Opportunity and risk in Australia’s commercial property market

Jarek Kowcza
08:30am October 25 2023

Melbourne cityscape. (Getty)

The pandemic brought about transformational changes in Australia’s commercial property market which continue to have an impact on risk and returns for investors in the sector.

In the initial stages of COVID, city centres were suddenly deserted as lockdowns forced office workers to rebase at home. Shopping habits also changed, with online retailers prospering as physical stores were deprived of foot traffic.

Supply chain disruptions meant businesses stocked up on whatever they could get their hands on in a shift from ‘just in time’ to ‘just in case’ inventory management.

As a result, demand for fulfilment centres and storage facilities skyrocketed as the ‘last mile’ of the supply chain became increasingly important to get products to customers.

While some of these trends have been unwound somewhat since pandemic restrictions were lifted, they’ve established new ways of living and working which are likely to endure.

It has been a bumpy ride for commercial property investors over this tumultuous period, with some seeing the value of their investments decline sharply. The steep rise in interest rates since 2022 has further weighed on valuations as higher rates reduce the present value of future income.

The office market has been hardest hit and faces the most challenging environment ahead. Weak demand against a backdrop of rising supply has seen vacancy rates rise, particularly in Sydney and Melbourne, placing pressure on returns.

Retail properties, including shopping centres, have also been impacted, albeit to a mixed degree. The pandemic saw many of us shop closer to home, and a continuation of that trend has played in favour of smaller neighbourhood retail centres.

Industrial property has performed strongly as demand boomed while supply couldn’t respond quickly. This sent rents sharply higher and attracted investors who drove prices up at a faster pace than rents, resulting in yields falling to record lows. While there has been some cooling from the scorching hot levels seen emerging from the pandemic, this market continues to benefit from robust demand for warehouse and other industrial space.

Despite these major market shifts, for many investors commercial property can still be an attractive, if potentially volatile, long-term investment option.

Beyond a direct investment in the commercial space, or the shares of a listed developer, individuals can gain exposure via an investment vehicle of pooled assets, of which there are listed and unlisted alternatives.

The listed option has been a rollercoaster ride compared to unlisted. Listed Australian Real Estate Investment Trusts (A-REITs) were hit hard during the pandemic, plunging almost 50 per cent in March 2020, and remain around 20 per cent below pre-pandemic levels.

In contrast, unlisted valuations only fell around 5 per cent during COVID and remain around pre-pandemic levels.

The lower volatility in the unlisted sector pre-dates the pandemic, and may be attractive to some investors, but there is more to this than meets the eye.
 

Listed funds are marked-to-market every day by the financial market, while unlisted assets are revalued only infrequently, typically quarterly. This has the effect of making unlisted valuations appear less volatile and less correlated with other investments.

In fact, if judged on a quarterly moving average basis, the difference in volatility between listed and unlisted commercial property exposures is much less marked.

While there will be deviations in the short term, in the long run, the risk and return characteristics are likely to be driven by the quality of the underlying assets, rather than whether the vehicle is listed or unlisted. This view is supported by academic research examining the risk and return characteristics of US commercial property investments.

Ultimately, investors need to weigh up the pros and cons of a particular approach and decide on the allocation that is most appropriate for them, with their eyes wide open. As with any other investment, there’s no substitute for meticulous research and a disciplined risk management strategy.

To read Jarek’s full report on the commercial property market, visit the BT website. 

Jarek Kowcza

Jarek joined the Westpac Group as a Senior Economist in 2021. He works across several businesses, including Westpac Business Bank, St.George Bank, BankSA, Bank of Melbourne and BT. Prior to this, Jarek worked for The Treasury in Canberra for over eight years. He holds a Bachelor of Economics and Bachelor of Finance double degree from the University of Adelaide.

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