Resilient Australian property sector maintains investor support through the economic cycle

What factors are driving property market investment strategies, trends, and values today?

Factors impacting today’s property market and investment strategies can be considered under three broad headings:

• Micro-economic issues that cover matters like occupancy rates, lease expiry profile, location – such as proximity to transport infrastructure and new growth corridors, and flexible working arrangements requiring adaptive workspaces. Other issues include normal supply and demand pressures for specific property types, such as industrial, office, discretionary retail, non-discretionary retail, logistical and high rise residential.
• Macro-economic factors such as interest rates which drive capitalisation rates, inflation that drives the cost of construction and replacement costs, the business cycle that is largely driven by household consumption, employment growth that drives consumer demand and population growth through immigration that is driving urbanisation and densification and regeneration of cities are also key factors that drive property market trends and values.
• Megatrends and structural drivers including growth in e-commerce, online retailing and the digital economy requiring distribution centres to meet consumer delivery and service expectations and data centres for essential computer processing power and data security, more sustainable and energy-efficient low carbon emission properties and societal ageing requiring changing accommodation needs as Generation Alpha enter and Baby Boomers transition out are also important considerations. Generation Alpha refers to the age group born between the early 2010s and 2024 who have never been without smartphones or social media. This explains the increasing adaptation to a sharing economy and shared access over ownership that is driving the potential emergence of generational renting and the institutionalisation of traditional rental sectors.

Property valuation methodologies

The three valuation methodologies used by investors to determine the potential value of a property and the relative risk associated with a property are:

• Capitalisation rate: This is the most widely used valuation methodology. It is the rate at which the annual net income from an investment property is capitalised to determine the capital value of the real estate asset. The rate is determined with regards to comparable market transactions involving similar assets and is the simplest way to estimate the value of a property. The formula is: Asset Price = Net Operating Income divided by Capitalisation Rate. For example, a real estate asset that generates net operating income of (say) $500,000, and if the capitalisation rate is estimated at 5 percent, the asset value is $10 million.
• Discount rate: This translates the forecast future cashflow of the real estate asset into present value terms. The higher the discount rate, reflecting higher risk relative to competing uses of capital, the lower the present value of the asset. Unlike the capitalisation rate, which is based on net operating income, the discount rate is based on forecast cash flow over the holding period of the property, which is similar, but not the same as income.
• Terminal yield: This is the capitalisation rate used to convert forecast annual income into a forecast real estate asset value at the end of the holding period when carrying out a Discounted Cash Flow calculation. The rate is determined with regard to comparable market transactions and the expected risk inherent in the cash flows over the cash flow period. Conceptually, the terminal yield reflects the rate of return that a real estate investor expects to earn on the date of sale, that is, the exit date.

Property investment outlook

The long-term investment outlook for Australian property is positive, driven by capitalisation rates that are forecast to stabilise, following a sharp increase in 2023. Capitalisation rates are influenced by long term bond yields and Australian 10-year bonds peaked at 4.98 percent October 2023 and today are sitting at just below 4.1 percent. This downward trend in the 10-year bond yield is likely to support lower capitalisation rates in 2024 and beyond, gradually taking property values higher. This is especially the case if, as expected, major central banks around the world begin to ease interest rates from late 2024.

Another contributing factor to the long-term favourable Australian property market outlook is the continued growth in the size of the domestic superannuation pool of funds, arising from compulsory superannuation contributions and the consolidation and emergence of mega superfunds. This capital pool needs to be invested in low volatility assets that deliver resilient returns through the economic cycle. Cash flow and value conscious international funds are also seeking out superior quality asset-backed income producing assets in relative economic safe haven jurisdictions like Australia. This is likely to drive demand for high quality Australian real estate investments for decades to come.