Soaring construction costs, plunging borrowing capacity and a growing divergence in listed and unlisted valuations means the pain from this cycle is yet to fully play out.
With property forming a key plank in wealth creation strategies, the recent market fluctuations are driving deep concerns across the investment industry. The rising cost of debt and supply chain issues have led to construction costs rising, corporate collapses and valuations coming under pressure.
The Reserve Bank of Australia began its inevitable tightening cycle a little less than a year ago. In that time, the cash rate has risen by 3.5 percentage points, the cost of borrowing has increased sharply – and, importantly, the supply of liquidity to the property sector has dried up.
Listed property prices on the ASX moved quickly last year. At its worst, the Australian listed property index fell nearly a third and remains about 25 per cent below its peak in 2021. While listed markets adjust quickly to the changing environment, residential prices are slower to move and have fallen 8 per cent across the country over the year.
To compound the pricing issues, the Australian construction industry has suffered a wave of company failures. Fixed price contracts combined with rapidly rising costs have had many companies running at negative margins, draining their cash. The fallout could significantly delay the completion of projects and create uncertainty about the start of new ones.
While the cost of housing construction has risen by about 30 per cent, the capacity of investors to borrow is estimated to have fallen by 25 per cent. As the current pipeline of construction finishes, new projects will be difficult to fund.
Although supply might be constrained, the demand for housing is expected to grow because of strong net migration and a reasonably resilient employment market. This supply shortage is likely to lead to continuing upward pressure on rents. Last week, Queensland rushed through legislation to prevent landlords from lifting rents more than once a year.
In contrast to the instantaneous reaction of listed property markets, private companies tend towards mark-to-model valuations, pricing future earning streams off steady long-term discount rates. Since the start of last year, a significant divergence has emerged between the prices of property implied in the listed market share prices and those of private company (unlisted) valuations.
This divergence will be resolved one way or another.
During the global financial crisis, private real estate funds limited withdrawals as asset values plummeted. Managers used the redemption gates to buy time to sell down assets in a more orderly fashion. Given the disparity that has opened this year between public and private valuations, many funds are already gated, given a rush of redemption notices.
The standoff between major institutional buyers and sellers has resulted in a lack of transactions, making it challenging to gauge the true price of properties, especially for CBD office towers.
The discounts being applied to listed market assets imply capitalisation rates (the income generated by the property over its value) for office assets of 7.3 per cent, compared with just 4.9 per cent based on the direct valuations. In a recent example, a super fund withdrew the sale of a $460 million tower in Melbourne’s Docklands after bids came in around 15 per cent below expectations, and market observers estimate the current bid-ask spread for some prime office towers is 10-20 per cent.
The office sector looks likely to remain the most challenging one as working from home, a slowing economy and asset devaluations all play a role in undermining it. Industrial and logistics exposures are likely to be favoured, given historically high rent growth and record-low vacancy rates. Retail is expected to moderate after a relatively strong 2022.
Debtholders are also feeling the pinch. The high-profile losses of the big construction companies appear to be falling on the banks, and the revaluations of large-scale debt lending are likely to show up in super fund returns at some stage. But the real pain may be felt in the niche private credit funds, small syndicates and family offices. Some may be taking possession of holes in the ground with very little prospect of delivering a completed project.
Investing in property requires a significant amount of due diligence and expertise – but the cycle can be cruel. The longer inflation persists, and bond yields remain elevated, the pressure on private sector capitalisation rates will continue. And while time heals most wounds, many in the property market will be hoping they can hang on long enough for underlying prices to recover. But hope is never a great strategy.