In a year where “risk free” Government bonds and cash in money market funds provided yields in excess of 5%, investors rightly questioned the historic low yields available in the commercial property market. Commercial property yields troughed in late 2021/early 2022, with yields on prime investments frequently seen below 4%, particularly in the industrial sector. This was justifiable in what was effectively a zero-interest rate environment but makes a lot less sense when the return on cash is above 5%.
The net result was a tough year for commercial property in 2023. Yields for most classes of real estate rose, corresponding to declining values. Whilst virtually all investment property was impacted by rising yields to some degree, there is clear differentiation in yield expectations for the various classes of property and quality of asset. Certain areas, particularly in the industrial sector, have held up remarkably well, whilst sub-sectors such as lower grade offices and certain retail have been very hard hit.
Similar to the residential market, commercial property transaction volumes were very low in 2023. Buyers were hit with rising debt servicing costs, tight bank lending requirements and the high cost of living, leaving less room for property investment. Sellers, on the other hand, were often anchored to the low yields and high prices from previous years and opted to try and wait out this cycle of higher yields.
However, the last quarter of the year showed some encouraging positive signs. Bond yields are now well down from their peaks, causing investors to shift their attention once again to other investment opportunities, including commercial property. Debt servicing costs have also eased slightly. We are expecting transaction volumes to pick up over the first half of 2024. As is typical in a recovery, the prime end of the quality scale has been first to show early signs of strength, whilst lower quality assets are expected to be slower moving.
Looking now at some of the various sub-sectors of the commercial market, we highlight the star performer of 2023, and in fact, the last five years, the industrial sector. Industrial investments were not spared from the rising yield environment, but yields were not hit quite as hard as some of the other sectors. Furthermore, continued strong rental growth, driven by historic low vacancy rates (sub 1% vacancy in many precincts) offset much of the decline in value caused by rising yields. As a result, industrial property average values showed only a marginal decline over 2023.
The outlook for the industrial market is solid, but perhaps not as exceptional as it has been over the last few years. Warehouse rentals in Auckland have increased by an astonishing 40% since the start of 2021, or more than 12% per year, on average. One would think this level of growth simply cannot continue, especially in a soft, potentially recessionary economic environment, where businesses may not be able to pass on the additional costs. This appears to be playing out, with rentals in the second half of 2023 showing subdued growth compared to recent years.
Industrial development activity remains strong, underpinning high land values. Activity has exploded in areas such as Hobsonville/Westgate, Silverdale, and Drury, which were historically peripheral locations, but have now become sought after precincts.
It is worth highlighting how well the industrial sector has performed over the last decade. Values have increased by an average of close to 15% per year since 2014. This exceptional performance has been driven by the coincidence of steadily increasing rentals and gradually declining yields, creating the perfect storm for fantastic returns.
In the commercial office space, rising yields have been much more pronounced at the lower end of the quality spectrum. Yields on office investments currently range from a low of around 6% for prime stock, up to, and in excess of, 8% for secondary grade. Rentals in the office sector rebounded in 2023, following some tough years during the pandemic. Conditions are tighter now, as vacancy rates decline and new development in the office sector is subdued.
The outlook for the office market remains uncertain, although with positive signs. Work habits and demand for office space clearly underwent a massive change during the pandemic. The overarching trend is of businesses right-sizing, i.e. reducing their office space requirements. However, fears of total collapse in demand for office space have subsided, as businesses are increasingly asking workers to return to the office, at least on a hybrid model. Quality remains the key differentiator in demand for office space, with this sector showing perhaps the greatest spread in performance between desirable, high-quality space, where the market is now quite tight, and lower grade stock which faces risks of long-term vacancies.
The retail investment market has faced a particularly tough time over the last couple of years. Like the industrial and office markets, yields have risen, however unlike the other sectors, this has not been offset by rental growth, which has been subdued. Investors have been faced with increased debt costs at a time where demand has been variable, rental growth has been flat, operating expenses have increased with high inflation and incentives are having to be offered to attract tenants. However, the hospitality sector is now recovering strongly, tourist numbers are rising and international students returning, all providing some welcome stimulus. Vacancy rates and rentals showed some improvement, or at least stabilised in 2023.
There are reasons to be optimistic heading into 2024. Interest rates appear to have reached, or be close to, their peak, debt servicing should be easier and other investment classes may become less attractive. Industrial remains the favoured sector, underpinned by very low vacancy rates, although we perhaps cannot expect quite the same outstanding returns that have been seen in the last few years. There may be opportunities to explore in the beaten down retail sector, whilst good quality offices in sought after locations continue to look more attractive.
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