Heightened uncertainty as commercial property returns diminish

With the Australian economy showing signs of slowing down, the three commercial property - sectors – office, retail and industrial – have weakened over the past six months, bringing with it increased uncertainty among investors.

The KPMG Commercial Property Uncertainty Index, which measures the unpredictability and potential risks associated with investing in commercial property,​ has risen for all individual sectors. 

The office sector increased 3.2 index points to 12.9 – the highest uncertainty rating since December 2009, and about triple the average value of the Office Uncertainty Index for the period June 2008 and September 2023.

Industrial property, which has been the shining light in the commercial sector for more than a year, is also feeling the heat now.

That property sector rose by 2.1 index points to 6.6, which is substantially lower than the same time in 2022. 

The retail sector recorded the smallest Uncertainty Index increase of the three commercial property sectors, up 1.1 index points to be 4.7 at the end of the quarter – slightly higher than its long-term average of 4.5.

Investment performance has weakened further over the past six months. 

The KPMG report, authored by Dr Brendan Rynne, Chief Economist and Partner, and Dr Brian Tran, Economist, found the office sector appears the most exposed to higher interest rates, with lower grade office towers most at-risk due to weaker tenant demand.

“Industrial sector investment activity remains selective, with investors being more cautious on asset purchases and reassessing yields in the context of challenging macroeconomic conditions and heightened geopolitical uncertainty,” the report authors noted.

“Retail yields have begun softening across all sub-sectors, with the greatest falls being seen in large-format retail and sub-regional centres.”

More than stamp duty tinkering needed

Reforms in Victoria that will put an end to commercial stamp duty have taken another step towards their 1 July 2024 implementation, with the Government completing its targeted consultation on the details of this reform with business and industry leaders.

But it has yet to instil a greater degree of confidence in the industrial sector. Total returns for industrial property in Victoria are now very close to zero due to the sharp fall in valuations, leading to negative growth since early 2023, KPMG noted.

“Total returns for industrial property in New South Wales, Victoria and Queensland have been trending downwards since peaking in late 2021.

“However, Sydney’s industrial market continues to attract investors, buoyed by a persistently low vacancy rate and a limited forthcoming supply.”

The switch from stamp duty towards a fixed annual tax has done little, if anything, to encourage commercial property investment.

Steve Douglas, Chairman of aussieproperty.com, said that while any reduction to the upfront cost of stamp duty is welcomed, there is great concern that it is replaced with an annual cost that can quickly spiral out of control as the base taxable value rises in coming years.

“The fact that this deferral is seen as an advantage is sad, as the greater conversation should be around the issue of bracket creep on stamp duty, where Governments continue to charge more and more due to price rises and are not trying to keep the transaction cost to a realistic level,” Mr Douglas said.

“Of even greater concern, is the fact that the new regime will not replace land tax, so property owners will be liable for both costs each year, making it even harder to be a commercial property owner or tenant.

“The Victorian Government seems determined to lift revenues from property owners regardless of the hurt and cost it may inflict upon them, and this attitude will be discouraging investment and job creation and put extra pressure on businesses already struggling with cost increases and labour pressures.”

Logistics benefiting from global risks

Industrial property returns for five and 10 years have outpaced most other segments at 15.3 per cent and 13.9 per cent, respectively.

Nils Miller, Chief Executive Officer of BC Land, on Wednesday (31 January) said industrial property was a standout of the Australian commercial real estate sector last year, but investors will need to work harder to seek-out the bright spots this year.

He identified logistics as an area of potential growth, saying it would actually benefit from global uncertainty.

“Today, global uncertainties are almost certain to ensure the asset class will continue to rank as a major source of growth in 2024,” Mr Miller said.

“Logistics businesses are seeing considerable delays, sometimes of up to six weeks to receive shipments from Europe and that, coupled with concerns of DP World (global logistics company) related strikes or industrial action, are forcing occupiers to consider taking more space or at least holding onto excess space - that might have gone into the sub-lease market - to enable greater stock levels to be held.

“Another alternative is air freight and with costs lowering and more supply back into the market (of as much as 10 per cent in the year to December 2023) means air freight is becoming an alternative for some products.

“Locally, this is translating into increased demand for logistics sites here.”

He also supported Mr Douglas’ views on Victoria’s stamp duty reforms.

“Sydney will likely outweigh Victoria, not only because of the new airport, but also because the Victorian State Budget brought in stamp duty and tax changes from 2024 that will transition from stamp duty to an annual property tax for commercial and industrial properties in the state, and this is causing concern for investors.”

Commercial property sales declining

Commercial transaction values have been on a downward slide for two years and the latest data on 2023 activity reveals the extent of the decline.

Ray White data showed that last year commercial volumes totalled close to $50 billion in transactions above $2 million, down from 2022’s $67 billion after a record breaking 2021, which amassed close to $95 billion.

Vanessa Rader, Head of Research, Ray White, said the volume levels of 2023 highlighted a change in confidence for the commercial sectors.

“Last year we saw many owners reluctant to transact and adopt a ‘wait and see’ attitude, while in 2024 we expect to see an increased need by vendors to bring their assets to market, which will impact turnover levels,” Ms Rader said.

“Encouragingly for 2024, the stagnant feel of 2023 will move and sentiment shifts, either positive or negative, will result in property decisions being made and opportunities presenting themselves, resulting in some turnover activity rebound for the year ahead.”

The office sector was struggling the most, based on the transactions.

As vacancy concerns continue across the office sector, the outlook for this year will continue to be tough for this asset class.

“Offshore interest has declined and investment yields are expected to be further pressured upwards until occupancy improves and the outlook for face rents stabilise,” Ms Rader said.

“Opportunistic buyers, however, are likely to seek out assets due to recent price declines in anticipation for the future rebound of the office sector.”

Industrial regained its number one position as the most active asset class in 2023, representing 29.4 per cent of all sales. During 2022 this sat at just 25 per cent with assets tightly held and larger office transactions dominating total volumes.

With construction activity remaining limited across the industrial sector, the mismatch in supply and demand has ensured this asset class is one of the more favourable for many investors. 

“For retail, investment remains robust, representing 21 per cent, with many larger centres changing hands, while a slowdown has occurred across the smaller end of the market, with strips, standalone and bulky good type assets all more difficult to shift.

“Until interest rates start to see some relief, this sector is expected to remain subdued.”

Perth is the capital city with the highest retail vacancy rate, at 21 per cent.

In January 2024, national retail property rent asking prices were forecast to increase by around 0.04 percent, according to the Commercial Property Asking Price Index data published Friday (26 January) by Statista Research Department.