Is There Blue Sky Ahead For Commercial Property Funding?

Is There Blue Sky Ahead For Commercial Property Funding?

A recent long-range market analysis by property construction and development financing house Development Finance Partners has highlighted key fundamentals that argue for a confident outlook for commercial property investment and lending in Australia for the next five years. In this article we explain these factors and focus on how investors and developers can best leverage the commercial property funding market.

Australian Commercial Property Investment – 5 Pillars of Confidence

Looking ahead to the medium term we see five definitive features on the property funding market’s landscape:

  1. 5 year fixed rates are under 5%
  2. Subdued international markets and low domestic cash rate returns are diverting demand to Australian commercial property
  3. Improved economic confidence post-federal election is being supported by relatively stable fundamentals
  4. Medium to long term Bill Swap rates are relatively flat, even out to 10 years
  5. Commercial property yields around 7% are presenting sustainable arbitrage opportunities

These factors indicate that the commercial property cycle (which has always been a cycle, something which most forgot by 2007) is once again on another blue-sky rise. They also make commercial property attractive for commercial property development project funders and developers.  But within the opportunity are some key challenges to understand and adapt around.
To understand the opportunity and challenges better we now focus on:

  1. What is underpinning these factors, and
  2. What this outlook means for both investors providing funding and developers seeking funding for property development and construction projects.

5 Year Fixed Rates Are Under 5%

One of the major banks has just announced a significant drop to their 5 year fixed rate home loan, now matching another’s at only 4.99%.
Apart from sounding cheap, what does this really mean? Even fixed rate home loans are a result of supply & demand in the wholesale market – they are not in any way set by the RBA’s decisions.  As a result, they are generally a good indication of what the wholesale market believes is going to happen in the future, which would lead you to believe that there is not likely to be any increase in the RBA’s cash rate in the foreseeable future. In fact, the wholesale market is currently pricing in a 60% probability of a 0.25% cut by early 2015.

Subdued International Markets And Low Domestic Cash Rate Returns Are Diverting Demand To Australian Commercial Property

International Markets Are Seeking Australian Property Projects To Fund

Overseas markets remain subdued and are unlikely to improve dramatically in the near future, so foreign investors are looking for comparatively stronger returns on their money, which are available from Australian property funding and investment.
At Development Finance Partners we are seeing an increasing level of interest from offshore funders and investors seeking to place their money in Australian property construction and development projects.

Domestic Cash Rates Provide Comparatively Poor Returns

Secondly, as cash rates with banks for term deposits are getting pushed down to levels that represent very poor investments, investors are and will increasingly look for greater returns from investments that are still relatively safe.
As aforementioned, Development Finance Partners is seeing a significant increase in demand from its non-Bank lenders – particularly including investment grade off-shore and local Funds – looking for high quality property projects and sponsors to lend to and invest in as silent equity.

Improved Economic Confidence Post-Federal Election Is Supported By Stable Fundamentals

The old belief that “a Liberal government always improves the economy” gave confidence a shot in the arm immediately after the election. However since then consumer spending and housing has lost some momentum, the former being blamed on the tough Federal Budget.
Whilst unemployment is continuing to increase slightly (though remains low relative to international benchmarks), as long as this continues it would be very difficult for the RBA to increase the cash rate.

Medium To Long Term Bill Swap Rates Are Relatively Flat, Even Out To 10 Years

The wholesale market for Bill Swaps is sharing the view seen in the 5 year fixed rate market, with the 1 year swap currently being slightly less than the 90 days’ 2.64%, 2 year the same, whilst even the 5 year is only about half a percent more. In fact, even the 10-year swap is only 1.11% higher than floating; at what is really a bargain basement price of 3.75%.
As an example of how cheap money is at the moment, Westpac is forecasting that the 3 year swap will be up to 4.3% by September next year – fixed rates have historically always shot up very quickly a fair amount of time before the floating rates start moving up, so their forecast is not unreasonable.

Commercial Property Yields Around 7% Are Presenting Sustainable Arbitrage Opportunities

These factors make commercial properties a highly attractive investment. If a property is returning a net yield of say 7%, you can lock in a 5 year rate with a bank for around 4.5%, so with a secure lease profile you have got a great arbitrage for a long term – in fact, geared to 70%, your Return on Equity would be nearly 13%pa in year 1, or even with no capital growth and annual rent increases of 2.5%, IRR would be nearly 15%.
The question of capital growth has to rear its head here though – with interest rates being sustained at such low levels, the question continues to be asked, “when will yield compression really kick in?” as far more investors (including institutions) put their money into commercial property to get such strong returns with relatively safe risk.

What This Means for the Commercial Property Fund Market

Blue Sky Ahead For Commercial Property FundingDevelopment Finance Partners believe that the current scenario presents a rare opportunity to secure long-term capital at very low cost. To leverage this situation requires an optimisation of risk for both the funds provider and developer and an appreciation of future property development fund supply dynamics.

The Importance of Risk Assessment And Mitigation to Property Development Funding

The property construction and development funding market competes on risk. As a result, a pragmatic approach to risk assessment and mitigation to protect capital can result in strong returns and lower funding costs.
Here’s an example to highlight the benefits of such an approach:
Development Finance Partners recently re-structured and placed an $11.5m facility to fund the acquisition of a DA-pending property for 117 units. The result represented an LVR of 92% of the purchase price and 67% of valuation (noting that all banks would only ever lend on the former).

Bank Liquidity May Tighten Property Funding Supply

With Basel III having kicked in for the Australian Banks in February 2014, to be fully implemented by 2016, there is a possibility that their increased requirement for capital, combined with unacceptably low deposit rates, may lead to another “fight for deposits” at some stage in the future, bringing back Bank liquidity issues for developers and commercial property investors.
Furthermore, if the residential property market gets to a point where the regulator believes there is an “asset bubble”, Basel III allows them to increase regulatory minima, which would further exacerbate liquidity to developers and investors.

Optimising Risk Profile and Internal Rate of Return on Property Investment

Development Finance Partners has significant experience and capability in structuring and negotiating debt and equity to achieve optimum IRR for property development and construction projects, on project and portfolio sizes from $2m to over $300m.
Combined with a fundamental pragmatic approach to property funding risk assessment and mitigation of each property/project and a group portfolio strategy, Development Finance Partners are well placed to partner with you to achieve your long-term success.

Want to Discuss this Further?

Contact Development Finance Partners on 02 9976 5272 or click here.

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