrates just how far China has yet to go to give its citizens a similar quality of life.

The next two largest economies are Japan (US$4.9 trillion) and Germany (US$4.6 trillion). It’s India (US$2.6 trillion), however, which has now passed France and, given Brexit, probably also the UK, which is increasing the fastest. Brazil, despite its very recent economic woes, surpassed Italy in GDP rankings to take the number eight spot overall. Canada rounds out the top ten.

Australia’s GDP was US$1.32 trillion or 1.67% of the global economy, which just about puts it on par with Spain. While punching above Spain and most others in terms of GDP per capita, Australia remains a relatively small economy in global terms.

The infographic below shows the composition of the US$80 trillion global economy in 2017, the most recent year in which comprehensive figures were available. In nominal terms, the US still has the largest Gross Domestic Product (GDP) at US$19.4 trillion, making up 24.4% of the world economy, nearly 60% larger than China at US$12.2 trillion.

However, in 2016, the International Monetary Fund called the Chinese economy the world’s largest when adjusted for purchasing power parity (which allows you to compare how much your money can buy in relative terms).

Perhaps a more telling statistic is that per capita disposable income is US$39,513 in the US and just US$2,993 in China. This more aptly illustrates just how far China has yet to go to give its citizens a similar quality of life.

The next two largest economies are Japan (US$4.9 trillion) and Germany (US$4.6 trillion). It’s India (US$2.6 trillion), however, which has now passed France and, given Brexit, probably also the UK, which is increasing the fastest. Brazil, despite its very recent economic woes, surpassed Italy in GDP rankings to take the number eight spot overall. Canada rounds out the top ten.

Australia’s GDP was US$1.32 trillion or 1.67% of the global economy, which just about puts it on par with Spain. While punching above Spain and most others in terms of GDP per capita, Australia remains a relatively small economy in global terms.

Why diversify?

Australia has often been called the lucky country, given its more than 25-year run without recession. Luck, however, is not a strategy, nor is it sufficient to build a business, execute a strategy or pay distributions. Luck can run out and, diversification, whether or not it’s for personal investing or growing a business, is important.

Diversification doesn’t mean turning your back on what you know or are familiar with (Australia), but it does mean prudently assessing opportunities which can diversify investment portfolios or business income streams both by sector and by geography.

The European real estate market, for example, comprises approximately 350 million sqm of office stock, over 14 times more than the Australian equivalent. The market comprises more than 34 different individual office markets, each with more than 2 million sqm of office space.

To put it in perspective, that’s 34 different markets the size of Brisbane or Canberra that you can choose to invest in. All of these locations will have different local market dynamics, are at different points in the real estate cycle and are in differently performing countries, some of which, like Poland, currently have better prospects than Australia. Diversification matters.

Catchment refers to the sphere of influence from which a retail location – for example, a shopping centre – is likely to draw its customers. The general concept of a retail catchment area comprises three major considerations – supply factors, demand factors and consumer interactions.

On the supply side, there is the strength of the offering in terms of a centre’s quality, age, size, location and tenant mix. Alternatively, demand factors include location, population and demographic makeup of the catchment area. The supply and demand factors, in turn, dictate consumer interactions. A centre with a better offering will draw consumers from greater distances than centres with few points of difference to its competitors.

There are, however, a number of other important catchment-related considerations. Firstly, the position of a retail centre within the hierarchy of other local retail centres. This is determined by the format and size of the centre, population density of its catchment, the competitive intensity, and how well its proposition fits the needs of the consumer base.

For example, a high-end boutique centre with luxury fashion retailers would more than likely fare poorly in a low socio-economic area.

Generally, a catchment with a large population will have a greater retail offering, to the extent it acts as an employment hub and economic driver, thereby attracting customers from a wider area. A smaller, or remote catchment, will more than likely serve a different function, be more embedded in local economies and be patronised more frequently by local communities.

In Australia, the Property Council of Australia sets out classifications for shopping centres, which are closely aligned to the concept of ‘catchment’. This is shown below.

The importance of catchment cannot be overlooked. It is vital shopping centre investors and managers understand their catchment area in terms of socioeconomic status, size and demographics, and are able to tailor their offering accordingly.

Global economic outlook

World gross domestic product (GDP) growth slowed over the last year, but there are some signs that momentum is turning. Central banks have relaxed monetary policy since the start of 2019, Chinese authorities have intervened to support domestic growth momentum, the tariff wars may prove less destabilising than originally thought, and expansionary fiscal policy has been implemented across many key Asian markets.

Global growth is projected to be around 2.9% p.a. on average over the next five years, although Australia’s trading partners’ economies are forecast to grow at 3.8% over the same period. Long-term GDP growth, however, will be structurally weaker than in the past due to slower population growth and more limited improvements in productivity.

Australia’s economic outlook

GDP growth remains weak, at 1.4% for the 12 months to 30 June 2019. The key factor remains subdued household consumption. Although lower interest rates and income tax cuts are generally supportive, the Australian consumer seems to have their hands firmly in their pockets.

Residential building has turned down sharply and is likely to be a large drag on growth until late- 2020. Conditions remain conducive to a pick-up in business investment, as monetary conditions are accommodative and utilisation rates are high, but deteriorating confidence and some remaining uncertainty around the global outlook is causing firms to take pause.

Mining investment will trough soon, however, and the absence of any drag will support growth. Underlying export demand continues to be strong and will contribute around 2.1% of GDP growth for FY19 and FY20 before stronger growth of around 3% thereafter.

Employment growth also remains healthy, but price pressures are weak and wage growth is only slowly trending higher. The RBA lowered the cash rate by 25 basis points in June, July and October and is likely to pause now with the cash rate at a record-low 0.75%.

Office markets

Australia’s major office markets are at different stages of the office cycle. CBD vacancy rates range from 3.3% in Melbourne to 18.4% in Perth. Sydney and Melbourne have the tightest leasing markets and offer strong rental growth prospects over the next five years. They also offer the best five-year investment returns, albeit the ten-year returns are much lower.

For the other major capital city markets, the converse is true. Ten-year returns eclipse five-year returns, reflecting stronger leasing conditions further out in the cycle. In Brisbane, Perth and Adelaide, we are past the trough in the cycle, but recovery in demand will be slow and it will take time for vacancies to fall.

In Brisbane, new supply could delay the recovery. In Canberra, the A-grade market is tight and returns will be solid over the medium to longer-term, but the market remains strongly driven by the requirements of government.

Industrial market overview

Australia’s eastern seaboard industrial property markets continue to experience strong occupier and investor demand. Construction of new space is struggling to keep pace with demand, leading to declining vacancy rates and, particularly in already built-up areas, putting upwards pressure on rents.

Meanwhile, the sector has delivered strong capital gains over the past five years. Most of that has been the result of firming yields, with rental growth only recently joining the equation. The resulting investment returns were amongst the strongest of all property investment classes in Australia over the past 12 to 18 months.

Retail sector outlook

The retail property market in Australia continues to face difficult conditions. The pace of retail turnover growth is weak from a long-term historic perspective. Data indicates 2.4% year-on-year growth, reflecting the volatility of the sector. The pattern of soft turnover growth is consistent with soft wages growth and weak consumer sentiment.

In the investment market, activity has slowed and, with more sellers than buyers, yields have started to soften for all centre types bar regional centres.

There are numerous examples of properties being sold for below book value or last valuation. We are likely to see further softening of non-core centre yields as investors increasingly question an asset’s income growth prospects.

The outlook for property returns

Investment returns from commercial property across Australia over the next five years will be well below those achieved over the past five years. The strength of recent returns was, for the most part, the result of falling bond rates driving firming yields, often completely out of lock-step with leasing fundamentals. The weight of money chasing investment property fuelled the fall.

Across most capital cities and sectors, yields have continued to firm over the year. Indeed, with bond rates reaching new lows, we have pushed back the expected timing of a turnaround (rise) in bond rates and associated yield softening, although the medium-term direction is unlikely to change.

Near term, yields could continue to firm modestly. There is still a significant differential between yields on offer for Australian property and those in Asian city markets, and both local and international investor demand for Australian property remains strong.

Moreover, most property markets that experienced oversupply following the end of the mining investment boom are now in a recovery stage of the cycle.

Industrial yields appear to offer the greatest scope for near-term firming. By contrast, retail yields (other than for regional centres) are showing signs of softening in response to risks around centre income returns.

As such, we expect office yields in Sydney and Melbourne to soften only once rentals start to decline in about five years. In the smaller city markets, where yields have firmed despite weak leasing conditions, there is a greater risk of yields softening in line with bond rate movements.

Many investors, institutional and private, will struggle to meet current hurdle rates of return on a five-year investment horizon. Lease expiry profile and vacancy risk will be critical, as will be value-add development opportunities. Investors may need to consider either a shorter, or alternatively a longer-term, time horizon for investments to stack up.