Watching Commercial Property

The potential for financial strains in the commercial property market remains a key macro risk. Property valuations are falling, and some owners will struggle with the higher cost and more limited availability of credit over the coming years.

The surge in interest rates has prompted a reassessment of commercial property valuations. In the US, prices have fallen 4-5% from their peak in mid-2022, with further falls on the horizon. There are also likely to be wide divergences by sector, with the office sector expected to fall by around 30%. The office sector has been affected by the trend towards remote working, particularly in the US.

Another important question will be whether property owners can cope with large increases in the cost of debt. Many firms locked in cheap debt when rates were low, so this effect will be delayed, but it may prove hard and costly to refinance this debt when it falls due. This is particularly the case in the US, where smaller banks have traditionally been major providers of funds, but these banks are now liquidity constrained.

Though these pressures are most acute in the US, they are also playing out in Australia to a lesser extent. Australian Real Estate Investment Trusts (REITs) have announced downgrades in asset values of around 3-6%, with Dexus being at the high end of that range, given its greater office exposure. Several large superannuation funds have also downgraded office tower valuations by 10-15%, while in other sectors, valuation changes have been small. The better news is that most listed REITs are trading at 20-30% discounts to current asset valuations, meaning this risk is comfortably priced into current share prices.

Australian REITs face the greater risk of their cost of funding rising over time. This would affect cash flows and the size of future distributions. The risk will vary by the REIT depending on the level and maturity of its debt. The extent to which rents are linked to inflation will also be an important factor for the size of future dividends. Overall, however, we need to be aware of the potential for lower dividends from the sector over time.