Is the Investment Outlook for Commercial Property Improving?

Commercial property, once challenged by rising interest rates and structural shifts like remote work, is showing early signs of recovery. Improving demand, constrained supply, and stabilising valuations are driving renewed investor interest.

A Turning Point for Commercial Property Investors

With many traditional asset classes being challenged by stretched valuations and lower income generation, investors have increasingly turned towards the Alternatives asset class. Within the Alternatives universe, investors have been drawn towards private equity and private credit over commercial property. This is primarily due to commercial property facing a variety of pressures in recent years, both cyclical (notably higher interest rates) and structural (e.g. the impact of higher working from home on the office sector).

Returns have started to recover in the listed Real Estate Investment Trust (REIT) sector, as lower interest rates have driven a stabilisation in asset valuations and the cost of capital. Corporate activity has also returned to the sector, which should provide a floor for equity valuations. Income seeking investors have perhaps benefited less during this recovery though, given a large portion of the improvement of the listed REITs has been generated by the low yielding developer/fund managers Goodman Group and Charter Hall.

Beyond listed REITs, which can be subject to significant market volatility, income seeking investors can access commercial property through a wide variety of unlisted investment vehicles, ranging from diversified managed funds to single asset syndicates. Whilst typically less volatile, these vehicles can be highly illiquid, so investors need to exercise caution and be wary of disproportionate risk.

Improving Fundamentals Support Sector Recovery

Signs of a recovery are now emerging for the commercial property sector. The sector will always be hostage to the macro outlook, and in particular market sentiment around interest rates, but improving demand and supply fundamentals is driving greater investor interest. In terms of demand, retail occupancy has recovered to pre-pandemic levels, while industrial vacancy remains low by historical standards, given positive structural drivers such as the growth of e-commerce. Rents have also started to improve in the office sector as the right-sizing of tenancies post COVID has eased. This has allowed ongoing population and employment growth to return as the pre-eminent drivers of demand for space.

Whilst demand indicators are improving, the strongest driver of an improving outlook for commercial property is the lack of growth in supply. Higher construction costs now mean that market rents are well below effective rents (i.e. the rent required to incentivise new developments). In the office sector, average per annum completions over the next three years in Sydney and Melbourne are expected to be 54% and 57% of the last ten-year averages respectively. Speculative supply growth in the industrial sector has shrunk, with the timing of many planned developments being pushed out as developers seek to de-risk higher costs through greater pre-leasing. Planning restrictions remain a key barrier to growing supply in both the industrial and retail sectors.