Commercial property yields still strong

Commercial property returns have averaged by about 11% pa since 2010. It was seen as a recovery from the GFC slump, after which investors eventually searched for income in response to low interest rates and bond yields that pushed property values up and property yields down. Mortgage broker Chan & Naylor analyses whether or not the yields have been pushed too low and if the global interest rates that are starting to hit rock bottom will move up to reverse it.

Real assets do well in an economic downturn phase because it takes longer for easy money to flow into them. However, its valuation process results have the tendency to lag and move more with current economic conditions that drive rents.

Commercial Property

The current investment cycle seems to be maturing. However, according to AMP, each 0.25% fall in commercial property yields roughly translates to a 4.25% capital gain. With average commercial property yields dropping from 7.3% to 5.25% since 2009, there was about 4.2% p.a. of return. Note that the values today are almost 40% more than the values that were in December 2009 and it could be because of the drop in yields.

In the 1980s, the residential and commercial property rental yields were similar but now commercial property has a much higher average rental yield. Residential properties are often over-valued but commercial property is more attractive on a medium-term perspective because of its low dependence on capital growth.

The biggest risk of commercial property is if bond yields back up sharply in case inflation and global growth rise. Note that commercial property has benefited from investor flows during the bond crash in 1994 and the gradual backup in bond yields in 2007 when investors switched out of bonds into commercial property because it offered higher yields. Property was vulnerable in 1990 and 2008 when the property risk premium was less attractive and leasing deteriorated because of rising supply and falling space demand.

Sydney and Melbourne office markets have seen vacancy rates falling to about 6% and with even more drops ahead. Rents are rising strongly as well. There will be new office supply in the next decade but the market seems to be stable. Leasing conditions remain difficult in Brisbane and Perth, though, but office is expected to be most attractive while retail is expected to be the least.

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