Commercial property is flooding onto the market in the wake of the sub-prime crisis but there is still more pain to come. 
 
Story Turi Condon Illustration Ned Culic  
 
Another day, another downgrade,” quipped one stockbroker as the rout in Australia’s $75 billion listed property trust sector took hold, halving the market value of the sector in the space of a year. 
 
It all started nearly 12 months ago in December 2007 when the debt-laden Centro Properties Group was unable to refinance $3.9 billion of maturing debt in the wake of the credit crisis, sending its shares into freefall. Then financially engineered groups like the Allco-managed Rubicon stable of trusts came under cannon fire. By June one of the country’s biggest residential developers Mirvac Group was flagging $300-400 million worth of writedowns on its $7.5 billion property portfolio, only to be outdone by Australia’s oldest listed property trust GPT’s 27 per cent earnings downgrade. 
 
And every day stockmarket investors savage the trusts for their boom-time follies where managers bought everything that wasn’t nailed down, bundled it up with some dubious quality corporate earnings and pushed gearing levels through the roof. The upshot has been a flood of commercial property onto the market. 
 
Analysts estimate up to $20 billion of Australia’s office towers, shopping centres, industrial sheds and hotels are on the sales block either publicly or on the quiet, in the make-me-an-offer mode. To put this figure in perspective, $6.63 billion of property sold in the six months to June 2007 when the commercial property market was on fire. But in the first half of this year, the sales tally was only $3.33 billion, according to real estate agent Jones Lang LaSalle. 
 
“I’m guessing over 50 per cent of assets are available off-market,” says Alistair Meadows, director of sales and investment for global real estate adviser DTZ. “The big questions are how much will sell in the next three to four months and where will the buyers come from?” 
 
Meadows expects wealthy private investors and offshore groups to dominate any buying with listed trusts more likely to be sellers as they move to reduce debt. “Buyers with capital are taking a wait-andsee attitude, which will elongate the period for transactions to happen,” says Meadows. Owners in trouble are not just at the big end of town. Meadows says requests by receivers for submissions to sell properties in the $1-10 million price range are growing. “It (receiver requests) has probably doubled,” he says. 
 
Accountants Ernst & Young is also getting more calls from banks to review companies’ positions. However, financiers prefer to work things out rather than make a formal appointment of a receiver, says Ernst & Young partner real estate services group, Marcus Willison. 
 
The upshot, says Willison, is that some of the best quality properties will come onto the market as these are the most saleable and most likely to recoup the banks’ debt. “There are properties for sale that haven’t been on the market for a generation,” he says, allowing a new breed of buyers like sovereign wealth funds and cashedup private investors as well as traditional investors to build up or rebalance their portfolios. 
 
“People used to queue up to buy prime and even secondary assets. Now there are serious buyers, but the number is severely diminished,” he says. 
 
In a market where for-sale signs multiply like rabbits, buyers are scarce and capital is even harder to find, the value of Australia’s commercial properties has only one direction to go. 
 
It will be the second-grade properties that will experience the biggest falls in value, according to Colonial First State head of listed property, Darren Steinberg. “There is no way the wholesale (property) market will be protected from what’s going on,” he says. 
 
While there was not a lot of activity at present, Steinberg believes there will be forced sales over the next six to 12 months. 
 
Best Buys 
So where will the best buys be in the current market? Steinberg says they will be Australian residential property and selected office or retail assets. “It’s really down to when the banks make a move and get a bit more forceful, 
 
“When they lose patience with the management of some vehicles and step in, then you will see some good quality assets come to the market at realistic pricing levels.”  
 
Steinberg believes that may start happening in the final quarter of this calendar year. The underlying problem is the rise in cost of the debt, says Jones Lang LaSalle head of forecasting services John Sears. “Many of the players have left the field and the yields being paid last year don’t stack up.” 
 
Sears, one of the speakers at the Chartered Accountants Property Industry Day in June, says one obvious group of buyers is the cashed-up superannuation funds. “But they are either pausing, waiting for reasonable value or the fall in the sharemarket has reduced their equities’ weightings, pushing their property holdings to being overweight.” 
 
“So even if they are getting our 9 per cent super in, they are not allocating it to propertyat the moment,” he says. 
 
Sears says to get transactions moving at least one or a combination of things have to happen: interest rates need to fall, property yields have to rise and the stockmarket must recover so the superfunds aren’t overweight in property investments. 
 
And until the credit crisis eases, possibly mid next year, according to PriceWaterhouseCoopers real estate partner James Dunning, there won’t be much money in the system to fund property acquisitions. “The banks have had their own capital adequacy requirements hard hit as a result of the sub-prime collapse, so there is not a lot of money for them to lend,” he says. 
 
Funding issues go to the heart of the property sectors problems, says Dunning. “You would expect some merger and acquisition activity later this year,” he says. But, if the ownership of a trust changes then its lenders may, under the terms of the borrowing arrangements, have the right to call in the debt or revisit the margins being charged. In this market that would mean a higher cost of funding, even if funding can be secured, he says. 
 
Among the biggest property portfolios listed for sale as a result of the credit crisis were the billions of dollars of US and Australian shopping centres controlled by Centro Properties Group and the Allcomanaged Record Realty, which put its entire $2 billion Australian, US and German portfolios up for sale earlier this year in a three-year disposal program. 
 
Even before one of Record Realty’s properties was sold, a June 30 valuation on its second biggest asset, the Centrelink Headquarters in Canberra, resulted in a 13.8 per cent fall in its worth from $217.5 million in December last year to $187.5 million. The office building is jointly owned with another Allco-managed listed trust. Another high profile property in the Record portfolio is the ASX Building in the heart of the Sydney CBD with analysts saying its $250 million book value is well and truly overblown. 
 
Finding the Bottom 
The Australian property market looks as though it still has some way to go to hit the bottom. 
 
The Future Fund’s investment director, private markets, Barry Brakey says buyers will come back to the market, but only when properties are at a certain price. “The market is dancing around itself to find what that level is,” he says.  
 
Brakey believes there will be more joint ventures and that big investors will expect to exercise more control over their managers on issues of investment strategy. They will want managers who genuinely add value, he says. Investors, like superannuation funds, were likely to engage a smaller number of more specialist managers, he says. 
 
Investment bank JP Morgan expects a sizeable sell-off, not only of listed property trust’s Australian assets, but their offshore holdings as well. 
 
“The tactic of beating competitors into niche asset classes and geographies before capitalisation rates compressed was seen in portfolios of storage assets, pubs and childcare in countries such as Poland, Greece, and the Czech Republic,” says the bank. 
 
But many of these highly leveraged properties and businesses have been given “a zero or indeed negative value” by the market, says JP Morgan. 
 
“The majority of groups have non-core assets offshore that should be sold,” it says. The capital markets of the US, Europe and Japan are broader and deeper and the billions of dollars of real estate on the Australian market is selling at a snail’s pace, so selling offshore assets might be the way to begin recapitalising the cash-starved sector and perhaps prevent a fire sale in Australia. 
 
JP Morgan estimates there is $16 billion of non-core overseas property owned by listed trusts compared with $3 billion in Australia. Why sell the property trusts’ family jewels – its Australian regional shopping centres and CBD office towers – if the rats and mice can be cleared from offshore. 
 
Projects Shelved 
Another fundamental and credit crisis-led shift in the property market is the shelving of big development projects. 
 
In March, JP Morgan said $32.5 billion of development projects were planned locally by listed trusts; add their international development plans and the tally blew out to almost $58 billion of work in the pipeline. The scale of developments planned by Australia’s listed property trusts had “never been matched”, the investment bank said at the time. The biggest was Westfield, with $18.4 billion of projects, followed by Goodman Group ($15 billion), GPT ($4.47 billion), Stockland ($3.4 billion), Dexus Property Group ($3.32 billion), Valad ($2.34 billion) and Mirvac ($2.2 billion). But with no cash, both listed players and private developers can’t build the next wave of office towers and shopping centres. 
 
“All this (credit crisis) will do is delay new projects and lengthen the next upswing,” says BIS Shrapnel chief economist Frank Gelber. 
 
He argues the correction is a financial market downturn, not a property downturn. While listed property trust shares have been in freefall, Gelber points out that office tower rents are rising, and very few CBD buildings have empty floors. The upshot will be office rents surging by up to 30 per cent in the next two to three years, says Gelber. BIS Shrapnel has forecast that office rents will grow between a negative 0.9 per cent in Canberra, where a rash of new buildings are being built, to 28 per cent in Perth during the next two years. 
 
Jones Lang LaSalle’s Sears points out that there is a fundamental difference between this crisis and the property market downturns of the early 1990s and in 2001. “In 1991 we had a wall of supply and vacancy rates in Perth went over 30 per cent, they were over 20 per cent in Sydney and Melbourne. This time vacancy rates are only about 5 per cent and the supply pipeline is relatively limited,” he says. 
 
Last year there was a record level of office demand around the country, says Sears. “This year there won’t be that level of tenant demand and next year will also be soft. But I think there is the potential for a bounce back in 2010 and 2011 assuming the current economic slow down isn’t too deep or prolonged.” 
 
Retail Markets 
The retail market is in a similar state, says Sears with shopping centre vacancies only 1 to 2 per cent. “Retail sales have slowed, but there’s still a queue of retailers waiting for the best centres,” he says. Sears says economists are generally predicting economic growth of 2.9 per cent this year and 2.8 per cent next year. The long-term average since 1960 is 3.6 per cent. “It’s below average growth, but it’s not a recession,” he says. “It could take until mid or late 2009, but then hopefully things will start to get back to normal. If you look at past crises, they tend to take 18 months to two years to wash through.” 
 
After the 2001 tech wreck things started to move in financial services again by 2003. With the 1997 Asian crisis, things recovered a little more quickly A 2008 survey of lenders by DTZ found no significant freeing up of the European debt markets was expected until 2009 at the earliest. In the meantime, the underlying real estate markets continue to deteriorate with demand for office space in London falling 30 per cent in the last quarter of 2007, DTZ says. 
 
Macquarie Bank head of property research Rod Cornish says the Australian story was being echoed in global circles. “Around the world there will be hardly any construction,” says Cornish. But unlike Australia, in some cities an oversupply of office space was looming. In London, there were already towers coming out of the ground, but in Sydney very few cranes were on the horizon, he says. Australia didn’t have the yield compression that occurred in the US and western Europe, says PwC’s Dunning, and as a result values are unlikely to fall as far. 
 
In the future, Dunning believes tenants will increasingly want green or environmentally friendly new buildings and that tenant demand will help underpin their value. 
 
In Melbourne and Perth, 75 per cent of the new office supply already had tenants lined up, but the figure was only 40 per cent in Brisbane, where more towers were being built, according to Cornish. While there was less supply to worry about in Australia, the credit crunch had also taken the initial steam out of rents, Cornish notes. 
 
On the basis that Australia’s underlying property markets were largely in better shape than their overseas counterparts, Gelber believes that Australia’s listed property trusts have been oversold. “There will be a property downturn at some stage, but this isn’t it,” Gelber says. “I think there are huge bargains emerging in listed property trust stocks.”