Recapitalisation – why now?
A recapitalisation cycle is underway across the Australian commercial property sector. The drivers, in common with markets in other developed countries are financial and physical. What differentiates Australia is the structure of the financial and commercial property sectors, creating opportunities and imposing limitations.
Three long-term trends – a four-decade secular decline in interest rates; thirty years of sub-5% inflation; twenty years of stable value relativities between core real estate sectors (office, retail, industrial) – all appear to have decisively terminated. The shifts in interest rates and relative valuations that have accompanied the recovery from the COVID-19 pandemic challenge these three “certainties”.
The key financial driver is rising interest rates and a reassessment of capital costs, both debt and equity. At the same time a wide divergence in valuations has emerged between private and public commercial assets (such as REITs). In comparison with European and North American markets, in Australia commercial real estate debt (CRED) duration tends to be short. Residential mortgages are typically linked to floating rate instruments. So rising interest rates have an immediate impact.
The physical drivers of the recapitalisation cycle are changes to office working, travel and shopping habits as well as longer-term demographic shifts. This is driving a re-rating across real estate sub-sectors – the core office, retail and industrial markets, as well as a range of other non-core sub-sectors – hospitality, residential build-to-rent, data centres for example.
Even if policy interest rates are now at, or close to, cyclical peaks, effective interest rates paid by many borrowers will rise as loans mature. Asset values therefore are likely to remain under pressure. Alternative scenarios are explored in a recent research paper: Mind the Gap from Madigan Market Insights.
How will recapitalisation play out?
Traditionally Australia’s Big Four commercial banks have dominated the market, still accounting for around 70% of the domestic CRED market. This contrasts with total bank lending below around 50% (US) and 40% (UK). While the Australian banking sector is competitive, the major banks operate under identical domestic regulatory constraints and Basel III and IV rules. Indeed, competition between the banks, it might be argued, increases the correlation in their reactions to market shocks and asset exposures.
