The Financial Review, 21 February, 2008.

Prices will fall across the board
Property observed
Robert Harley

Commercial property yields will rise. Which means that prices - of most office towers, strata suites, retail properties and factories - will fall.

I made the call in a column last year. Within days one leading agent told me how wrong I was. The collapse in UK prices would not happen here, he said. To prove the point, he had just sold an industrial investment on a record low yield and a record high price.

Well I am not right yet, but I am less wrong. The global credit crunch has bitten. Sadly it will keep biting until the bears are proved correct.

Australian Public Trustees chief executive Darren Olney-Fraser is a buyer. He already has a $170 million portfolio and is looking for more. At the end of last year, he was poised to buy four of the Investa assets but pulled the deal.

“The world changed when the Centro problems emerged, that was the primary evidence in Australia that everything had shifted,” he says.

“We are having quite a few new assets put to us off-market at more attractive yields.

“Yields are spreading again, where we are seeing shorter-term leases back out to even 9 per cent and good quality property at 7 per cent rather than 6 per cent. Better buying for us.”

The logic is quite simple. As interest rates rise, yields must also shift out, unless income can rise fast enough to rebalance the equation. At the same time, buyers will become more cautious and some sellers, pressed by their banks, will become keener.

To date, the published evidence belies the theory.

The CFS Retail Property Trust increased the value of its $7.1 billion portfolio of Australian shopping centres, tightening the yield by 0.13 percentage points. The Macquarie Office Trust also increased the value of its Australian office towers in the December half, cutting the yield by 0.3 percentage points.

But those properties are some of the nation’s best. They will be the last to take a hit, if ever. Remember that valuation lags the market, particularly when sentiment turns and turnover stops.

Macquarie Office Trust chief executive Adrian Taylor told investors yesterday to “expect some reversal of cap rate compression on poor quality, poorly located, lease-challenged and value-add offerings” in the US. But he stressed that “some trophy asset sales are still proceeding at strong pricing”.

That two-tier theory is the current market mantra. Just as poorer quality debt was the most mispriced, so it will be with property.

“Six months ago you could sell a prime piece of industrial real estate, with a long-term lease to a top 200 company on the same yield as a secondary shed in a poor location and with no covenant. Not any more, today it is a two-tier market,” says Goodman Group’s Australian chief executive, David nav Aanholt.

Similarly the most overpriced retail properties were not the mega malls bought with equity, but the smaller secondary shopping centres leveraged up with debt and packaged to retail investors who will soon have to face declining payouts.

It’s a good theory for those who hold prime property. But there are several caveats.

“Most properties are not super-prime.” Says Tim Green of Tim Green Commercial. “Yields are blowing out as investors anticipate further interest rate rises.”

Secondly, the property trust’ fall is a warning to all property holders.

“Listed property trusts are predictive. An LPT sell-off implies direct property [prices] will fall,” says Perpetual’s head of property securities, Sean Murray. For 35 years, whenever Mercer’s unlisted property index reached annual returns of 20 per cent – as it did in December – “it’s always followed by a sharp correction”.

Thirdly BIS Shrapnel director Frank Gelber believes yields will soften across the board by a half to one percentage point – and not just for secondary property.

“Secondary property is where yields will blow out the worst, but some will have to sell good property to limit their losses, so good property will be affected,” he says.