Who wins – and who loses – in the current real estate environment of high inflation and rising rates?

Unless you have been living under a rock you will be aware that Australia is experiencing a period of rapidly rising prices. The latest ABS data recorded annual inflation of 6.9% in October, down from September but still amongst the highest rates for over three decades. Inflation will exceed the Reserve Bank of Australia’s (RBA’s) target rate of 2-3% for at least another year, according to forecaster Oxford Economics.

This implies that the base rate, which is the interest rate the RBA charges to other banks, will rise as the RBA looks to deter consumption and encourage saving to cool demand. The base rate is already up from 0.10% in April to 2.85% today – a prediction made early by many of Australia’s ‘Big Four’ banks.

These changes will impact most of the Australian economy, by their very design. But what does this mean for real estate? We see the greatest impact in three specific areas.

1) Occupier Flight to Quality

Higher inflation and interest rates usually throw a wet blanket over spending and investment activity. With less spending and activity, pressure mounts on business profitability and performance. The latest Australia PMI survey, a forward-looking private sector output indicator, shows that activity has steadily fallen this year and is now in contraction. Nobody wants that. A more precarious operating environment implies higher costs, lower revenues and more bankruptcies.

Figure 1 – Australia Composite PMI: Falling Activity

Counter-intuitively, these trends may lead to businesses paying more to occupy real estate – provided the value still adds up. For all occupier types, rent is usually a tiny proportion of overall operating costs . Well-specified, well-located and right-sized assets can tangibly increase sales and decrease costs, which far outweighs any rental uplift required to occupy them.

Figure 2 – Typical Cost Structure: Office, Logistics and Retail Occupiers

2) Price ‘Re-rating’ and Fewer Transactions

As interest rates go up, so do debt costs and the minimum required rate of return (or hurdle rate) for any investment decisions. In the short-term, these moves will adversely impact capitalisation rates in all real estate sectors and cause pricing to ‘re-rate’, affecting returns.

However in the longer-term, real estate fundamentals will smooth out the bumps for more sound footing – these macro movements usually lead to an acute shortfall of good quality space, a rise in GDP and positive employment growth. With low debt levels, these are the best leading occupier demand indicators.

As real estate often has index-linked rents and includes segments that are non-cyclical such as living and supermarkets, performance is believed by many investors to be resilient in times of higher inflation. As such, when inflation is high, greater demand means investors are prepared to accept a lower return to access real estate. This means that real estate yields are likely to soften over the next 12 months by far less than the corresponding rise in the RBA base rate.

Because people treat real estate as an inflationary hedge, investment in real estate during periods of inflation drives the cap rate down as money seeks physical assets and the protection they bring, with the return on investment coming down. Rent over the price you pay, gets smaller.

In the short-term a wider gap between buyer expectations, which reset quickly, and seller expectations, which do not, will lead to lower deal volumes and quieter investment markets. This will provide welcome relief to the First Home Buyer market wanting to access the market but reduces the ability for commercial real estate investors to reweight their portfolios ahead of cyclical and structural change.

3) Exacerbated Supply Crunch

Expect the development pipeline to slow to a drip. Higher debt costs and hurdle rates combined with construction cost inflation, which was up 12.5% year-on-year in Q2 according to the ABS, will erode the development pipeline as projects are put on hold or shelved completely. This will compound declining construction activity that was already occurring this year, attributable to labour and material shortages, inflation and supply chain challenges.

Figure 3 – New Private Dwellings Commenced: A Thinning Pipeline

Australia has an existing shortfall of high quality space, as shown by the gap in prime versus average vacancy rates in all sectors. This reflects the rapid fluctuations in occupier demand, a result of the technological and demographic changes over the last decade, changing the characteristics of successful real estate. Emerging segments such as urban logistics, build-to-rent residential and data centres also demand new space with new and unique needs.

Current conditions will exacerbate the lack of supply and, in the medium-term, will worsen externalities around affordability for those seeking to rent or acquire property, supporting even faster capital appreciation for home-owners and investors alike. With the financials for new construction tilting out of balance, it will increase the viability of repositioning or repurposing real estate which is ill-adapted to modern standards. This bodes well for struggling shopping centres and periphery offices, unlocking their underlying potential for alternative use.

Selective Performance and Future Affordability Challenges

The main outcomes brought on by higher inflation and interest rates are likely to:

• Stimulate faster rental growth for well-specified floorspace
• Lower transaction volumes
• Raise cap rates, and
• Erode the development pipeline which will exacerbate the supply shortfall.

Ultimately this will drive faster performance polarisation in the market towards modern, fit-for-purpose real estate at the expense of everything else. It will create even greater urgency for landlords, investors, developers and councils to deliver new space which can satisfy occupier demand and alleviate rising affordability challenges.

The rub is that real estate is a long-term game, meaning investors must always look to the future to ensure assets can meet tomorrow’s occupier needs not just today’s. Owning or creating assets that are quality, flexible and adaptable over time is the key to protecting performance throughout market cycles – both the good and the bad.