Stop Investing in Melbourne CBD

Lei Feng | December 8, 2015

The real estate that’s worrying the RBA (Hint: Not Residential)

Watching the big money part II – this time we’re in the Melbourne CBD.

The RBA is worried about a property bubble.

“Finally!” I hear the chicken-littles say. “We’ve only been talking about it for 15 years! At last the RBA has come round.”

Well, let’s not get too excited little chickies. The RBA’s not worried about residential property.

Nope. It’s actually the commercial property market that’s keeping them up at night.

That’s the latest insight that Assistant Governor Malcolm Edey has given us.

Edey took the opportunity at the Australian Property Institute’s Qld Property Conference last week to fly a few flags over the commercial property sector.

As Edey points out, there has been strong investor demand for commercial property in recent years, but rents have failed to keep pace with strong price gains. As a result yields are falling, at the same time as vacancy rates are rising.

The disconnect between prices and rents – which is another way of framing for the fall in yields – is eyebrow raising.

Commercial Rent Yield

I mean check out the yawning gap that’s opened up between CBD office prices and rents. Industrial is not fairing all that much better, although retail still seems to be in reasonable territory.

So the question is why? What’s driving the strong price gains? If it’s not asset returns, what is it?

In short, the answer is China.

Edey went on to present this chart, although there’s no reference to it in the speech notes, so we just have to guess at what he said.

My guess is that he said, look at the top half of this chart. It shows commercial property transactions by type. There we can see that all the action in recent years has been in office space.

Then look at the bottom chart. It shows you that foreigners are becoming increasingly important players in the commercial property markets, and it’s this foreign buying that has taken transactions beyond previous records.

And we don’t know where this buying is coming from, but one way or the other it probably goes back to China. Chinese companies are either directly active in the market themselves, or Asian developers, empowered by cheap Chinese credit and the drying up of opportunities in Asia, are making their way here.

Like most things, it’s made in China.

Edey also showed us this chart, which shows the explosion in Chinese debt over the last 5 years – something we just haven’t seen in any other part of the world.

So this is the story. Cashed-up Chinese and Asian developers are on the hunt for large scale property projects, and all that extra demand is helping juice commercial property prices.

And this feeds into residential property. Remember that a number of CBD offices in Sydney and Melbourne have been bought up by developers in recent years – with the express intent of pivoting from offices to residential apartments.

A market that itself is already starting to look over-supplied and over-priced.

And this all has Edey worried, because banks typically have large exposures to commercial property, and it’s often commercial property that leads the way into recession:

Historically (commercial property) has been a common source of financial instability both here and abroad. During the height of the GFC, Australian banks remained in comparatively good shape but they did suffer a noticeable deterioration in asset performance, with the aggregate non-performance rate rising to just under 2 per cent of loans.

A significant part of that deterioration was in commercial property lending; impaired commercial property exposures accounted for around 30 per cent of Australian banks’ non-performing domestic assets at that time.

And what does the big money think about all this?

Well, Michael Pascoe of the weekend was calling the top in commercial property, based on what developer Lang Walker is doing:

Lang Walker knows a bit about property development and investment – he’s been doing it for the better part of 40 years and became a billionaire twice over in the process…If one thing has distinguished Walker, it’s been his ability to sell out at the right time, or close to it, and come back to the party later. He’s been as much a trader as an investor.

While the Walker empire is always open to deal, he has two major sell-downs on his corporate CV: In 1999 he sold his stake in the then-listed Walker Corporation to Australand – the dot-com bomb hitting the next year didn’t damage him; and in 2006 he flogged a $1.25 billion portfolio to Mirvac – and his business kept growing through the GFC.

And now he’s attempting his biggest sale ever – about $2.5 billion for Melbourne’s Collins Square properties. There might be a lesson here somewhere.

I once asked Walker how he knew it was time to bail out ahead of the GFC. He said it was because the money being paid for property simply didn’t make sense, he couldn’t see how it could be developed and rented at a profit. He mentioned a particular competitor in the industrial space who seemed to be sending “kids with clipboards” to auctions paying more for land than the land could return. It wasn’t hard to decide to sell down.

The more I look at it, the more nervous I get about the inner-city apartment markets. Prices and valuations are stretched, and the big money is pulling the pin.

For small-time investors, you’ve really got to be thinking twice.

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