The Australian commercial property market has experienced significant fluctuations in recent years, prompting many to ask: are we at the bottom of the market? 

During the pandemic period of 2019 to 2022, historically low interest rates spurred investment in commercial property, leading to rapid yield reductions across both traditional and alternative investment types.

This occurred despite less-than-optimal occupancy and demand fundamentals for some asset classes. The value proposition remained compelling for investors across all price points, with the spread between the cash rate and yield reaching up to 500 basis points.

Faced with sub-1 per cent bond rates, investors moved swiftly in these property investments, resulting in declining yields and record-breaking commercial property investment in 2021/22.

However, the landscape changed dramatically from mid-2022 as interest rates began to rise rapidly. This, combined with the previous yield compression, significantly narrowed the acceptable spread between finance costs and capitalisation rates.

The industrial sector was most affected, as its strong fundamentals had kept capital growth positive and yields relatively low despite these changing interest rates. In contrast, the office market saw a more substantial yield turnaround due to high vacancies, while retail fundamentals improved with population growth keeping yields more competitive.

Consequently, the yield spread to the cash rate has plummeted to between 50 and 150 basis points, reminiscent of levels seen during the Global Financial Crisis. This range is well below the historical yield spread averages of 280 to 350 basis points, depending on the asset class, indicating that further market adjustments are necessary.

While interest rates are expected to decrease, particularly following the latest CPI results (3.5 per cent in July 2024), bringing Australia closer to the optimal 2 to 3 per cent band, capitalisation rates will likely need to continue their upward correction. This adjustment is necessary to bring the spread back to a comfortable level above 250 basis points for many investors.

As of June 2024, average Australian prime yields stand at 5.4 per cent for industrial, 5.9 per cent for office, and 5.7 per cent for retail properties. These rates have increased by up to 150 basis points from the market peak, resulting in capital value corrections. However, it's likely that capitalisation rates will face continued pressure to restore the spread to investable levels.

It's important to note that all asset classes are currently experiencing negative capital growth. However, growing income returns, particularly in the industrial and retail sectors, are helping to maintain positive total returns. These positive income results may soften the impact of continued yield corrections in the current market.

Looking forward, expected interest rate improvements in late 2024 and into 2025 will contribute to moving the spread back to acceptable levels. However, we cannot definitively say we are at the bottom of the market yet.

Quality assets with strong returns or future development potential will continue to exert downward pressure on yields in an upward moving environment.

While we may be approaching the bottom of the market, the current landscape presents both challenges and opportunities. Despite the overall downturn, astute investors can find promising prospects, particularly in high-quality assets and properties with future growth or development potential.

This period of market correction, though difficult, opens doors for savvy buyers to acquire assets at more favourable yields. Those who can identify longer term opportunities or untapped potential in existing assets may be well-positioned to benefit.

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