21st Jan, 2013 Economy

Peeking Into the Murky Crystal Ball and the 2013 Property Market – Part 1

Predicting the future is always a precarious exercise to undertake. In fact, forecasting future events, to borrow a quote, is like searching for a black cat in an unlit room, that may not even be there.

In this two part blog series, Trident Real Estate will look at the key events that will shape the global economy and will attempt to forecast how these events will impact on the Australian real estate market in 2013. In Part 2 of this series, Trident will undertake a more specific property type analysis, which we will conclude by revealing our investment property of preference for 2013.

The Global Economy and Australia

2013 begins with a legacy of problems handed down by its predecessor, 2012. Budget showdowns, the next scheduled in March 2013, continue to rattle the US economy. It would seem that Washington DC is pleased to put off sensible decision-making behaviour, notwithstanding that the country’s fiscal deficit is spiraling out of control. Despite all this political uncertainty, corporates have deleveraged and improved the health of their balance sheets. A housing recovery is now well on its way, assisted by the Fed’s open ended quantitative easing. Oil and shale gas production has surged, thanks to fracking, and manufacturing has experienced somewhat of a renaissance (a special reference to the Detroit car manufacturing industry is warranted here). We believe that the strong private sector recovery and an inevitable meeting of the minds by the Democrats and Republicans, combined with low levels of new supply, will produce compression of yield for the residential, industrial and office sectors in the US for 2013.

Europe, unfortunately, is not faring as well as its trans-Atlantic neighbour. The crisis in Greece continues to bubble, albeit somewhat less aggressively. The Italians are set to vote in February and, unsurprisingly, Berlusconi’s decision to run for office is causing a little trepidation in the markets. To further aggravate the situation, it is only a matter of time before Spain will need to apply for assistance from the bailout fund and the European Central Bank. Notwithstanding, the ECB’s intervention, which involves the purchase of government bonds for fiscally challenged countries, together with Angel Merkel’s new tune of “more Europe, not less”, has assisted in sedating investor concerns at least for the short term. The fact that many of the peripheral European countries continue to shrink will mean that there is little, if any, possibility that these economies will be able to grow their way out of their mountainous debt piles. In our view, the effort to save the Euro at any cost is misguided. Peripheral countries should consider letting the Euro go and reestablishing their own national currencies, allowing for the necessary adjustment to fiscal and competitive imbalances as well as a necessary default on foreign debt. Unsurprisingly, we consider that the greatest risk to the global economy and the real estate market is the Euro zone. In 2013, expect to see political tension rise as parties debate whether fiscal austerity measures are the solution and what policies may be implemented to generate real GDP growth.

China’s most recent statistics have showed business activity picking up steam with HSBC China PMI of 51.5 reaching a 19-month high. Such momentum is likely to be sustained in the short term as a result of government stimulus policies including US$150bn of infrastructure approvals, an easing monetary policy and the cutting of the reserve-requirement ratio for bank deposits. Economic growth is, however, relatively low with an annual GDP growth of 7.9% for 2012 being the lowest reported since 1999. Investors should be reminded that local governments are responsible for reporting accounting data in China and that such numbers are not always reliable. Trident Real Estate’s most concerning long term issue when questioning China is the country’s ever increasing supply of housing on the one hand and the low birth rate on the other. Economist Andy Xie recently made the dire prediction that the overhang of empty properties will haunt China’s economy for a decade or longer, causing land prices to fall by up to 80% in most Chinese cities, triggering yet another Asian financial crisis. Notwithstanding Xie’s dire predictions, in the short term, further stimulus by the new leadership and improved demand for exports will give an overall level of growth of circa 8% in 2013.

Shifting our attention to the Australian macroeconomic environment, the key issue for the property investor is to understand where interest rates are headed in 2013 and where rates will be when they attempt to exit their investment. Currently, the cash rate is at a record low of 3%. This has meant that Trident Real Estate is able to borrow at rates as low as 4.5% for a multi-family residential project. Going forward, the requirement to shift the economy’s dependence on the mining sector, the stubbornly strong Aussie dollar and the need to kick start manufacturing will mean for the next twelve months further monetary easing is expected of at least 50 basis points. At these low rates the pro forma models for real estate investing seem very attractive. Trident Real Estate believes, as the Reserve Bank drops rates and provides a short-term sugar rush to the Australian economy, commercial property investors should focus on transactions that provide a large margin of safety and a sizeable cash yield upfront.

According to consulting firm CBRE, Australia attracted half of all real estate capital placed by funds in Asia in 2012, with cross-border capital capturing circa 40% of all deals. We believe Australia will continue to attract foreign direct investment in 2013 for a number of reasons: (1) cap rates for A-grade buildings are attractive at above 7% and compare very favorably to prime yields in other Asian countries/regions such as China, Hong Kong and Singapore, that enjoy yields of only 2-4%, (2) Australians have been described as having a recession mentality in a booming economy. This pessimistic mindset means that local money loses out to hungrier international money, (3) certain Australian banks require stringent lending criteria to be satisfied before granting a commercial loan. Recently, we found that one major bank required an interest coverage ratio of at least 1.7 and a weighted average lease term of 5 years as well as a loan to value ratio of at least 60%. Domestic banks, therefore, remain weary of financing commercial real estate deals. We believe the flow of hot money into Australia is a sign that both houses and equity prices will rise in 2013, albeit those more liquid assets will enjoy stronger interest from international investors.

In Part 2 of this blog series, Trident Real Estate undertakes a property type specific analysis and offers its views about how each of these sectors will perform in 2013.