Rental growth to continue to underpin commercial property

Strong rental growth will help mitigate the impact of rising interest rates on commercial property according to a new report.

Knight Frank’s 2023 Outlook Report predicted that if bond yields settle at 3.5 per cent over the next 12 months and the current rate of rental growth is maintained, there should be 50 basis point yield shift in the prime Sydney and Melbourne CBD office markets and a 100 basis point rise in prime industrial markets. 

Knight Frank Australia Chief Economist Ben Burston said that while not immune from global economic and market pressures, underlying demand for Australian real estate remains high from international investors.

“This will help to mitigate against downside risks in the near term and underpin a resurgence in demand once conditions settle, especially when set against the backdrop of Australian dollar depreciation which will bolster demand from US and Singaporean investors,” Mr Burston said.

“The strength of rental growth is acting to offset these macro headwinds – across both the industrial and office markets. 

Mr Burston said rental growth across industrial and office markets is helping to drive the market.

“In industrial, surging rental growth is providing a powerful counterpoint to outward yield shift, and to date has been sufficient to offset the yield shift and allow values to continue to grow,” he said.

“In office markets, a return to rental growth has helped to support values, particularly for prime assets in major CBDs.”

According to Mr Burston, the offsetting influence of rental performance is a reminder that the outlook for income growth is a key determinant of property value alongside the prevailing yield. 

“With higher risk-free rates on offer to investors, required returns and hence target IRRs will rise, but this will have a divergent impact on yields depending on the income growth outlook, with markets and assets perceived to have strong income growth prospects much less exposed to outward yield shift,” he said.

“The past decade has delivered significant yield compression, allowing for high investment returns even in the absence of strong rental growth. 

“In the current climate, however, the growth equation has become more urgent, and Knight Frank expects a renewed focus on income growth to guide investor strategy and asset selection during 2023 – including through interest in emerging asset classes such as life sciences and healthcare.”

James Patterson, CEO of Knight Frank Australia, said next year the search for income growth will lead to new product types, such as multi-level logistics facilities in infill locations and the next generation of new office towers, providing ultimate flexibility and heightened tenant experience and engagement. 

“It will also drive demand for emerging sectors such as life sciences and the wider healthcare space, where demographic and behavioural trends point to the need for more investable stock,” Mr Patterson said.

“For the life sciences sector to flourish in Australia, we require better quality infrastructure that will enable the sector to leverage the strong underlying research foundation we have in our universities. 

“We anticipate that the current macro headwinds are likely to generate further interest in alternative sectors linked to a strong underlying growth story, and we expect to see a sustained depth of both venture and institutional capital targeting the life sciences sector throughout 2023. 

“It will also cast a spotlight on lease structures, and the ability to ratchet up rents relatively quickly in line with higher inflation. 

“This is a key thematic underpinning the rise of build-to-rent which is keenly sought by investors seeking to diversify.”

Mr Patterson said the industrial sector is currently facing a dramatic undersupply of stock. 

“Much of the ‘available’ space is still under construction with very limited existing stock available and as a result, lease deals are increasingly being negotiated six-18 months in advance for existing space,” he said.

Knight Frank predicts that the focus in industrial will shift from rapid upscaling to strategic optimisation of the distribution network, encompassing cost, location, design, operational and environmental considerations to maximise returns from significant investments in property and technology. 

Mr Burston said the industrial sector remains the one to watch, with the market expecting a record year for development completions in 2023, led by Brisbane and Melbourne. 

“While this will be welcomed by tenants, it is still likely to be insufficient to restore a more normal balance between supply and demand, particularly in Sydney, with an equilibrium unlikely to be restored until a larger quantum of developable land comes online in 2024-25.

“We are likely to see major players continue to vacate older buildings and focus on more efficient facilities which are designed for automated warehouse systems and can maintain higher sustainability ratings.

“Efficiency of the warehouse, stock control and transport costs will all come under greater focus as cost-cutting returns to the fore to sustain margins in a tougher economic environment.”

According to Mr Burston, there will also be a rise of multi-level industrial in Australia, which has taken off overseas but is yet to do so in Australia due to planning regulations and the high cost of construction. 

“But with the industrial market suffering from severe supply shortages and rents rising rapidly, the economics for the introduction of multi-level are compelling, particularly in South Sydney,” he said.

“We expect that the multi-level industrial assets will largely be an adjunct to primary facilities for the larger logistics players and their high-turnover, last mile warehouse facilities.”

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Rowan Crosby

Rowan Crosby is a senior journalist at Elite Agent specialising in finance and real estate.