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Commercial property markets expected to be weaker in 2023 than in 2022

A broader weaker property market is anticipated for 2023, when compared to 2022, according to FNB Commercial Property Finance. With consumer price inflation slowing, the bank believes that interest rates are near their peak, but the full impact of rate hikes has yet to be felt.

Here are the key themes that the industry needs to look out for:

A slower economic growth rate in 2023 could cause a renewed rise in the All Property Vacancy Rate

The MSCI Bi-Annual All Commercial Property Vacancy Rate was on a broad multi-year rising trend, from a low of 4.2% as at the first half of 2016 to 9.5% by the first half of 2021. A rebound in the economy during 2021, following the hard lockdown recession of 2020, led to some minor decline in this vacancy rate to 8.2% by the first half of 2022.

However, a renewed increase in economic pressure may once again place additional constraints on commercial space demand this year, in turn causing the national vacancy rate to resume the earlier rising trend.

FNB projects Gross Domestic Product (GDP), the measure of economy-wide production or output, to grow by 1.2% in 2023, following an estimated 2.3% in 2022. This slower growth forecast is expected as a result of a slower global economy impacting on SA’s trade-related production for the rest of the world, the lagged impact of a recent series of interest rate hikes to still feed through, and the escalation of load shedding.

The bank predicts a further 50 basis point interest rate hike during January 2023, bringing interest rates to their peak with prime rate reaching 11%.

The end of rising interest rates would ease one source of upward pressure on capitalisation rates, but weaker property income prospects may sustain the slow upward drift in 2023

While the expected end to interest rate hiking may ease one source of upward pressure on property capitalisation rates, another source may intensify: weaker property income growth prospects.

Financial pressure on SA’s commercial tenants is expected to increase, driven by slower economic growth this year, and a higher average interest rate on debt compared to 2022.

In addition, operating cost inflation faces upward pressure from the next severe electricity tariff hike while many businesses may have to incur further costs to ensure a reliable electricity supply.

From a decade low monthly average of 6.9% in May 2013, the monthly average government long bond yield (ten years and longer) ended 2022 4.5 percentage points higher at an average of 11.38% for December. This broad rise in these longer-term interest rates has been a key influence on capitalisation rates too, driven higher by long-term deterioration in government finance, government debt issues rising sharply over the past decade with few noticeable improvements expected in 2023 as slower economic growth likely constrains government revenue growth.

FNB expects the continuation of the gradual multi-year upward drift in capitalisation rates throughout 2023.

During the multi-year commercial property valuations correction, which commenced mid-last decade, the average regional shopping centre capitalisation rate has risen from a 7.5% low during the first quarter of 2015 to 9.3% in the final quarter of 2022, according to Rode and Associates.

The average prime industrial capitalisation rate rose from 8.9% to 9.9% over the same period (Rode and Associates) and National A-grade decentralised office capitalisation rates from 9.3% during the third quarter of 2015 to 11.3% by the end of 2022. Capitalisation rates have drifted significantly higher since multi-year lows reached around 2015 and the bank does not expect a reversal of this broad trend.

Average capital value per square metre of commercial property expected to shift back into slower nominal growth but ‘real’ (inflation-adjusted) decline

MSCI data for the first half of 2022 showed the first noticeable ‘real’ (GDP inflation adjusted) year-on-year growth rate in the All-Property Capital Value/Square Metre since the second half of 2015. In actual value terms, there have been quite a few semesters with low positive single-digit growth in average capital value, but this has rarely kept pace with general economy-wide inflation since 2015, translating into a correction in average commercial property values in real inflation adjusted terms.

FNB does not believe that the long-term correction is over in SA but that the positive real growth rate of 3.9% (GDP inflation adjusted) and 8.4% year-on-year growth in actual value terms, was likely a result of valuations coming off a low base caused by the severe 2020 lockdown-related recession and valuations merely ‘normalising’ as the economy opened to business once more.

Given the economic slowdown and rising interest rates since late 2021, it is expected that capital value growth will once more slow into single digit territory in 2023, not keeping pace with general inflation, and the real long-term valuations correction will once again resume.

How far are we into the multi-year correction in real property values?

Compared with the first half of 2018 high, average capital value per square meter was only -2% lower as at the first half of 2022, having made up a significant portion of its lockdown drop, according to MSCI.

But 2016 was when the correction started, in a lagged response to stagnating economic growth since 2012. While actual (nominal) valuations were not yet declining, 11 out of the 13 semesters from 2016 to the first half of 2022 have shown real (GDP inflation adjusted) declines in average values when compared with the preceding semester and while actual valuations have dropped far less, in real terms, the cumulative decline in the MSCI All Property Average Capital Value has been a significant -27.2% from the first half of 2016 to the first half of 2022.

All three major commercial property markets are expected to be weaker in 2023, compared to 2022

The office market is expected to remain the underperformer with its already high national vacancy rate of 18.5% (according to MSCI data) as at the first half of 2022. It is also expected to see its national vacancy rate continue to rise in 2023, with little to drive any significant growth in demand for space in the near term.

While a portion of the office workforce has returned, FNB believes that this level of attendance does not appear to have gone back to the same levels as before the lockdowns, and as technology continues to improve, so the multi-decade trend towards greater remote work levels will likely resume.

People also often overlook two other sources of pressure on demand for office space; the first is the normal ’weak economy’ effect which caused a major drop in employment numbers in the office-bound sectors of the economy – even without any increase in remote work, there are less employees in these services sectors, which would normally imply less office space needed. Employment numbers in the Finance, Real Estate and Business Services Sector, a key driver of office space demand, was still -3.7% below the first quarter of 2020 level as at the third quarter of 2022.

In addition, the trend towards improved utilisation of desk space seems to have picked up, with ‘hotelling’ of desk space increasing in popularity. ‘Hotelling’ refers to a desk booking system, something FNB has also implemented, meaning that employees either book a desk for a day or they don’t have one.

The retail property environment is also expected to be more challenging in 2023. While consumer price inflation may gradually slow, eating less into household disposable income growth as the year goes on, the average interest rate on household debt is projected to be significantly higher in 2023 for the year as a whole, compared to 2022. FNB anticipates a further 50 basis point rate hike in January, bringing the current rate hiking cycle to an end, whereafter it expects only one 50 basis point reduction later in the year. This implies that the year will end on a prime rate of 10.5%, where it currently stands now.

Slower economic growth in 2023 will also likely translate into slower employment growth, and real household sector disposable income growth is forecast to slow from a positive 0.8% in 2022 to a negative -0.2% in 2023.

Industrial property has the most going for it in 2023, but its main economic drivers are still under pressure. FNB expects the industrial property market to remain the relative outperformer of the major commercial property classes. It is the most affordable of the three and arguably the most adaptable, and this puts it at a relative advantage when the economy is under financial pressure, although it can’t entirely avoid the current economic pressures.

In addition, it appears set to benefit relatively speaking in the coming years from increased online retail focus. However, in 2022 the FNB Property Broker Surveys did point to signs that demand for this property class may have also been peaking for the time being, rising interest rates and a weakening economy also taking its toll.

Real seasonally adjusted Manufacturing Gross Value Added (GVA), a key driver of industrial space demand, was still -9.3% below its end-2018 high and had only shown growth of 0.3% year-on-year for the first three quarters of 2022. Economy-wide inventory levels have also declined significantly in recent years, so the traditional economic fundamentals related to industrial property are not overly strong.

The residential rental market may be peak in 2023. TPN data had seen a reasonable recovery (decline) in the national residential vacancy rate estimate from just after the 2020 lockdown to mid-2021 and the CPI for actual residential rentals saw its year-on-year rate of inflation go from a lowly +0.61% as at March 2021 to 2.82% by the September 2022 CPI survey.

TPN also reported a significant recovery in tenant payment performance following the 2020 lockdown dip.

However, while rising interest rates can initially strengthen a rental market, as aspirant home buyers delay purchases and rent for longer in some cases, ultimately the rising interest rates and a slowing economy can begin to exert financial pressure on rental tenants. After a very significant 350 basis points’ worth of interest rate hikes to date, and a further 50 basis points still expected, such renewed pressure may have begun, and the December CPI rental survey actually showed a slightly slower rental inflation rate of 2.5% year-on-year (from 2.82% in the prior survey). This was due to a slowing in the rental inflation rates on houses and townhouses, with only the smallest and most affordable flats component still showing a further acceleration in inflation.

FNB believes it is possible that the mild post-lockdown residential rental market recovery may have run its course and this market may ‘level out’ in 2023 as interest rates hit their expected peak and then start to decline mildly late in the year.

The residential development market to have a slower 2023. Higher interest rates have gone some way to cooling home buyer demand, and with a lag this normally translates into slower newly developed home demand as the existing home market becomes better supplied.

Residential building plans passed, a lead indicator of building activity to come, saw a -6.4% year-on-year decline in the third quarter of 2022, after a bout of solid positive growth in prior quarters. It appears that building planning has already begun to slow in response to interest rate hiking, and this points to a slower 2023 on the new residential building front.

Only late in 2023, should FNB’s forecast for the start of mild interest rate cutting prove true, could we see renewed strengthening in home buying demand followed by newly built home demand, but that would more likely translate