Sydney & Melbourne: world capitals of real estate

Australians have always punched above their weight, whether it's on the sporting field, in Hollywood, business or elsewhere.

But now our commercial property is joining the likes of Nicole Kidman, Rupert Murdoch and the Atlassian founders on the world stage.

At its recent AGM, Cromwell Property (ASX: CMW) CEO Paul Weightman noted 'that Australia now ranks as one of the world's largest destinations for commercial real estate investment with Sydney the fourth most popular global gateway city behind only London, New York and Paris when considering international flows.'

I admit to being a little surprised upon reading this and had to read it again to make sure I had done so correctly. 

Sydney, a city of four million people in a country of 24 million that produces a mere 2% of world GDP is the fourth most popular destination for commercial property investment on Earth. And Melbourne isn't too far behind.

The result of all these foreign inflows has been higher commercial property prices, helping capitalisation rates approach historical lows (all things being equal, capitalisation rates fall as prices rise).

Fundamentals poor

One driver has been the fall in the value of the Australian dollar against many other currencies recently, which has meant foreign investors need to fork out less Chinese Yuan or US dollars for Aussie hotels and office towers.

Another has been the yields on Australian commercial property, which are still higher than those in countries such as the United States or United Kingdom.

The still meaningful gap between the Australian ten year bond rate and capitalisation rates suggests the latter could decline further, especially if Australian long-term interest rates remain at low levels as the economy continues its slow transition away from the resources bust.  

But with long leases and rents that usually increase by fixed amounts each year making commercial property a 'bond equivalent', probably the most important driver of increasing commercial property prices has been very low long term interest rates. Low rates have also kept the cost of financing very low and are the result of extremely easy monetary policies pursued by the world's central banks.

Despite rising prices, however, the fundamentals remain poor, with moderate demand, supply generally increasing and effective rents (face rents less incentives) showing little improvement in most regions.

Check your assumptions

When investing – whether it's in commercial property, residential property or shares – it's always wise to check the assumptions underlying your investment case. If you do so and conclude that your assumptions are unreasonable and aggressive rather than realistic and conservative, then perhaps you are speculating rather than investing.

The assumption underlying much commercial property investment is that long term interest rates will remain low for many years, if not decades.

I don't know where long-term interest rates will be one, five or ten years for now, nor can I predict when (and even if) bond yields will return to more 'normal' levels. In fact, demand for quality commercial property with long leases and strong tenant covenants could well remain high for a while yet, as DEXUS's (ASX: DXS) proposed takeover of fellow office landlord Investa Office Fund (ASX: IOF) shows.

Yet ignoring fundamentals and justifying your investment in commercial property solely on the assumption that low long-term interest rates are here to stay strikes me as aggressive at the very least.

To me, those doing so are closer to being speculators than investors. I suggest they consider the consequences if this assumption turns out to be incorrect.

To get more insights, stock research and BUY recommendations, take a 15 day free trial of Intelligent Investor now.