What Historically Low Interest Rates Mean for Commercial Property
Cut on the Australian Cash Rate
On Tuesday 1 October, the Reserve Bank of Australia (RBA) decided to cut the Australian cash rate to a historic low of 0.75%. RBA Governor, Philip Lowe, cited global economic risks and Australia’s weaker-than-expected economic growth of 1.4% stifling employment growth. The US-China trade war and subdued global inflation have contributed to lower rates globally.
Furthermore, the RBA is beginning to consider other stimulatory policy options including quantitative easing (i.e. printing money). Quantitative easing is already popular in Japan and Europe. Some economists believe that the RBA may decide to engage in quantitative easing rather than cut the cash rate to the traditional lower bound of 0%.
Risk of a recession
Additionally, Kevin Rudd believes that Australia has a ⅓ possibility of recession by 2020. This would likely result in even further rate cuts to stimulate a deteriorating domestic economy. However, it is important to remember that a deteriorating economy could put pressure on tenants’ ability to pay rent. Increased tenant risk negatively impacts property valuations (across both commercial and residential properties). As an investment-focused newsletter recently pointed out, “Investing in property as a bond proxy is great when cash rates fall… until tenants can’t pay their rent.”
As shown below, Australian interest rates are now at record lows:
The relationship between interest rates and commercial property
The relationship between interest rates and commercial property is through yield compression (in property, this is expressed through a falling cap rate). When interest rates fall, investors demand lower returns on capital. This results in capital flow from all forms of bank deposits to other yielding assets, increasing their valuations and consequently applying downwards pressure to their yields. In relation to commercial property, a constant rental yield will become more attractive to investors and the price of underlying assets will rise (e.g. in a market where the desired return from commercial property falls from 6% to 3%, the value of an asset will double all else being equal).
Current yields of property across the country
Grade A commercial property yields around 5% in some capital cities (yields are lower in Sydney and Melbourne). This yield is far greater than the cash rate. It is over 5X the 10 Year Australian Government Bond yield (0.95%).
Most of the growth in commercial property has been attributed to falling cap rates as investors’ desired returns have fallen with the risk free cash rate. Over the 5 years to May 2019, industrial warehouse values have appreciated over 60% in the last 5 years, with over ⅗ of the gain driven falling cap rates rather than other factors. Furthermore, regional retail centre values have risen 25%, with around ¾ of the gain driven by compressing cap rates.
Tenant CS’ dedicated team can help you navigate the commercial property market in the face of current economic uncertainty.
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