Over the past two years we have seen a moderation in the West Australian property market with both rents and sales prices softening as demand is stripped and construction of new space continues. This has caused vacancy rates to increase and there is some expectation that this trend is likely to continue, perhaps ballooning as new buildings are commissioned. Despite this, we continue to actively look for properties in WA that meet our criteria. These are more likely to come with a long existing or pre-committed leases to support the returns through the current soft patch. They may also come with a little twist, something that makes them non-vanilla, putting them in the too-hard basket for other, would-be buyers.
Although national business activity and economic growth could generally be described as lack-lustre, the Sydney and Melbourne property markets are generally pretty stable at the current moment. This, in part, is due to the fact that, not having the exposure to the resources and mining services sector to the extent of WA and Queensland, they did not experience the strength and tightness of market of the latter two. As a result the risks of owning property in these markets may be considered to be lower, they have lower vacancy rates, stable to firming rental rates and lower tenant risk.
As a result, whilst we continue to actively pursue properties to complement our portfolio in WA, at present we see better value (and lower risks) in the Sydney and Melbourne markets.
Importantly, demand from both local and foreign investors has been comparatively strong, causing property prices to be somewhat mis-aligned with their related rental market. This means that investors are not necessarily pricing in the full extent of the risks inherent in that market. Australia has been attracting more than our fair share of global investment capital because we have some of the highest investment yields in the world, (think bond yields, dividend yields and property yields).
Consequently it has become increasingly difficult to buy properties at prices that make economic sense, reflecting their risks and returns. We have submitted in the order of 20 to 30 offers to purchase in the past 18 months and each time, until recently, someone else has offered to pay more than we thought the property was worth (sometimes a lot more!) and therefore accept a lower rate of return on their investment than we are. This highlights the value of the Lester Group actually having their own money invested in syndicates.
The latest exception has been our successful purchase of an industrial property located in Ingleburn in Sydney’s south west. With a new 6 year lease to a financially sound tenant, the 9% investment yield is attractive and beats all but the most risky of opportunities.
As mentioned above, Australia has some of the highest yields in the world… but they are at record lows. The RBA recently reduced the cash rate from 2.5% to 2.25%.The same rate during the GFC got down to a low of 3.0%. The 10 year government bond rate has periodically dipped below the cash rate, currently 2.5%.
This implies that investment returns will be lower in the future and that investors will pay high prices for assets because there is little alternative for their money. Where else will it go? Overseas? Yes, money has flowed out of Australia contributing to the AUD’s fall from USD1.10 to USD0.7800. But when they get their money overseas, the foreign return on investment is even lower. The 10 year US government bond rate is 1.75%! Perhaps they see strength in the US or Chinese economies and have bought their shares, driving the S&P 500 Index up 44.4% in past two years and the Shanghai A market up 53.1% in 2014 alone. Source: rba.com.au
Local investors, intending to keep their money onshore, can either hold cash at 2.25%, shares at 6.0%* (ASX market dividend yield) or A-Grade property yields at sub 7%. Other investments, including our Ingleburn property come with a little more risk and therefore should be part of a diversified portfolio. *Grossed up for franking at 75%.
Given that all investment returns comprise the risk free rate plus a risk premium, the Lester Group are willing to accept lower returns on investment when it is the result of a lower risk free rate. We are not willing to accept a lower risk premium.
The Lester Group, are only willing to buy properties and invest our money when we receive our required rate of return given the risks involved. Otherwise we are happy to sit on the sidelines and watch others pay higher prices, and by definition, receive lower investment returns. This is why we have acquired so few properties in recent times.
This does make us look at other less vanilla properties, perhaps with more development or more niche, but using our ability to manage those risks to deliver a higher return outcome.