Bank report grim reading for property

The shake-up of the commercial office market has some way to run, with a major investment bank tipping a big drop in rents.

The full negative financial impact of Perth’s commercial-office glut is shaping as a significant test of the local business community, with one leading investment bank tipping a 40 per cent fall in effective rents over the next few years.

JP Morgan, in a report written at the same time that Dan Wilkie was putting together last week’s excellent Business News cover story on the oversupply of office space, focused on stock-exchange listed property owners and how they will feel the pressure of a busted boom.

Singled out for special mention because of their exposure to Perth property were three big Sydney-based property owners – Dexus, Investa, and Mirvac.

None is likely to suffer in the short-term from falling Perth property values because most tenants are locked in to rental agreements; but as tenancies are renegotiated, there are likely to be hefty asset-value write-downs to reflect reduced rents.

What JP Morgan has done is analyse the full effect, over time, of falling rents and falling capital values to arrive at its grim forecast of a 40 per cent effective rent decline in the three years between 2013 and 2016. Here, effective-rent is defined as the ‘true rent’ after adjustments for incentives, concessions and other costs to the face rent, spread over the life of the lease.

When considering the views of JP Morgan as they apply to the three big property owners, valued on the ASX at a collective $15 billion (Dexus at $6.4 billion, Mirvac at $6.6 billion and Investa at $2.2 billion), it is important to consider what declining values mean for smaller property owners who might not have assets outside the Perth market to cushion the effects of the fall.

Those smaller owners will already be feeling the pressure as the banks apply debt-servicing tests amid concerns about their exposure to a falling Perth market.

If commercial banks arrive at the same conclusion as JP Morgan, then owners are likely be squeezed for extra capital to ‘comfort’ the banks as values decline closer to the value of loans, a situation that could be compounded should interest rates rise, hiking loan repayment commitments.

A secondary effect is that property owners thinking about developing their asset will have already mothballed those plans. They will not even get past first base at the bank.

As last week’s Business News cover feature pointed out, the end of the mine-building boom is the root cause of the slow-moving property crisis washing over Perth, just as it has many times in the past with an inevitable shake-out of ownership as overstretched owners depart and bargain hunters move in.

JP Morgan’s view of the Perth market, as seen through the three ASX-listed owners, is that a peak vacancy rate of 20 per cent is likely over the next few years, higher than the 17 per cent tipped by local market observers in last week’s Business News story.

The rising vacancy level is a direct result of mining companies and their contractors exiting the city in the aftermath of the resources boom, combined with the building boom about to flood the Perth market with new floor space, triggering a rush to secure tenants by cutting rents and offering fit-out incentives.

The speed of the exodus is alarming, with the forecast 20 per cent vacancy peak compared with a rate of 6.5 per cent just 18 months ago, and an estimated 13 per cent today.

“The contraction has been led by resources and engineering firms which have rationalised their office space,” JP Morgan said.

“We estimate that incentives (rent reductions) have increased from 10 per cent to 27 per cent and prime net effective rents have declined by around 25 per cent.”

JP Morgan said new supply of 167,000 square metres represented an 11 per cent increase in space, all due for completion by the end of next year.

“This will be the highest level of completion since 1991,” the investment bank said.

The combined effect of new building and the exodus of resource-sector workers is how JP Morgan arrives at its 40 per cent effective rent decline, adding the 20 per cent vacancy rate to a net effective rent decline to conclude that this will bring: “the total correction in effective rents to 40 per cent since 2013.”

If there is blue sky on the horizon it is a comment that, from 2016, the office vacancy rate would start to decline and rent incentives will normalise.

Until then, the Perth property sector will suffer the best part of two more tough years.

Running off track

EXPERIMENTS in trying to process low-grade magnetite iron ore into a high-grade finished product, and therefore cash-in on a price-premium for quality, appear to have run off the rails, with the pain of heavy iron ore discounting being felt as far away as China.

Until now, the primary criticism of the magnetite processors, such as Gindalbie and Sino Iron, has been about their big construction cost overruns and completion delays.

Apologists for the companies involved have tried to offset the critics by claiming that the finished, low-impurity product from iron ore upgrading will attract a price premium above that earned by conventional dig-and-deliver mines.

That claim has been weakened with the Tasmanian magnetite mine of Grange Resources suffering a 50 per cent fall in its ‘quality premium’ from $US38 a tonne to $US19/t in the June quarter.

Grange is not alone in being hit by falling prices, with news from China that Gindalbie’s majority shareholder, Angang Steel, is having a horror year that led to investment bank Citigroup tipping a 20 per cent profit fall, partly as a result of having to pay high prices for raw materials.

Citigroup has downgraded Angang to a ‘sell’, with the company’s share price expected to fall by 17 per cent over the next 12 months, putting it in the same boat as Gindalbie, its Australian subsidiary, which is trading at around 5.8 cents but has one big investment bank, UBS, saying it’s a ‘sell’ and has a 12-month price target of 2 cents.

London not calling

PERTH is not alone in entering a period of falling property prices. The London market, which featured in a mid-week comment on Business News in mid-June as a threat to the global financial system, has started its inevitable slowdown.

Up more than 60 per cent over the past five years, the London market is tipped by Deutsche Bank to stop rising before ‘potentially’ falling, thanks in part to the strength of the British currency making the city too expensive for foreign buyers.