More property pain predicted as rising debt costs take toll

Rising interest rates are dramatically shifting the landscape for commercial as well as residential property, with higher debt costs slamming into both sectors.

Commercial property deal-making at the big end has almost ground to a halt, with buyers ­either demanding discounts on agreed deals or unable to secure debt to complete transactions. Picture: NCA NewsWire / Jeremy Piper

Rising interest rates are dramatically shifting the landscape for commercial as well as residential property, with higher debt costs slamming into both sectors.

The most vulnerable groups are highly leveraged developers exposed to the disruptions in building supply chains and residential property buyers who have loaded up with debt to buy just as the property cycle peaked.

The collapse of Melbourne-based property developer Caydon and job cuts at home builder Metricon reflect the strain across the sector.

Commercial property deal-making at the big end has almost ground to a halt, with buyers ­either demanding discounts on agreed deals or unable to secure debt to complete transactions.

This week’s warning sounded by the Centuria Office Fund about the impact of higher interest rates has rattled investors in the listed market who are nervous about the implications of higher debt costs for real estate investment trusts.

The issue for direct investors and the sharemarket is uncertainty about real estate asset values in a rising rate environment, with problems not likely to show up until later this year.

“It sets the tone for the rest of the reporting season as everyone is looking at the downside,” one investment manager said. “No one knows the bond rate and the real value of assets.”

Jefferies analyst Sholto Maconochie said A-REITs were pricing in the expansion of capitalisation rates, with the sector being hit by higher than expected inflation and rates rises.

Monetary conditions were tightening, with A-REITs trading at a 15 per cent discount to net tangible assets, implying asset value declines of 10-20 per cent, he said.

Jefferies expects capitalisation rates to expand by 30-50 basis points over the next six to nine months, with the secondary office market to be the most affected.

Major investment house Resolution Capital warned that Australian REITs were exposed due to poor capital management because of their debt structure and the Reserve Bank’s “woeful misreading of the economic picture”.

Resolution said Australia lacked a deep corporate debt market that would enable A-REITs to “borrow long”.

Larger A-REITs can access the US private placement market, but it said they had instead favoured lower-cost, short-term local debt, partly influenced by the RBA’s guidance that it did not expect rates to increase until at least 2024.

A-REITs now have a relatively high exposure to floating rate debt and short-term fixed rates and interest rate hedge maturities.

“We expect A-REIT earnings growth will be significantly eroded in the next 12-36 months, in some cases earnings per share will be negative – much depending on the dynamics of the economy and rent profiles,” Resolution said.

The Centuria Office REIT is down almost 13 per cent despite reporting a 50 per cent profit jump as it navigated the pandemic. The fund trimmed its guidance citing higher interest rates.

“We recognise that a rising interest rate environment creates some future uncertainty, but we remain optimistic for Australian office markets,” fund manager Grant Nichols.

The residential outlook is also clouded by rising rates.

PropTrack senior economist Eleanor Creagh said Tuesday’s lift in the cash rate was widely expected given the RBA had signalled a desire to “get ahead of the curve” and the bank board was committed to “doing what is necessary” to overcome high inflation.

“To ensure inflation expectations remain anchored around their 2-3 per cent target, the board is expected to continue to frontload their hiking cycle,” Ms Creagh said.

She said how household spending held up against a backdrop of higher inflation and falling house prices versus savings and wealth buffers, and hopefully stronger wages growth, would be crucial in determining the cash rate, and how far house prices fell.

“As interest rates have risen, housing market conditions have moderated, and this is likely to continue as interest rates continue to rise,” she said.

“Current market conditions have cooled as buyer confidence has waned, and auction volumes and clearance rates have fallen, sales volumes have slipped, and home prices are falling.”

The PropTrack Home Price Index showed a national decline of 1.66 per cent in prices since March, and as repayments become more expensive with rising rates, housing affordability would decline, pushing prices further down. “For sellers, it’s time to reset price expectations,” Ms Creagh said.

AMP Capital head of investment strategy and chief economist Shane Oliver, warned that many households would see significant mortgage stress with a 3 per cent or more rise in interest rates, with an estimated 1.3 million households affected.

Combined with falling real wages he warned this could have a “huge impact on spending in the economy and risk a significant rise in forced property sales”.

“Coming at a time when home prices are already falling rapidly due the impact of rising rates on homebuyer demand it will only add to home price falls, which will weigh further on consumer spending,” Dr Oliver said.

CommSec chief economist Craig James said the central bank had made the most aggressive interest rate moves in 28 years by lifting the cash rate by 50 basis points for an unprecedented third straight month up to 1.85 per cent.

“This also represents the most aggressive monetary policy action since 1994,” he said.

Mr James said the housing market had “quickly responded” to higher interest rates. ”Since rates started to rise, Sydney prices have slowed by the most in 40 years. Outright falls in home prices will become common across the country in the next few months,” he said.

HSBC chief economist Paul Bloxham said the RBA tends not to increase its cash rate when the unemployment rate is rising.

“In our view, the cooling housing market, weakening consumer spending and global downturn are set to worsen in the next few months, which we expect will see the RBA pivot to smaller hikes from here before stopping in November, as the local labour market turns and inflation peaks,” he said.