Will retail property be the down turn ‘out performer’ again?

Overview: Commercial Property Outlook – Can Retail Property once again be the Relative ‘Out Performer’ in a Soft Property Period?

• Signs of slowing in the Commercial Property Sector have been evident for some time

The signs of slowing in the Commercial Property Sector have been emerging for some time. From a multi-year high of 10% year-on-year in the 1st half of 2013, Bi-Annual IPD Commercial Property Data showed a gradual slowdown in All Property Average Capital Growth per Square Metre to 3.5% by the 1st half of 2016. It must be emphasized that such estimates of capital growth are net of capital expenditure on properties.

The slowing in capital growth was broad-based, extending across all 3 of the major Commercial Property Sub-Segments. While all 3 segments showed slowing capital growth in the 1st half of 2016, Retail Property was still holding up best with growth of 5.3% year-on-year, Industrial and Warehouse Property in the middle with 3.5%, and Office Property the weakest with a negative rate of -0.9%.

Recent SARB (Reserve Bank) data, too, has pointed to weakening in the Commercial Property Market, with its estimate for the value of New Commercial Property Mortgage Loans Granted declining by -16.44% year-on-year in the 2nd quarter of 2016, the 2nd successive quarter of year-on-year decline.

• A slowing in the Commercial Property Sector is easily explained by the past few years of economic weakening and mild interest rate hiking

The slowing in various forms of growth in the Commercial Property Market of late is explained in part by a broad economic growth stagnation which started back around 2012. Following the massive global and local monetary and fiscal stimulus packages which lifted the economy out of its 2008/9 recession, South Africa’s GDP growth accelerated to peak at 3.3% in 2011. Since then, however, it has tapered all the way to an average of 0.3% year-on-year for the 1st half of 2016, the result of South Africa’s myriad of structural constraints, a global commodity price slump and a domestic drought to add to the pressures.

In addition, short term interest rates have risen by 200 basis points since January 2014, while Government Long Bond Yields have risen from a 6.9% average for May 2013 to 8.7% by November 2016.

Weakened growth, implying the prospect of higher vacancy rates, along with increased interest rates, have conspired to lift capitalization (cap) rates off their best levels.

• FNB forecasts are for slight improvement in overall economic conditions in 2017, but perhaps not yet enough to turn the Commercial Property Sector stronger just yet

FNB believes that interest rate hiking may be over for the time being. As the drought conditions look set to ease, domestic food prices could come off quite strongly, helping CPI inflation back into its target 3-6% range. That would end the need for further rate hiking for the time being, provided the Rand behaves reasonably well. Economic growth could also be given a mild boost to around 1% in 2017, as Agriculture picks up after the drought and slightly higher commodity prices begin to provide some additional support to especially the mining sector.

But slightly improved economic conditions may not yet turn the Commercial Property Sector stronger as early as next year.

This is due to certain leads and lags built into the economic cycle. “Mainstream” Retail Sales have seen growth beginning to slow more sharply only in recent months. This Retail, most relevant to shopping centre space demand, lags the cycle a little, unlike the more ‘leading” Vehicle Retail component. FNB thus projects further annual slowdown in real retail sales growth from a forecast 2.1% for 2016 to 0.7% in 2017, which could be expected to raise the average Retail Property Vacancy rate.

Our 1% overall economic growth forecast is also not expected to be sufficient just yet to lift Manufacturing Capacity Utilization or economy-wide inventory growth significantly, which would be required to boost Industrial and Warehouse Space demand.

And with regard to growth in demand for Office Space, the fortunes of the Finance, Real estate and Business Services Sector are crucial, though not its GDP growth but rather its employment growth. This sector lagged the recovery post-2009 and has also lagged in the economic slowdown since 2011. Unfortunately, therefore, it is expected that it will weaken further before turning the corner, and that during the forecast period there could be some job loss that could slow the demand for office space.

• 2017 expected to be another year of slowing in capital growth (net of capital expenditure)

Therefore, despite some expected turn in fortunes for the overall economy, FNB would still expect 2017 to be a slower year on the Commercial Property front than 2016.

• Retail Property expected to again be the “relative out performer” in a weaker property period, while Office and Industrial could see some capital depreciation (net of capital expenditure)

FNB’s econometric model-driven forecasts are for Retail Property Capital Growth to slow to 3.9% in 2017, which is low but positive. However, as was typical in the last 2 periods of market weakness, they project some capital depreciation (remembering that this data is net of capital expenditure) for both the Industrial and Office Property Sectors. These 2 sectors already showed significantly weaker capital growth than the Retail Property Sector in the 1st half of 2016, according to IPD bi-annual stats, and have typically performed weaker than Retail Property in the past 2 periods of market weakness.

From 1998 to 2003, Office Property experienced a capital depreciation per square metre of -16.2%. From 1998 to 2002, Industrial and Warehouse Property experienced a -20.7% capital depreciation. During the same weak property period, Retail Property managed to grow by low positive rates in each of those years, although certain sub-sectors of Retail Property did have some mild depreciation. In the very short-lived 2008/9 dip in the market, Office Property (-1.5% and Industrial Property (-0.2%) once again experienced slight capital depreciation while Retail Property (+1.2%) had very low positive capital growth.

• Some questions must admittedly be asked as to whether Retail Property can remain an “out performer” after 2 decades of “running the hardest” of the 3 main Commercial Property segments?

But whilst FNB once again forecasts Retail Property getting through the slow property period as the “out performer” relative to the other 2 sectors, admittedly there are some risks to such a projection. FNB says this, firstly, because Retail Property has run the hardest of all of the major property segments over the past 2 decades. Since 1995, Retail Property’s Capital Value per Square Metre (inclusive of Capex), according to IPD annual stats, has risen by a massive 770.7%. By comparison, Industrial Space has inflated by a lesser 466.7% and Office Space by 464.5%.

Even FNB’s estimates of cumulative house price inflation since 1995 haven’t kept pace with Retail Property values, despite having inflated by an impressive estimated 594.6% since 1995.

Some key further questions that has to be raised with regards to our projections of relative segment performances are:

1. How will online retail affect the way we shop and the extent to which we visit retail centres? Whereas Retail Property has been the best performing segment in previous periods of market weakness, could the additional challenge of online shopping change its position relative to Industrial and Office Property performance?

2. Within Retail Property, will the larger Regional Centres be the better performers in a downturn? Many smaller Neighbourhood Centres have received major ugrades, and have some strong brands as tenants. Will they compete better with Regionals in tougher economic times in future?

For the time being, though, early signs in IPD bi-annual data are once again that the Retail Property Sector’s capital growth is slowing a little less than the Industrial and Office Segments of late.

Read more here: FNB-Property-Barometer_Commercial_Property_Forecast_15_Nov_2016