According to AMP Capital Investors head of investment strategy and chief economist Shane Oliver, nonresidential property generated a total return of 17.5 per cent in 2006, compared to 6.3 per cent for residential.
Residential property provided a third straight year of disappointing returns in 2006, Oliver says, and the sector remains unattractive. He expects lower returns in 2007, at about 12 per cent for non-residential and about 5 per cent for residential.
"Unlisted nonresidential property should have a strong year with returns of around 12 per cent as investor demand continues to push yields down and underlying supply/demand fundamentals remain favourable," he says.
"Australian housing remains more than 20 per cent overvalued versus rents and wages. Gross rental property yields of 3.2 per cent compare poorly to other investments, housing affordability is poor and even if house prices do turn up, the Reserve Bank of Australia would be likely to raise interest rates again."
In addition, residential property is bearing the brunt of a new factor in the property markets: investors selling property to raise funds to top up their superannuation up to $1 million in after-tax contributions before June 30 (see box).
FKP executive general manager of funds management Adam Learmonth says that across all sectors, yields have been firming since 2002, driven by the weight of money - which has seen increased demand for assets of all kinds.
"It's been phenomenal that particularly in the office and industrial sector over the last five years - until very recently - the leasing market has been pretty weak. The industrial market has been pretty flat, there hasn't been any major rental growth, and in office property - outside of Brisbane - recently it has been the same phenomenon," Learmonth says.
"Instead of investors coming into the sector based on really strong growth in rents and projected income, which is the traditional attraction, they were coming in because there was simply a weight of money in the system needing to find a home, and the returns in property still looked better than what you could get in fixed interest asset classes."
The non-residential sectors have also benefited from strong interest from "refugees from residential", he says. "The market has seen a lot of people who would normally be investors in residential property who baulked at the low yields available in residential and instead decided to look at 7-8 per cent in a warehouse," he says.
"They might not have done that themselves, but they gave it to syndicate managers who then bought those assets. Even 6-6.5 per cent, which we consider in the institutional sector to be a pretty low yield, looks good against a residential yield of 3 per cent. So we've seen quite a bit of demand from those non-traditional sources." While all of the nonresidential sectors are "pretty strong", he says each is at a different point in the cycle.
"I think the office sector is at 10 o'clock on the cycle; industrial is at 11 o'clock; and retail is just before midnight," he says.
"If you were an outsider looking in, you'd say retail was the strongest: but prices don't have much more room to move. "We don't see much rental growth still to come in retail: there are enough shopping centres out there now and the provision of retail shopping space per person is at the right level. Rental growth won't be negative, but neither will it grow dramatically. That market will bubble along from here: we don't see big drop-offs in prices or rents, but we won't see massive increases in the next three years, it will just be stable."
From a tenant point of view, he says the retail sector is fairly stable. "In yields, the investor demand for shopping centres remains strong, but now the income return you can get out of a shopping centre is now equal to what you can get by putting your money in the bank," he says.
"We don't see that going any further, but retail is at the top of the cycle. It won't crash, because the demand for retail assets will remain strong - it's a tightly-held market, and there is a limited number of investors in the sector." For the self-managed super fund and direct retail investor, PRD Nationwide Research national research director Tim Lawless says the non-residential category that looks most attractive is industrial.
"Industrial is the market that stands out at the moment, particularly in Sydney, Melbourne and Brisbane," Lawless says. "In the suburbs - particularly in areas that have a lot of infrastructure development going in - you have a good long-term prospect of capital growth because of that infrastructure development. But again, it is a funny market, because it is not wholly based on rental growth, which is what usually drives any investment property market."
Rents in the industrial sector have largely been flat for quite a while, he says, and the heat in the industrial sector is coming from owners, not from the tenants. "People haven't bid up prices because strong rental growth points to future strong earnings growth; they've bid up prices because they're interested in the sector as a diversification play, and they want to own industrial assets," he says.
"Assessing industrial investment is all about trying to get tenant demand in the industrial sector to work its way through to rental growth. The industrial sector is pretty fragmented at the moment along the east coast: we have seen some rental growth in Brisbane; in Sydney, there is a lot of tenant demand, tenants are moving around a lot, taking more space, but we're not really seeing that translate into strong rental growth. The tenant market is not weak but it's not strong, it's just moderate."
Of the non-residential sectors, van Eyk Research head of property research Louis Christopher is most bullish on office. "It depends on the city you look at, but we see Sydney as the outperformer," Christopher says. "Brisbane and Perth had tremendous years last year - rent rises of 20 per cent-plus, and vacancy rates of 2 per cent - and we still expect them to have good years in 2007, but from 2008 we're concerned for those markets.
"In contrast, we see Sydney as reaching the midpoint of its upswing, and it has a lot further room to move than those two. Melbourne is also recovering, but we don't see it as being anywhere near as strong as Sydney."
He expects to see vacancy rates edge down below 7 per cent in Sydney this year, which should help office rents to rise up to 10 per cent. "The supply situation is favourable, because there is not a lot to come onstream over the next two years," he says.
"The increase in demand that we see, coupled with the lack of new supply, should see rents rise in Sydney and that should start to flow into rising capital values. The demand is not as strong in Melbourne, and new supply started to come onto the market in 2006, so we see rental increases of about 5 per cent as possible in Melbourne - but it's simply not as attractive a market as Sydney."
Lawless says non-residential property investment is difficult for non-retail investors, but not impossible. "Research on those sectors is more readily available than ever before and that's good," he says.
"A lot of the major real estate companies put out market reports that outline in simple terms what's happening in those markets, so people can assess those markets and make an informed decision. In the past, understanding those markets has taken a bit of time to get your head around the numbers. "Non-residential is a slightly more sophisticated investment because it is quite numbers-driven: you have to look at the quality and location of the building, the quality of the tenant and the length of the lease.
"Quite a bit more goes into the negotiation of the lease. Rather than finding a residential tenant on a six or a 12-month lease, in nonresidential you may have incentives on an industrial lease, and a lease over a longer time frame. You have to assess the quality of the tenant.
"Direct investors buying into the nonresidential asset classes are probably looking at a yield of at least 6 per cent. But the longer they leave the purchase, finding that level of yield is becoming harder and harder." For most people, he says, buying into nonresidential property is more of a major financial decision than traditional residential property investment.
"If you're looking at the bottom of the residential market, where you might be investing $250,000-300,000 for a unit or a house in the suburbs, it's pretty hard to find those kinds of price points in the nonresidential markets," he says.
"But there are a lot of people who are able to put $1 million or more into residential investment property. If those people have made the jump to commercial or industrial - in effect, to the bottom end of the nonresidential markets - they would have found a fairly similar experience; that is, as long as they have a good agent who can 'proof' the tenants and negotiate the incentives and that sort of thing."
Investors with "an informed opinion about the markets" probably see residential at the moment as not providing the same level of capital growth as the industrial or office market, he says. "But now we're seeing residential yields improving, we're seeing the prospect of capital growth coming back into the market; maybe not over the next six months, but a lot of people are starting to reposition themselves in residential for the longer-term growth," he says.
"The non-residential markets are at a high, and residential is at a low - so it is finally attracting interest." A rental recovery is beginning to emerge in the residential market, he says. "Vacancies in most capital cities are at historic lows. In Brisbane, for example, the vacancy rate is less than 2 per cent, and rental rates are going up a lot faster than capital values, so we're seeing significant improvements in rental yields," he says.
"It's still not at a lucrative enough level to really lure investors back in, but now is the time to position yourself for the growth that is coming into the marketplace.
"Even in the best market, which is Brisbane, the average yield is about 3.8-3.9 per cent, which might not be enough yet to attract back the serial 'segment-swappers', who follow the yield and the growth. But it's poised to move up, and you have to remember that a lot of the 'segment-swappers' would prefer to be in residential, if they could, because they understand it better and are more comfortable in it. A lot of them would like to go back." Christopher agrees residential is at the bottom of the cycle in Sydney and poised for an upturn, but he says the Perth and Brisbane residential markets are entering a downturn.
The rest of the markets, he says, are in between these extremes. "Melbourne and Canberra are in a slower recovery phase than Sydney and Darwin is probably in the Perth basket," he says. "We definitely see Sydney as coming off the bottom and due for recovery in 2007, but the caveat on that is that interest rates really have to remain unchanged - or better still, lowered."
