Savills Weekly Cut: Volume 3

The week saw financial markets challenged with the ongoing spread of the coronavirus (death toll at writing reportedly >560 with >28,000 infected) and the emerging impact on the Chinese economy and the flow on of that. China, on return from its week long Lunar New Year celebrations (albeit quite subdued this time), rightfully, took precautionary actions to maintain liquidity in its financial markets system, injecting vast amounts of cash to thwart any crisis of confidence. This in turn stabilised global markets, allowing them to concentrate on their own domestic issues, such as Brexit and how the UK will advance, and impeachment rejection allowing the US to get back to managing itself and so on.

Global bond and equity markets recovered through the week, supported by a good US company reporting season. In addition and perhaps as a result of the worsening coronavirus epidemic, China on Thursday announced tariff cuts onus $75bn of US goods effective 14 February. The China Ministry of Finance said tariffs on an array of US goods will be reduced from 10% to 5% and from 5% to 2.5% on others. The Dow, S&P500 and Nasdaq all closed at record highs on Thursday.

Australia followed suit with the stock market higher as our company reporting season kicked off.

RBA keeps rates unchanged at 0.75% as we expected

The RBA has cited a “reasonable” economic outlook, with the global slowdown that started in 2018 now coming to an end, as reason to keep rates unchanged at this month’s board meeting. The RBA did note that the US/China dispute remains a risk as does the coronavirus, which is having a “significant effect on the Chinese economy at present”, but is “too early to determine how long-lasting the impact will be.” Domestically, the RBA wants to see GDP growth back to 2.75% in 2020 and 3% in 2021, however notes the bushfires will be a drag near term. Unemployment remains relatively high, while wages growth is too low, meaning inflation is still below their desired target range of 2-3%. 

The RBA acknowledges rates have “already been reduced to a very low level” and that they recognise the “long and variable lags in the transmission of monetary policy.” This means the impact of low rates will take some time longer: “Due to both global and domestic factors, it is reasonable to expect that an extended period of low interest rates will be required in Australia to reach full employment and achieve the inflation target.”

The current interest rate settings may be great for the mortgage holder, but if you are a retiree living off savings, the chances you have a mortgage are slim and you have seen a major pay cut, limiting your ability to spend. A third of Australian households have a mortgage, another third do not and own outright and the remaining third rent, meaning 2/3rds of Australia’s households are not benefiting from lower rates. Credit Cards rates are still to reflect current low interest rate levels, with average still around 15% depending upon type.

The graph below highlights the increase in credit card balances, number of cards and balances per account in 2019. At the same time households haven’t seen pay rises and have eaten into their savings as highlighted by the Household Savings Ratio graph.

The RBA will ease further if required, but we maintain what real impact would this have from 0.75% to 0.50%? We advocate other policy initiatives to take over from the blunt instrument of monetary policy. Fiscal policy easing via lower business and household tax rates and continued infrastructure spending (such as a water distribution network from Northern WA and NT to the southern states and regions) is required to boost economic activity in metro and regional Australia. To offset the reduction in revenues, GST could be increased from the current 10% to 13.5%, effectively taxing consumption and not savings as the current personal tax rate levels do; it may be controversial, but the policy needs to be rethought to stimulate the economy.

Australian Building Approvals fall -0.2%sa in Dec 2019

While the number of dwellings approvals fell in Dec, year on year rose +2.7%. Houses excluding apartments increased +0.3%, while apartments increased +4.9%. The value for total building fell -0.6% in trend terms, made up of Resi building up +1.1% and non-Resi down -2.7%. Dwelling approvals rose in VIC (+6.1%), ACT (+1.0%), NSW (+0.5%) while WA was down -1.4%.

Australian December Retail Sales lower than expected

As feared, the adopted retail trade sales marketing exercise of Black Friday took away Christmas sales, with Dec retail sales down -0.5%sa vs -0.2% expected. The Bushfires will have also had a major impact which should see a reversal into January/February. Retail remains challenging as the economy remains within a slow growth environment, hindered by an effective consumer recession due to low income growth.

PCA Office Market Report release – Melbourne & Sydney CBD remain our preferred office markets

The Property Council of Australia released their latest 6 monthly Office Market Report this week with the CBD markets of Melbourne, Canberra and Perth all experiencing vacancy declines. Melbourne’s vacancy rate dipped to 3.2% (down from 3.4%) however as the city braces for the next wave of development completions, we anticipate that this will be the last of the downturn in vacancy as close to 400,000sq m comes to the market in 2020 and a total of 600,000sq m between 2020 to 2022. Despite the record levels of stock to be delivered, pre-commitments are close to 70%, meaning the vacancy will come in the form of backfill supply which may take some time to refurbish.  

Sydney CBD’s vacancy ticked up to 3.9% (from 3.7%), recording the largest negative net absorption (demand) figure across all capital cities of -41,110 square metres over the six month period. Anecdotal evidence suggests tenants have had no choice but to look outside the CBD parameters to Sydney’s fringe markets due to the sub 5% vacancy that we have seen over the last two years. Over the next two years close to 400,000 square metres of stock is due to come online (with circa 50% pre-commitment levels), with major projects including 388 George St, 231 Elizabeth St due for completion in the second half of the year. 

With the addition of 300 George Street to Brisbane CBD’s office market at the end of 2019 attributing to the increase in vacancy (to 12.7% up from 11.9%), positive net absorption (demand) of 23,581 square metres demonstrated strengthened tenant demand which was well above historical averages. Although Perth CBD’s vacancy rate has consistently declined over the last three years, at 17.6% it still sits well above all other major CBD’s and the Australian average (8.3%). 

Dexus 1H20 Company update supports Office as our favoured asset class.

Please note: Commentary on Dexus does not constitute an investment recommendation.

Dexus saw further cap rate compression, with its Office portfolio tightening 17bps to 4.98% from 5.15% at June 2019. This highlights its high quality portfolio and market confidence, with the company stating formal 12 month market valuation guidance of expecting “further cap rate compression of circa 12.5-25 basis points”. Leasing showed strong fundamentals with the 97.4% occupancy, albeit down from 98.0% at June 2019 (due to refurbs on vacating space) and a WALE of 4.5yrs (4.4yrs at June 2019). Re-leasing spreads were a strong 18%, with positive comments on still being under-rented. Incentives were reported at 16.2% excluding dev leasing (up from 13.4% at June 2019). Sydney and Melbourne are driving the portfolio.

As a function of the current all-time low interest rate environment, Dexus has reported their all in cost of debt 3.5% down from 4.0% at June 2019, highlighting our thesis of the funding margin to cap rate as being supportive of further Office compression in 2020/21.

Shopping Centres Australasia First Half 2019/20 supports our preference to non-discretionary spending in a challenged Retail environment

Please note: Commentary on SCA does not constitute an investment recommendation.

SCA reported a meaningful uplift in its 1H20 report as a result of its acquisition of assets from Vicinity in 2019, with funds from operations (FFO) up +19.1% on pcp. As a function of low for longer rates, SCA’s cost of debt was at 3.4% over 5.6yrs average, leveraged at 34.2%. Portfolio occupancy was 98.3% with specialty vacancy down to 4.8% from 5.3%pcp. Supermarket MAT growth was +2.6% up from +2% at June 2019 and specialty MAT growth was +2.3% up from +1.8% for the same period. Interestingly valuations remained somewhat static with the average cap rate compressing only 2bp from 6.48% at June 2019 to 6.46% at Dec 2019. The weighted average cap rate at June 2018 was 6.33%.

With Retail out of favour at present, SCA highlights that exposure to non-discretionary spending via supermarkets and day to day living retail provides somewhat of an exception to the rule, albeit with increasing negative average releasing spreads (-1.7% on renewals and -3.9% on new leases) and higher incentives (0.3mths on renewals and 15.9mths on new leases) highlighting that all retail is under pressure. SCA reiterated they are maintaining +3% to 4% annual fixed rental increases for 85% of their specialty tenants. 

SCA’s portfolio metrics provide a good snapshot of the current non-discretionary retail (Savills Research preferred sub-sector of Retail) environment.

CoreLogics’ January 2020 National Home Value Index rises +0.9%

Housing values in every State capital rose in January, demonstrating price recovery as a direct response to the RBA’s easier monetary conditions and lower interest rates. Melbourne and Sydney lead the Resi price reflation, with Perth showing signs of coming out of its 5.5yr slump. Sydney and Melbourne are still leading the recovery and perhaps highlight current interest rate settings are creating a 2-speed Residential economy that could be exacerbating a Resi price bubble again. According to CoreLogic Brisbane, Adelaide, Hobart and Canberra are posting new record highs, while Sydney needs to recover another 5.4% and Melbourne 1.2%.

Outside the square

Punxsutawney Phil, the Pennsylvanian groundhog, has predicted an early US spring. His 134th prediction was made on 2 Feb when he emerged from hibernation. The superstition says the if the groundhog emerges from its burrow after hibernation on 2 February and sees its shadow due to clear weather, it will be a long winter. It was a cloudy day. This is a rare event as since 1887, Punxsutawney Phil, has forecasted a longer winter more than 100 times…he bit his top hat wearing handler as he was hoisted into the air on Gobbler’s Knob.

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