Australian Real Estate Quarterly Review. Property performing well. What next? Q2/2016

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1 Australian Real Estate Quarterly Review Property performing well. What next? Q2/2016

2 In summary Investment climate Occupier and capital markets supportive While the economic outlook is somewhat mixed, the capital and occupier markets continue to support real estate values as we move towards FY17. The price cycle appears to be at a mature stage. Page 3 Transactions - How much more yield compression? Investment demand remains strong with transaction volumes at high levels and supported by a broad range of buyers. Yield tightening may begin to taper in FY17. Page 4 Performance Property performing well. What next? A-REITs and unlisted property delivered above average total returns over the past year of 11.3% and 13.9%, respectively. However, returns for underlying property are expected to ease to more sustainable levels from late FY17. Page 5 Office markets - Supply lull to support rental growth Most office markets are now close to, or have passed, the peak of this supply cycle. A relatively benign supply outlook for FY17-FY19 in many markets should allow incentives to ease and effective rents to firm. Page 6 Industrial Conditions supporting development Tight pricing and low yields have made it more difficult for domestic players to acquire core buildings on the open market but easier to develop or manufacture core stock. Consequently, development activity is slowly gathering pace. Page 8 Retail Subdued but positive conditions ahead On the one hand, retail sales growth is expected to remain around current levels as housing activity slows but on the other, spending is supported by low petrol prices and the prospect of lower interest rates. Page 9 2

3 Investment climate Occupier and capital markets supportive While the economic outlook is somewhat mixed, the capital and occupier markets continue to support real estate values as we move towards FY17. The price cycle appears to be at a mature stage. A key feature of the economic outlook over the next two years is the prospect of divergent growth between states and sectors. Key assumptions about the outlook include: Victoria and NSW will outperform other states, driving national growth. QLD is forecast to improve in the next two years and WA will lag Official cash rates are likely to fall by % Residential construction is expected to slow over the next year as prices ease. A sharper than expected contraction in construction is a key risk for the economy in FY17 Commodity prices will remain weak in the short to medium term, reducing government revenues and constraining public spending Service sector exports like education, tourism and finance will remain a growth driver, benefiting from China s transition to consumption. Other growth industries will be IT, health and agribusiness and small-scale business services Cheap debt and secure property yields will continue to drive investment in property, however prime yields are assumed to be approaching a low point in FY17 Overall, the real estate sector looks like seeing another year of strong investment demand with pricing running ahead of growth in income. Pricing is approaching a peak but the exact timing or extent of any peaking of values is hard to predict while capital and occupier markets remain supportive. Figure 1. NSW and VIC lead the other states Final demand p.a. NSW VIC QLD WA 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% -8.0% Jun-15 Jun-16 Jun-17 Jun-18 Source: Deloitte Access Economics (DAE) Figure 2. Dwelling commencements 000 per annum Dwelling commencements Standard bank variable mortgage rate % % 8.0% % % % % % Jun-05 Jun-07 Jun-09 Jun-11 Jun-13 Jun-15 Jun-17 Jun-19 Source: Deloitte Access Economics (DAE) Table 1. Australian economic forecasts: Q Jun-16 Jun-17 Jun-18 Real GDP %pa 2.6% 2.2% 3.0% Final demand %pa 0.5% 1.1% 2.4% Employment %pa 1.7% 1.1% 1.4% Goods imports %pa 1.4% 2.3% 2.5% Retail sales %pa (real) 1.9% 2.7% 2.7% CPI %pa 1.4% 2.6% 2.5% 90 Day bill % 2.1% 1.7% 2.1% 10yr Bond % 2.4% 2.6% 3.2% AUD/USD Source: DAE, DEXUS Research (90 day Bill) Investors will benefit in the long run from a strategy of being selective and disciplined in acquisitions while taking advantage of conditions to dispose of off-strategy assets. 3

4 Transactions How much more yield compression? Investment demand remains strong with transaction volumes at high levels and supported by a broad range of buyers. Yield tightening may begin to taper in FY17. Total transaction volumes for the March quarter 2016 were $4.35 billion, above the same time last year but down from the previous quarter, which was one of the highest recorded. The largest recent sale - the acquisition of 420 George Street, Sydney by ICPF shows how expected IRRs have fallen for high quality assets. The estimated unlevered IRR of approximately 7.2% (on an equivalent yield of circa 5.3%) is based on a reasonably full 4.0% growth assumption and a tight terminal yield of 5.4%. Foreign investors have been driving demand at the upper end of the market, capturing a 44% share of transactions. All the main categories of domestic buyers such as privates, A-REITs and unlisted funds have been buying. But they have also been selling. The striking statistic is that foreign investors were the only significant category in which more property was bought than sold during Some major domestic players have sought higher returns by selling core-stable assets to deploy their capital to value-add opportunities and development. Strong pricing on core stock is also leading to growth in the values of riskier stock as investors move up the risk curve. Yields in Sydney and Melbourne could inch lower in the short term. However, given lower return expectations we are less confident of seeing further transactions at materially tighter cap rate than seen recently. We note that valuations may be lagging the transaction market. While the lower for longer interest rate view supports structurally lower IRR expectations, lower economic and corporate growth expectations will mean that yields will not necessarily fall to the same extent. Figure 3. Buyer origin all sectors $bn Unknown Foreign Domestic % Foreign Source: DEXUS Research Transaction Database, JLL Research Figure 4. Average prime yields all sectors % 9.0% 8.5% 8.0% 7.5% 7.0% 6.5% 6.0% 5.5% Source: JLL Research, ABS, DEXUS Research Table 2. Q Top transactions Price ($m) Asset/portfolio Buyer George St, Sydney ICPF Woolworths HQ Inmark Group Arthur Street, North Sydney Ascendas Forrest Centre, Perth YT International Oxford Cold Storage Portfolio, VIC King Street, Sydney Invesco % 9% 26% 17% 14% George Street, Brisbane 179 Elizabeth Street, Sydney 25% 29% 28% Logos Property AEP Investment Management Markham Corporation Market City, Canning Vale Perth Markets Macquarie St, Sydney Macrolink Collins Street, Melbourne Harry Stamoulis Source: DEXUS Research Transaction Database, JLL Research 23% 32% 44% Syd CBD Office Syd Sub-Regional Retail OWSyd Industrial 5.0% Mar-06 Mar-08 Mar-10 Mar-12 Mar-14 Mar-16 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 4

5 Performance Property performing well. What s next? A-REITs and unlisted property delivered above average total returns over the past year of 11.3% and 13.9%, respectively. However, returns for underlying property are expected to ease to more sustainable levels from late FY17 as yields stabilise. Both listed and unlisted property have outperformed broader equity and fixed interest investments in the past year, registering strong capital growth as income yields have tightened. Equity returns were held back in the March 2016 quarter by significant volatility in global markets and some downgrading of earnings growth expectations. The Australian equity market returned -9.6% in the year to March Returns on fixed interest assets have remained low but positive, returning 2.0% for the year to March The A-REIT sector outperformed the broader equity market, returning 6.4% over the quarter and 11.3% for the year to March A-REITs have benefited from lower yields on financial assets such as bonds and a preference for defensive assets with stable income streams. With bond yields so low, the extent of further support for A-REITs from this source appears limited. Unlisted property returns have benefited from strong capital gain in the past 12 months. To date, the contribution of income growth to capital growth has been limited with tightening yields driving most of the gains, led by the Sydney and Melbourne markets (Figure 6). The rate of capital growth is expected to ease in FY17 and FY18 as yield tightening tapers, although the prospect of increasing rents could provide support in the east coast markets. Unlisted returns are expected to ease towards 7% as cap rates stabilise and returns become more reliant on income yield. Figure 5. A-REIT vs Bond returns Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Source: RBA, Bloomberg, DEXUS Research Figure 6. Unlisted property returns by sector Source: Mercer/IPD, DEXUS Research, NAV pre free Table 3. Index returns to 31 March 2016 Qtr. % 1 yr %p.a 3 yr %p.a A-REITs Unlisted property Australian fixed interest Australian shares Australian cash S&P/ASX 200 A-REIT Index Source S&P/ASX 200 property accumulation index Mercer/IPD Aust. Pooled Fund Index* BACM0 Index yr gov bond yield (RHS) 0 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 S&P/ASX 200 Accumulation BAUBIL Index The indices are copyrighted by and proprietary to the relevant issuers: Mercer/IPD Unlisted Index; Standard and Poor s Australian Securities Exchange Accumulation Index; Bloomberg/UBS Composite and Bank Bill Indices. *NAV Pre-fee % 5 Office Retail Industrial Diversified

6 Office markets Supply lull to support rental growth Figure 7. Office net absorption by market Most office markets are now close to, or have passed, the peak of this supply cycle. A relatively benign supply outlook for FY17-FY19 in many markets should allow incentives to ease and effective rents to firm. Lead indicators for demand remain mixed but mildly positive, pointing to further absorption of space in the year ahead. The latest NAB Business Survey revealed a significant improvement in both business conditions and confidence, and while the ANZ job ads series has started to level out, it is still firm. Equity market volatility remains the major wildcard for both confidence and leasing. Occupier demand continues to track in line with expectations. Sydney and Melbourne have surged ahead, reporting strong levels of positive net absorption. Brisbane demand improved slightly, while Perth experienced another negative quarter. On the supply side, most markets are now close to, or have passed, the peak of this supply cycle. While Sydney has approximately 250,000 square metres of office development under construction and due to complete over the next 12 months, there is little in the pipeline after that. Limited new supply combined with an increase in withdrawals over FY17-FY19 for a majority of markets is expected to lead to a tightening in vacancy. Effective rental growth has varied across the markets, with Perth, Brisbane and Adelaide the weakest (see table 4). Incentives have remained relatively steady except for Sydney where a tightening in vacancy for B and A grade buildings has supported a marginal decline in incentives. If demand stays positive, the benign supply outlook in all markets should allow for an easing of incentives and effective rents to firm in FY17 and FY18. Source: JLL Research, DEXUS Research Figure 8. Vacancy rates by market Parramatta Sydney CBD Sydney Olympic Park Macquarie Park Melbourne CBD North Sydney Chatswood Canberra Adelaide CBD Brisbane CBD Perth CBD Vacancy rate 5.6% Source: JLL Research, DEXUS Research Table 4. Q office snapshot Vacancy % 6.8% 7.3% 8.3% 9.2% 11.6% 12.6% 13.4% Prime net face rental growth % p.a. 16.6% 18.2% 24.5% 0.0% 10.0% 20.0% 30.0% Prime net eff. rental growth % p.a. Parramatta Sydney Macquarie Park Melbourne North Sydney Canberra Adelaide Brisbane Perth Source: JLL Research, DEXUS Research 6

7 Office market wrap Market Sydney Comments Sydney continues to perform strongly with vacancy dropping to pre-gfc lows of 6.8% and annual net absorption tracking at nearly triple the long run average. Strengthening demand has started to translate into a firming of rents, and modest falls in incentives in A and B- grade assets, with prime gross effective rents increasing by 2.9% in Q1-16. Looking forward, while vacancy is forecast to rise temporarily over the next 6-12 months, positive demand and withdrawals should drive vacancy back below 6.0% by FY18. Direction of trend for next 12 months Vacancy 1.0 Rents 1.0 Incentives -1.0 North Sydney North Sydney demand turned negative this quarter (c-8,800sqm), which led to a rise in vacancy to 11.6%. Despite the softer demand conditions, prime gross effective rents increased by 3.1% in Q1-16, and incentives remained steady at 28%. An increase in withdrawals over the next months, mostly associated with the Sydney Metro Rail, will assist in bringing vacancy down and support a further uplift in rentals. Rents 1.0 Incentives -1.0 Macquarie Park Parramatta After a period of positive demand for Macquarie Park, demand softened in Q1-16 (c-90sqm), while vacancy remained relatively steady at 8.3%. Prime face and effective rents saw no growth over the quarter, but are expected to show some upside given the relatively benign supply pipeline and anticipated positive demand. Parramatta vacancy rates held steady at 5.6% as demand softened in Q1-16 (c-3,400sqm). Prime face and effective rents saw no growth over the quarter, and incentives remain steady at 22%. The market is expected to continue to perform strongly over the next 12 months, benefiting from a limited availability of prime space and no immediate supply risks. Rents 1.0 Yields 0.0 Rents 1.0 Incentives -1.0 Melbourne Brisbane Perth Melbourne demand was positive for the eighth consecutive quarter (c31,400sqm), which allowed vacancy to tighten by 0.8% to 9.1% in Q1-16. Despite the improvement in demand, incentives have continued to remain stubbornly high, with only modest growth of 1.0% in prime net effective rents recorded. Over the next 12 months demand is expected to remain positive, supported by a continuing centralisation of tenants from fringe/suburban markets. Vacancy is likely to hover around current levels as circa 126,000sqm of new developments complete. Brisbane demand was positive for the fifth consecutive quarter (c2,600sqm in Q1-16), but the completion of new supply saw the vacancy rate continue to rise to 18.2%. Rising vacancy, and increased competition from new supply has led to an increase in prime incentives (c36%), and a marginal decline in prime gross effective rents (-0.7%). Vacancy is expected to remain elevated in the year ahead, but should start to decline post FY18, which will allow for rental growth. Perth experienced a further increase in vacancy up 1.0% to 24.5% as net absorption turned negative (c-17,100sqm in Q1-16) with a number of mining and construction firms reducing their space requirements. Weakening demand coupled with high vacancy saw prime incentives rise to 45%, and net effective rents decline c-7.0% in Q1-16. Conditions are expected to improve from this point on, with no new developments anticipated until FY19. Rents 1.0 Vacancy 0.0 Rents 0.0 Rents -1.0 Yields 0.0 Adelaide Adelaide recorded slightly positive demand in Q1-16 (c950sqm), while vacancy remained Vacancy 0.0 steady at 16.6%. Prime gross effective rents rose only marginally (0.4%) as prime incentives Rents 0.0 reported no change, holding firm at 30%. Demand growth is anticipated to remain weak over the next one to two years as the state government continues its policy to cut public service numbers, which will keep vacancy elevated and rental growth moderated. Canberra Canberra recorded strong positive net absorption (c13,700sqm in Q1-16) and a tightening in vacancy to 13.4%. Improved demand saw prime gross effective rents rise 1.5% as prime incentives declined slightly. Demand conditions are expected to continue to stabilise, and combined with a relatively subdued supply pipeline, should see vacancy trend down. Rents 0.0 7

8 Industrial markets Conditions supporting development Tight pricing and low yields have made it more difficult for domestic players to acquire core buildings on the open market but easier to develop or manufacture core stock. Consequently, development activity is slowly gathering pace. Solid regional economic growth is supporting solid occupier demand in Sydney and Melbourne. However, conditions remain patchy in Brisbane and Perth. Demand is expected to remain positive in the short term due to the beneficial effect of low interest rates and petrol prices on retail expenditure and wholesale activity. After a more subdued period, 2016 is likely to see industrial supply return closer to long term average levels, helped by low development costs. With built and leased product attracting high valuations there is little upward pressure on prelease rents. Markets with limited land availability or change of use potential, including inner city industrial markets are most likely to see upward pressure on rents. The key themes this quarter include: Tenant demand in Melbourne and Sydney is improving, supported by the strong state economies. Demand in Brisbane and Perth on the other hand is subdued, supported by major retailers optimising their supply chains The competitive pre-commitment market is resulting in tenants relocating more readily into new facilities as the rents for new buildings are often the same or cheaper than existing deals Older industrial stock (15 to 25 years old) faces occupancy risks as major tenants consider attractive deals on new stock The slowing residential market is likely to see the amount of stock withdrawn in inner city industrial markets ease in the short term as site values begin to taper. Figure 9. Upper prime industrial cap rates 9.0% 8.5% 8.0% 7.5% 7.0% 6.5% 6.0% 5.5% Mar-06 Mar-08 Mar-10 Mar-12 Mar-14 Mar-16 Source: JLL Research, DEXUS Research Figure 10. Capital city industrial supply pipeline 000 sqm 3,000 2,500 2,000 1,500 1, Outer West Sydney South Brisbane *2016 is projected supply Source: JLL Research, DEXUS Research. Table 5. Q industrial snapshot Ave prime cap rate change from Q Existing prime net face rental growth % p.a. Outer West Sydney Southern Brisbane East Perth South Sydney West Melbourne Source: JLL Research, DEXUS Research West Melbourne East Perth 10yr average = 1.6m sqm p.a * 8

9 Retail Subdued but positive conditions ahead On the one hand, retail sales growth is expected to remain around current levels as housing activity slows but on the other hand, spending is supported by low petrol prices and the prospect of lower interest rates. Retail turnover growth was 3.7% for the year to February 2016 and is on an easing trend. While positive, this figure is lower than the potential long term level of 4.0%-4.5% p.a. based on population growth. Turnover growth is expected to remain around this level in FY17, but much will depend on interest rate settings and confidence. The sales growth rate between categories varies with household goods as well as clothing, footwear and accessories the best performing categories, recording growth rates of 5.8% and 5.0% respectively for the year to February Key themes this quarter include: The performance of major tenants varies significantly, with Kmart and Coles continuing to outperform Big W and Woolworths Almost 75% of major regional shopping centres have recently completed or are in the process of being redeveloped. Developments are largely focused on food/dining, leisure and entertainment facilities Myer s strategy to focus on flagship stores continues with announcements that they will exit Brookside Shopping Centre (QLD) when the lease expires and will not proceed with planned stores at Coomera (QLD) and Tuggerah (NSW) May 3 has been slated as the date for closure for the remaining physical Dick Smith stores, with Kogan recently acquiring the online business International retailers continue to expand with commitments by Seiko to QVB (Sydney) and Omega (Brisbane CBD) as well as the recent opening of Uniqlo (Brisbane CBD) Figure 11. Retail sales growth and cash rate Year on year growth 7% 6% 5% 4% 3% 2% 1% 0% 0% Feb-13 Aug-13 Feb-14 Aug-14 Feb-15 Aug-15 Feb-16 Source: ABS, RBA, DEXUS Research Figure 12. Retail growth by category (YOY) Household goods Clothing, footwear and accessories Dept stores Pharmaceuticals and cosmetics Liquor Supermarkets and grocery stores Cafes, restaurants and takeaway Source: ABS (February 2016), DEXUS Research Table 6. Q retail snapshot Specialty rent growth since Q % p.a. Ave cap rate change from Q (%) YOY state retail turnover (Feb 16) % p.a. Sydney 4.8 Regional Sub-regional Neighbourhood Melbourne 5.1 Regional Sub-regional Neighbourhood South East QLD 2.0 Regional Sub-regional Neighbourhood Source: JLL Research, ABS, DEXUS Research Retail Turnover Interest rate 0% 2% 4% 6% 8% 7% 6% 5% 4% 3% 2% 1% 9

10 To discuss any information in this report please contact: Peter Studley GM Research DEXUS Property Group peter.studley@dexus.com Lee Cikuts Research Manager DEXUS Property Group lee.cikuts@dexus.com Kimberley Slow Research Manager DEXUS Property Group kimberley.slow@dexus.com Yolanda Torres Research and Information Manager DEXUS Property Group Yolanda.torres@dexus.com Date of issue: May 2016 This report makes reference to historical property data sourced from JLL Research (unless otherwise stated), current as at Q1/2016. JLL accepts no liability for damages suffered by any party resulting from their use of this document. All analysis and views of future market conditions are solely those of DEXUS Property Group. Issued by DEXUS Funds Management Limited ABN , Australian Financial Services Licence holder. This is not an offer of securities or financial product advice. The repayment and performance of an investment is not guaranteed by DEXUS Funds Management Limited, any of its related bodies corporate or any other person or organisation. This document is provided in good faith and is not intended to create any legal liability on the part of DEXUS Funds Management Limited. This economic and property analysis is for information only and DEXUS Funds Management Limited specifically disclaims any responsibility for any use of the information contained by any third party. Opinions expressed are our present opinions only, reflecting prevailing market conditions, and are subject to change. In preparing this publication, we have obtained information from sources we believe to be reliable, but do not offer any guarantees as to its accuracy or completeness. This publication is only intended for the information of professional, business or experienced investors. 10