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THE RISING COST OF CREDIT & ITS IMPACT ON COMMERCIAL REAL ESTATE PRICES
As the ready supply of cheap credit begins to draw to a close with the dawn of a rising interest rate environment, the nation’s economists are worried about a commercial property bubble which could result in a 1990s-esque bust. In layman’s terms, commercial rents have not kept up with property prices.Yield compression
The increased price-rent differential has resulted in an incredible yield compression. Average commercial property yields have fallen from 7.3% in 2009 to 5.25% as of 21 March 2018. This yield compression has boosted returns by roughly 4.2% per annum, with values around 40% above their 2009 low.
Source: JLL, AMP Capital
Since the peak of the Global Financial Crisis (GFC), the RBA has engaged in highly expansionary monetary policy. Interest rates have been progressively cut from 7.25% to a record low of 1.5%, where they have remained for nearly a year.
Cheaper credit has consequently flowed into capital expenditure and property investment, with commercial property attracting a higher yield differential to bond yields when compared to residential property. After the GFC, commercial yields were hovering at around a 2% premium to the average of share market dividend yield, real bond yield and housing yield, resulting in increased investment into the asset class.
Source: REIA, Bloomberg, AMP Capital
A rise in interest rates, likely
Economists are wary that contractionary monetary policy is likely to increase capitalisation rates and lower property valuations over time, ultimately leading, again, to a buyer’s market. The US Federal Reserve has continued to raise short-term interest rates and indicated that the pace of rate rises could become more aggressive.
The Federal Open Market Committee’s (FOMC’s) meeting held in May revealed that “Participants generally agreed with the assessment that continuing to raise the target range for the federal funds rate gradually would likely be appropriate if the economy evolves about as expected.”
When the US raises its interest rates, Australia often follows suit to prevent capital outflow and remain competitive by minimising the interest rate differential between the two nations. The RBA currently sees Australia’s neutral cash rate level at 3.5%, some 200 basis points higher than where it sits today. If rates gradually rise to this neutral level over time, the cost of credit could more than double, putting increased pressure on mortgage repayments and consequently, downwards pressure on commercial property valuation.
Borrowing costs may increase, even if the official cash rate remains steady
Recent developments from Australian financial markets indicate that the cost of credit may increase without the RBA’s engagement of contractionary monetary policy. Credit Suisse believes there is a “material risk” that mortgage rates will increase due to the increased cost of interbank lending. “If the RBA does not cut rates, we could see out of cycle rate hikes from the major banks,” said Damien Boey, a research analyst at Credit Suisse.
High leverage in the economy will exaggerate the impact of the rising cost of credit. Leverage magnifies both gains and losses. Therefore, an increased cost of credit will compress asset values through nationwide decreased debt serviceability and elevated default rates. Cheap credit has resulted in a record level of household debt ratios.
Household debt has hit record highs
Record household debt has led to record mortgage stress despite the low cost of credit. Over 956,000 households are in mortgage stress as of April 5, 2018, up from 924,500 in March. This is approximately 30% of households, while 21,000 of these households are in severe stress. Flat wages growth is adding to debt burdens. Although the consequence of mortgage stress is residential real estate asset value compression, there is a direct flow on to commercial real estate as fewer households purchase investment properties and are more cautious.
(Source: Macro Business)
The risk of a 1990s-esque bust is exacerbated by a decreased number of foreign real estate approvals, with foreign investment into Australia notorious for driving up commercial property prices post-GFC.
The impact of decreased foreign investment
With a decreased dependence on foreign investment, the impact of Australia’s domestic consumer credit costs becomes more significant. Tighter domestic and overseas regulations have resulted in a two-thirds reduction in residential real estate approvals in 2016/17. Further decrease in foreign investment would have an enormous detrimental impact on both residential and commercial property values. Chinese investors continue to outlay $1 in every $4 spent by foreigners in residential and commercial property despite Chinese investment halving in the last year.
A classic case of history repeating itself
George Santayana once said, “Those who cannot remember the past are condemned to repeat it.” And this still rings true today.
During the 1980s, there were multiple residential property bubbles, a commercial property bubble, and a stock market bubble and collapse.
Housing prices rose 39% from 1987 to 1989 on the back of the commercial property bubble, resulting in a bust in the 1990s, the worst financial collapse in Australia since the 1890s property bust. Between 1887 and 1891, housing prices increased by 32% and then collapsed by 31% over the following five years.
Throughout history, despite Australia’s unique current economic circumstances (most notably, high foreign investment and low cost of credit), economic booms and busts have been caused by two innately human emotions: greed and fear. To insulate against the economic cycle, investors should use minimal leverage despite the enticing abundance of low-cost credit to avoid the euphoric mania of a boom and spectacular collapse of a bust.
Australia has avoided recession for the past 27 years but a global rising interest rate environment, spearheaded by the US Federal Reserve, coupled with incredibly high household debt ratios and mortgage stress levels, could mean that history is doomed to repeat itself.