THE REAL ESTATE CARNIVAL GAME OF SKILL

Transcription

1 MACQUARIE REAL ESTATE REAL ESTATE MARKET OUTLOOK 2007 THE REAL ESTATE CARNIVAL GAME OF SKILL

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3 2 FOREWORD WELCOME TO THE 2007 MACQUARIE REAL ESTATE MARKET OUTLOOK (REMO). This year, the carnival theme reflects exciting trends in most markets around the world. The global economy is in an exceptional cycle. We re forecasting a fifth consecutive year of steady growth, the strongest since the early 1970s. While residential on the east coast of Australia and across the US has been tougher, there is plenty to celebrate in other markets. With global conditions providing plenty of momentum for real estate markets, record amounts of money are being invested. There appears to be no end in sight to high levels of liquidity. This means opportunities here and abroad. Of course carnivals don t last forever. Investors need to be selective, which is why Macquarie partners with clients around the world. We offer our partners a great international track record, local expertise and excellent global research over numerous cycles. This year s REMO provides a summary of the big picture with predictions on where key markets are heading. As our business has expanded globally, our insight and experience have grown. It s now challenging to encompass the scope of our business in a single report, once a year. Our focus in REMO is now on key themes in Macquarie s main global markets. More specific research will continue to be available throughout the year from the research and client teams. gwe trust you will find value in this year s report. Stephen Girdis Global Head Macquarie Real Estate

4 24 AUSTRALIA

5 ECONOMIC OUTLOOK Triple Treat The Australian economy is currently being driven by three incredibly supportive structural factors. First, the ongoing surge in commodity prices and the resultant strength of the resources sector have unleashed a surge in business investment and the demand for infrastructure. Combined with State governments who are intent on ramping up public infrastructure, this has ensured that non-residential construction activity has been incredibly strong. Second, the ongoing surge in global liquidity has kept a lid on Australian interest rates, ensured that demand for Australian products remains healthy and has resulted in vibrant asset markets, like the equity market. Third, employment growth has been exceptionally strong which has ensured that overall confidence among householders has been robust. It is important to note, however, that the strength of the labour market does not simply reflect strong labour demand which can tend to boost wages growth and inflationary pressures. In recent years, much of the strength of employment growth reflects rising labour supply. The strong growth in the supply of labour is reflected in the rise in the participation rate and reflects two developments. First, it has been underpinned by very strong overseas migration which has been concentrated on skilled workers. Second, it reflects the impact of the baby boomers, who unlike previous generations, are remaining in the workforce in large numbers as they approach retirement age. Interest rates remain key With these strong foundations, the overall economy has remained in good shape, recording remarkably consistent though unspectacular growth. The main reason why growth hasn t been even more impressive is that housing activity has been weighed down by rising interest rates and the Reserve Bank of Australia s (RBA) ongoing threat to raise interest rates further. The steady increase in interest rates has deterred investment in the housing market and limited the ability of potential first-home buyers to enter the housing market. At the same time, the fact that Australia s level of interest rates remains much higher than comparable economies in Asia, Europe and North America has (together with the strength of commodity prices) underpinned a strong rise in the Australian dollar which has risen to its highest levels since the 1980s. This, in turn, has undermined the competitiveness of the manufacturing sector and acted as a brake on growth. As long as these benign structural factors persist, then the economy should also continue to remain healthy. And we don t envision any disruption to this pattern in the next few years. However, with the unemployment rate likely to remain low, the RBA will remain vigilant about the risk of wage and inflationary pressures developing. For that reason, they are likely to retain their ongoing tightening bias. State of play This pattern of growth is also being reflected in stark differences in regional performance. The outperformance of Western Australia, Queensland and the Northern Territory in recent years was clearly triggered by the resources boom. However, the resultant strength in employment growth and demand for housing was also a crucial factor in explaining this performance. While activity in Queensland should remain strong, the decline in housing affordability in Perth should reduce the incentive for migration to Western Australia and hence the demand for housing. This should result in activity in Western Australia slowing towards the national average. While growth in Victoria, South Australia and Tasmania has not benefited as much from the resources boom, they have enjoyed strong employment growth due to healthy migration flows and that should ensure that activity remains solid. In New South Wales, the economy grew 3. over the year to March 2007, as it moves more in line with the national average. With stronger state net migration, this should result in more retail spending and stronger housing demand. Richard Gibbs Head of Economics Macquarie Research Economics MACROECONOMIC INDICATORS (annual change %) GDP Growth (a) 2007 (f) 2008 (f) (f) World US Australia Consumer Inflation World US Australia AUSTRALIAN CONSTRUCTION INDICATORS (annual change %) Housing construction investment Non-residential construction investment AUSTRALIAN EMPLOYMENT INDICATORS (annual change %) Total employment Unemployment rate (%) Household disposable income FINANCIAL INDICATORS (annual average) Australia Cash rate (%) Australia 10 year bonds (%) US Fed Funds (%) US 10 year bonds (%) A$/US$ Source: Macquarie Research Economics REAL ESTATE MARKET OUTLOOK 2007

6 26 Residential NOT THE FASTEST RIDE IN TOWN YET OVERVIEW This year marks the stabilisation phase of the east coast market, which usually kicks in after a slowdown. Only parts of residential have come to the party, but the invitation is out there for the rest of the sector to join in. Housing cycles typically follow a similar pattern after a strong upswing. Post upswing, there are around two and a half years of a downturn followed by a stabilisation phase, with another two to three years of flat to moderate growth as affordability rebalances. This time, the east coast downturn/slowdown has lasted more than three years, largely because for the first time, rates were increased as the construction and pricing cycles continued to slow. Metropolitan Sydney, some regional centre lifestyle markets, the inner-city apartment sector and outer suburbs of Melbourne experienced a downturn in prices. In terms of median prices, Sydney spoilt the party by being the only capital city to fall. A number of factors are pointing to a stabilisation phase on the east coast, including the narrowing of the east/west divide, a fairly benign outlook for interest rates, the strongest inward migration into New South Wales in five years, the under-supply of new dwelling construction relative to underlying demand (particularly in Sydney) and the continuing improvement in yields as rents rise faster than prices. The east coast should move to the next phase of a long cycle with the upper end of the market still outperforming. Looking ahead, we expect a pick-up in demand to underpin moderate price rises in Melbourne with stronger growth in inner areas. In Brisbane, our models point to price growth at moderate levels. A stabilisation phase in Sydney is likely, particularly in inner-ring suburbs, although subdued confidence will continue to dampen the party in outer regions. For east coast developers, this is the time to get ready to assess infill sites for the next cycle with future development opportunities. Prior to that phase, we project price growth to be relatively moderate, although sales volumes should improve. Volumes are linked to interest rates and population growth, particularly migration. In the carnival-loving west, where Perth house prices rose 4 in the year to September 2006, the rate of quarterly growth has now eased. Sales volumes have dropped sharply because of weaker investor demand. Last year, we said Perth was overshooting our models, but we believed the momentum would keep prices rising for longer. This is what happened. Prices went up another 2 before the tail end of last year when they started to slow. Perth is just about the dearest ticket in town. For the first time, it is less affordable than Melbourne, Brisbane and Canberra and on par with Sydney. In Perth, the forecast is for slower conditions. The big factor for the west is deteriorating affordability. The situation is similar to Brisbane in 2003 where prices were rising at 43% a year. When affordability crossed over, price growth slowed to in Similar to Sydney in the downturn, Perth's upper end is likely to swim against the tide and experience stronger demand than the traditional heartland (including first-home buyers) which will be affected more negatively by over-stretched affordability. As such, the performance of Perth's residential market is likely to be quite differentiated between these segments of the market. KEY VISIONS FROM THE CRYSTAL BALL Macquarie Real Estate s models predict house price growth 18 months ahead, using leading indicators. Investor demand is starting to pick up but is likely to be subdued, relative to peak levels, around the country for some time. We expect moderately increasing owner-occupier demand, first for established properties, then for new housing. 1. All markets will be supported in the next 12 to 18 months by improving economic conditions, a relatively moderate interest rate forecast, healthy wages growth and high levels of net overseas migration. 2. Perth, however, has experienced a deterioration in affordability to levels not seen before. High construction as projects are completed in the next one to two years will temper still solid economic growth. 3. With the exception of Perth, low levels of approvals for new construction in the last 24 months will apply upward pressure on prices in scarce locations in the next 12 to 18 months. 4. Melbourne to outperform most capital city markets. Underlying demand is solid due to strongest inward migration in more than 20 years, and affordability in Melbourne is more favourable than Sydney, Brisbane and Perth. 5. Brisbane will continue to see a stabilisation in the recent slowdown in its inward migration from other states, which is in part due to the closing of the gap of its relative affordability to other east coast centres and the state s economic performance relative to New South Wales and Victoria. 6. Economic growth in Perth is rapid and inward migration has been strong, but affordability is a major problem and prices have overshot considerably in the last two years. We believe the market will experience flat prices (or slightly negative as in the case of Sydney in recent times) for a number of years. We do not expect a massive crash, as all other key economic fundamentals remain in place. However, overbuilding in the last one to two years could be a drag on prices.

7 27 7. In Perth, the outer areas will be most affected by the slowdown. The least impact will be felt in the inner (including Golden Triangle) and coastal suburbs. 8. In Sydney, moderate growth will be limited to inner and some middle-ring suburbs. In the outer suburbs, particularly in the west and south-west, there are signs that the labour market is stabilising and the fundamentals affecting the region, such as the underlying demand for housing, are becoming more supportive. The worst signs - from forced sales to higher unemployment - may be over. 9. Key risks in the outlook include a sudden pick-up in inflation and therefore interest rate rises before the end of This is a bigger risk for markets such as Sydney and Perth where affordability is tough. DRIVERS Affordability The Macquarie Real Estate Affordability Index is a measure of affordability which considers the portion of wages it takes to meet mortgage payments, based on the purchase of a median-priced house with a loan-to-value ratio of 75%. We also factor in the increase in the proportion of dual income house purchasers in the last 25 years. Alongside our house price models, our affordability measure is important in helping us to determine when to get in and out of markets and also to determine the relationship between capital city markets in Australia. In every capital city, except Perth, housing affordability is nowhere near the dire levels of the late 1980s when it took 58% of wages to meet mortgage payments in Sydney. Factoring in the interest rate increases in 2006, it now takes 39% of wages. We do not use the simplistic commonly used measure that compares house prices with wages. Our view is that this does not reflect the sometimes dramatic impact of varying interest rate environments in different periods. It is really a measure of how long it takes to pay off a home but does not factor in mortgage/interest payments. For example, when it took 58% of wages to meet mortgage payments in Sydney in 1989, far less of wages met principle payments than the current situation. Additionally, household structure has changed significantly in the last 25 years which means that average household income does not necessarily reflect the income of a typical first home buyer household. The average household in Australia has aged and is now smaller in size, while at the same time the number of dual-income first home buyer households has increased. In the late 1980s, average household income overstated first home buyer income and now is understating. Also, using an Australia wide measure fails to take into account the varying incomes between states. Interest rates House prices have a strong inverse relationship to interest rates. Macquarie Research Economics believes there is the potential for a rate rise in Before it occurs, there will be a long period of flat rates so the residential stabilisation phase should be strongly entrenched. Previous rate rises on the east coast have struck when the market was more vulnerable. The longer interest rates remain on hold and the stabilisation phase continues, the less impact an interest rate rise has, because some of the imbalances in the market will be corrected. Macquarie Real Estate Sydney house price model Source: Macquarie Real Estate Research, APM, Bloomberg LP, RBA, ASX, REIA 8 % ch. p.a Sydney house prices % ch. p.a. Macquarie Real Estate Sydney house price model 5 % ch. p.a Forecast Macquarie Real Estate Melbourne house price model Source: Macquarie Real Estate Research, APM, Bloomberg LP, RBA, ASX, REIA Melbourne house prices % ch. p.a. Macquarie Real Estate Melbourne house price model Forecast Flat conditions should encourage some improvement in sales on the east coast, but without the significant cut in interest rates that normally triggers the next phase of development, any upswing will be more subdued than previously. This is the first time that construction has fallen to such low levels on the east coast, particularly in New South Wales, yet rates have climbed. Every other time, prices and approvals have fallen, rates have also dropped. Macquarie Real Estate Brisbane house price model Source: Macquarie Real Estate Research, APM, Bloomberg LP, RBA, ASX, REIA 5 % ch. p.a Brisbane house prices % ch. p.a. Macquarie Real Estate Brisbane house price model Perth house price growth closely tracks changes in commodity prices Source: Macquarie Real Estate Research, APM, ABS Forecast Perth house prices % ch. p.a. (LHS) Commodity price index - base metals % ch. p.a. (RHS) Housing affordability Source: Macquarie Real Estate Research, APM, REIA, ABS, RBA Mortgage payments as % of wages (adjusted to account for the proportion of dual income households with a mortgage). LVR of 75% Adelaide Melbourne Sydney Brisbane Perth REAL ESTATE MARKET OUTLOOK 2007

8 28 Net Interstate and overseas migration Source: Macquarie Real Estate Research, ABS 75,000 person, moving annual 55,000 35,000 15,000-5,000-25, The shift from Sydney to South East Queensland has slowed significantly Source: Macquarie Real Estate Research, ABS, REIA, APM 35% % ch. p.a. persons 60,000 Migration leads by 15 months from % 50,000 40,000 15% 5% 30,000 20,000 10,000-5% 0-15% -10, Sydney house prices % ch. p.a. (LHS) NSW net interstate & overseas migration (RHS) For the first time mortgage rates have risen in a downturn Source: Macquarie Real Estate Research, ABS, RBA 18,000 15,000 12,000 South Australia Victoria New South Wales 9,000 Queensland Western Australia Qtrly number % ch. p.a. 4 Approvals lead by nine months 2 6, NSW quarterly building approvals (LHS) Australian mortgage rate % ch. p.a. (RHS) -2 Migration As noted in previous years, net interstate and overseas migration is an important driver of demand for housing. Trends in migration help explain and predict house price growth across markets, although it s not just the numbers, it s how they vary from long-term trends. Figures from the Australian Bureau of Statistics show net overseas migration was 147,700 in 2006, the strongest in 18 years and expected to increase. Higher migration supports house price growth as it creates underlying demand for owner-occupied and rental accommodation. New South Wales New South Wales has experienced its strongest migration in five years with 21,500 people migrating (net) from overseas and interstate in Affordability plays a key role in migration. In mid-2004, there was actually a net outflow, but this has been reversing in line with affordability rebalancing and now has almost reached long-term levels. Over 25 years, there has been a close relationship between house prices and migration in New South Wales, with migration leading by 15 months. With fewer people leaving Sydney and more people from overseas migrating to the state, particularly Sydney, underlying demand for housing is improving, sparking a rise in auction clearance rates and rents. With stronger migration, the forecast is for a pick-up in sales volumes and flat to moderate price growth. Queensland The exceptional pick-up in migration drove the really strong cycle in Queensland from 2001 to March Affordability again came into play with high numbers leaving Sydney for its northern neighbour, as well as a strong flow from overseas migration. Since then, migration has slowed with around 20,000 fewer people migrating a year. This has triggered a slowdown in price growth and sales volumes in South East Queensland, particularly on the Sunshine Coast and Brisbane. In 2007, we expect the recent slowdown in migration to Queensland to stabilise. Western Australia As forecast, the state has experienced a strong pick-up in migration due to employment growth. In 2006, net migration reached 25,700, 66% higher than two years earlier. Despite the strong job market, we expect migration will ease in the next one to two years due to deteriorating affordability. History shows that once affordability is an issue, migration tends to slow. In one to two years, the impact of affordability will moderate the exceptional underlying demand we have seen in the last three years. Victoria Underlying demand has held up in Victoria with migration, particularly from overseas, still at high levels. Net migration to Victoria was close to 41,000 in 2006, significantly above the long-term average of 17,600 per annum. Melbourne affordability didn t reach extreme levels at the peak of the cycle and has maintained migration and underlying demand at reasonable levels. South Australia South Australia has seen an exceptional improvement in migration. In 2006, there were net migrants compared with the longterm average of 1,700 per annum. Driving this was net overseas migration at 11,200, the strongest on record. The strength of overseas migration has maintained underlying demand in Adelaide, It s one of the reasons Adelaide s house price growth has been solid relative to many other capital cities. Affordability between Adelaide and Melbourne is important for interstate migration. When it narrows, the flow of people to other states tends to increase. RENTAL SCENE Exceptionally low vacancy rates (below ) in all major Australian capital cities are likely to continue this year, driving rents higher. In every other cycle, interest rate cuts have triggered the next construction cycle. However, rates should be on hold this year and rents should grow above long-term trends. Rental growth is not just an Australian trend. US apartments have achieved their biggest rise in 20 years. San Francisco rents are up 9% and New York s 6. over the past year, the strongest rise since In London, prime central rents have surged 8.1% in the last 12 months, resulting in a 2 increase over the past few years. Among the factors sparking vacancies to fall and rents to rise in Australia was the number of potential first home buyers who became renters and the fact that, not long after, investors deserted the east coast, making it tough to get pre-sales for construction finance. The $1 million super contribution offer had an impact but vacancy rates were actually falling well before this. As a result, NSW has witnessed construction levels at 30-year lows. The outlook for the rental market depends on how quickly construction can be turned around. In Australia, around 8 of rental property is provided by private investors and therefore they are important for Australia s rental market. When factors alter that dynamic, such as the retreat of investors, particularly when demand is high and supply is low, an imbalance is created.

9 29 For cities such as Sydney (in particular) and also Melbourne, there will be no quick fix. Supply cannot be alleviated quickly because developers are finding it difficult to get presales for construction finance unless the project is unique. Now investment housing construction in South East Queensland and Perth is more feasible. South East Queensland has the potential for further supply to match demand while in Perth there has been plenty of investment with more supply available in two years. We expect solid rental growth in the high demand inner-city areas of Sydney and Melbourne to continue. In Sydney, the rental market will remain tighter for longer. YIELDS Rents move in cycles as do prices. When rental growth was subdued in 2003, investors were willing to accept lower yields because of lower interest rates and strong price growth. Many in the industry are saying that yields need to rise back to previous levels of the first half of the 1990s. We think yields became too low, but do not believe they have to return to previous levels because we are in a very different interest rate environment. Like all property sectors residential and commercial around the world, property yields have declined in unison. With bond yields still well below levels of the late 1980s and first half of the 1990s, residential property yields will need to improve further, but not to the extent seen in that period. Nevertheless, investors will want strong confirmation that rental growth and yield enhancement will continue before a significant upswing occurs. RESIDENTIAL LAND DEVELOPERS Capacity for developers in the current market conditions varies across capital cities, within areas and within sectors. Sydney s levels of construction are at record lows, partly due to the market, the difficulty of making projects stack up and significant planning charges and delays. Given that developers are increasingly working on internal rates of return - not just development profit on cost - delays have a significant impact. We are also seeing more funds and trusts undertaking residential development a relatively recent occurrence. They too are working on internal rates of return. Many landowners are still able to hold on to their property and hold out on pricing because we have not had the big fallouts as in previous cycles, such as the early 1990s. While interest rates have risen, they are nowhere near previous peaks. Others are trying to make projects stack up by projecting sizeable gains in prices over the length of the project, some of which may be unachievable relative to costs. While these costs are not rising at the same extent as the last few years, they are still increasing and influenced by the non-residential price cycle and global demand for materials. The development recovery in Sydney and parts of Melbourne is therefore likely to be slower than previous cycles. The drivers of development sales volumes are cuts in interest rates and stronger migration. Australian net overseas migration is currently the strongest in 18 years, but for the first time, rates have been increased as development has weakened. Within capital cities, there are clearly defined submarkets. In the outer suburbs where land is available, the costing factor compared with the end value can make it uneconomic in some markets. Through housing finance figures, we can also see that investor demand has been weak, apart from Western Australia where it is now slowing. Investor demand is starting to recover with a higher proportion of investors at this stage of the cycle seeking existing rather than new product. In the short-term, investors will continue to seek existing stock. In the next year or two, sales volumes for new stock will improve, driven by a tight rental market, with the highest rental growth in Sydney. Construction costs Typically, we only ever see significant falls in construction costs in an economic recession. With solid economic growth and more office construction, costs are likely to remain high but not grow at previous rates. There is also extra demand created by infrastructure projects for materials and labour, and demand from Asia for materials. We expect to see more construction in the strengthening Europe market, which will counter the slack for materials from the softening US housing construction market. Land sales volumes Land sales volumes are highly related to changes in interest rates and population (migration) growth. Rates were not cut but population growth is intensifying, partly through continual increases in net overseas migration. This will help underlying demand. Sydney remains sluggish unless the location has scarce supply, though we believe sales volumes for land will improve in the next one to two years as migration picks up and the state economy reverts to the Australian average. Outer areas of Sydney will be slower to respond due to affordability and the impact of costing and charges on pricing of new land releases. WA investor finance returning to the pack Source: Macquarie Real Estate Research, ABS Value of housing finance to investors for the rent/resale of dwellings Indexed Jan 2000 = % 6% Victoria New South Wales 10 Year Bond Yield Queensland Western Australia Sydney apartment yields have followed 10-year bond cycle Source: Macquarie Real Estate Research, RBA, Residex Real 10-yr bond yields (LHS) Real Sydney apartment yields (RHS) 2007 Real Sydney Apartment Yield 8% 7% 6% 5% 3% 1% Brisbane land sales (LHS) Qld interstate + overseas migration (diff. p.a.) (RHS) -1% 2007 South East Queensland sales volumes have slowed as migration has slowed Source: Macquarie Real Estate Research, REIQ, ABS 18,000 15,000 12,000 9,000 6,000 3,000 Qtrly approvals Persons 30,000 20,000 10, ,000-20,000-30,000 REAL ESTATE MARKET OUTLOOK 2007

10 30 Office OPPORTUNITIES AND RISKS Opportunities Short-term, Brisbane and Perth to outperform as tight vacancy rates continue to drive rents. Medium term, Sydney offers the strongest investment opportunity; although a ostrengthening state economy is a key factor. The state economy has been weak but is now reverting back towards the national average. A scarcity of prime sites in the Sydney CBD means the next development phase will require demolition of existing buildings with cash flow. This will push out the timing of the next major construction phase and add to potential for rental growth. Melbourne office with significant rental growth in Brisbane and Perth, Melbourne now holds appeal as the most affordable major Australian office market. Yields remain above their prior cyclical lows in Melbourne and Sydney. With stronger rental growth expectations in these markets, yields should firm further. Suburban regions should start to benefit from increasing demand as CBD rents rise and push some tenants out. Risks With already high construction costs and developers taken by surprise in terms of the strength of markets, the supply cycle is only now picking up speed. In Brisbane and Perth, there are a significant number of buildings with or awaiting approval. Although not all will commence speculatively, this needs to be closely watched. In Melbourne, there are also sites available for the next round of construction, this could temper future rental growth over the medium term. A LONGER RIDE OVERVIEW Three years ago, the office sector was in the doldrums. There were even reports it would never recover. Despite the negative outlook, we took the opposing view, forecasting a strong office upswing. We have since been proved correct as investors enjoyed a thrilling ride. The question is now how much longer will it run for? We believe the strong leading indicators and demand drivers - the global economy, business conditions and the global share market will outweigh the moderating drivers - predominantly the slowing US economy - leading to a longer cycle than typically seen in the Australian CBD office markets. The global economy is in high carnival mode, enjoying an exceptional cycle, with growth expected to remain strong for 2007 and Business conditions are at their strongest continuous levels in 17 years since the start of the NAB (National Australia Bank) quarterly index and the global share market remains buoyant thanks to company profits and liquidity from superannuation. One happy consequence has been the strong office cycle. Brisbane and Perth s outperformance reflects their state economies, which, having been incredibly strong, are starting to ease as business and mining investment moderates. Sydney has lagged due to its previously slower state economy, with tenants less confident about taking up leases. So will Sydney miss out on the rest of the carnival? We don t believe so, although the delays seen may temper growth. We expect the New South Wales state economy will return to the pack in the next 18 months. Stronger signs are already emerging. Development will mark the next phase of the cycle. Investment yields have tightened, making it harder for listed investors to compete. At the same time, in some markets, the scarcity of institutional grade assets together with exceptional rental growth is making development more feasible for investors. Direct development by listed investors, such as LPTs and REITs, to bring on stock for a long-term hold will increasingly be a popular route to acquire assets. The strength of office markets has taken many developers by surprise and the construction cycle, apart from Melbourne, is taking place later relative to previous cycles. Additionally, until now, rents had not been at levels to make developments feasible. Construction costs have risen early in the cycle, driven by a previously strong residential cycle, powerful global economy and demand for resources. Office yields have firmed significantly, but are still above the low points normally reached in a strong upswing cycle. We believe they will firm even further this year, as growth continues short-term in Brisbane and Perth and mediumterm in Sydney and Melbourne. Another good year Strong conditions have benefited all CBD markets. But the shining stars have been Perth and Brisbane, which have achieved all-time records. In Perth, net absorption moderated from exceptional levels, as take-up levels have become limited by the amount of supply available. Vacancy rates have tightened dramatically. Strong demand and limited supply have resulted in solid rental increases, with prime CBD up 6 in the last year and 119% in the last three years, according to Jones Lang LaSalle. It s a similar story in Brisbane with rental growth almost on par with Perth.

11 31 Stronger conditions are also evident in Sydney and Melbourne, but to a lesser degree than Perth and Brisbane. Sydney has been a laggard due to the weakness of the New South Wales economy, but more recently rents have improved. Vacancy rates are at their lowest level in five years and are expected to fall further. Melbourne has been through the strongest demand cycle on record. Rents have been slower to react due to supply, but are now rising. Vacancy rates have fallen to 6.5%, close to the best achieved in the last office upswing. Demand could be boosted by the relative affordability of the market (Melbourne is currently cheaper than Brisbane or Perth). The office market is highly cyclical, with outperformance in returns occurring every 10 years: at the end of the 1980s ( ), at the end of the 1990s ( ) and the current cycle (where total returns in 2006 edged ahead of the retail sector for the first time since 1998). And clearly, office performance still has further to run this cycle. While we are not expecting the office market to peak this year, there are typically certain signs that mark the next phase of the cycle of which investors need to be aware. Historically, there tends to be three to four years of strong demand in each cycle. With supportive global and domestic macro conditions, we forecast the office cycle to run for longer than typically evident presenting an opportunity to investors in some markets. DEMAND DRIVERS GLOBAL STRENGTH TO WIN THROUGH A number of the key demand drivers and leading indicators are showing continued strength, highlighting that 2007 will be another good year for office market performance. In particular, it is the continued strength of the global economy, business conditions and the global sharemarket that will support the office cycle being a longer cycle than previously. These positive influences will outweigh the moderating influences, particularly the US economy and domestic business investment levels. We expect the global economy and business conditions to keep demand trends strong in 2007 and Beyond 2008, these positive influences are likely to be running out of steam, providing less support to the cycle. Global economy The last time we saw global economic conditions remain this consistently strong was in the mid-1970s. This strength, as we have said earlier, has led to significant improvements in tenant demand in Australia. The relationship between the global economy and tenant demand will help support demand for longer than a typical cycle in CBD markets around Australia. The current strength of the global economy is broadly based, with the significant economies of China, Europe and Japan all showing strength. The main risk to the global economy is the current weakness in the US. Despite this, the global economy is in uncharted positive territory. While the US economy moderated from late 2004, there was no accompanying global slowdown, as would once have been the case. If the US slowed more significantly than expected, there would still be significant repercussions for the global economy. Business conditions Business conditions in Australia (as measured by the NAB Business Conditions in Finance survey) are a reliable leading indicator for office performance around Australia. Even when there has historically been a large divergence between improving business conditions and net absorption lagging these trends, there has subsequently been a significant catch up in net absorption levels. Business conditions are at their strongest continuous levels in 17 years and net absorption trends are mirroring this strength. While markets vary, there is typically a nine to 12-month lag between changes in business conditions and demand for office space. Equity market performance The fortunes of global equity markets have historically been heavily linked to the prospects for the US economy. This is not surprising given the historic dominance of the US in the global economy. There is already evidence that this relationship is dissipating, equity market performance hasn t slowed to match the prospects of the US economy. In Australia, Asia-Pacific equity market performance has been a reliable indicator for office market performance. The recent moderation could have indicated a potential slowing in demand trends but equity performance has since plateaued at solid levels. This fits with signs from other leading indicators that this cycle could run for longer. Sydney net absorption cycle long-term relationship with the global economy Source: Macquarie Real Estate Research, Jones Lang LaSalle, CEIC, Bloomberg, Macquarie Research Economics 240,000 sq. m. p.a. 180, ,000 60, , ,000 % ch. p.a. 6% Forecast 5% Sydney net absorption (moving annual) (LHS) World GDP (trade weighted) % ch. p.a. (RHS) Since the early 1990s Perth s demand cycle has had a strong link to the global economy Source: Macquarie Real Estate Research, Jones Lang LaSalle, Macquarie Research Economics, ABS 100,000 sq. m. p.a. % ch. p.a. 6% 80,000 Forecast 5% 60,000 40,000 20,000 3% 0-20,000-40,000 1% -60,000-80, Perth net absorption (moving annual) (LHS) World GDP (trade weighted) % ch. p.a. (RHS) Economic Forecasts - real GDP (annual ave % growth) (f) 2008 (f) Australia GDP Global GDP US GDP Source: Macquarie Research Economics 3% 1% REAL ESTATE MARKET OUTLOOK 2007

12 32 Strong relationship between Melbourne net absorption and business conditions Source: Macquarie Real Estate Research, Jones Lang LaSalle, Datastream 240,000 sq. m. p.a. Index , ,000 60, , , Melbourne net absorption (moving annual) (LHS) NAB business conditions survey - finance (RHS) Business conditions leads by one year 2007 Brisbane demand cycle has followed business conditions closely since 1991 Source: Macquarie Real Estate Research, Jones Lang LaSalle, Datastream 70,000 sq. m. p.a. Index 40 50,000 30,000 10,000-10,000-30,000-50, Business conditions -70,000 leads by one year Brisbane net absorption (moving annual) (LHS) NAB business conditions survey - finance (RHS) Asia Pacific equity performance - a consistently good indicator of Sydney net absorption Source: Macquarie Real Estate Research, Jones Lang LaSalle, Bloomberg LP 240,000 sq. m. p.a. %ch. p.a , ,000 60, , , Sydney net absorption (moving annual) (LHS) MSCI Pacific equity performance index % ch. p.a. (RHS) Australian economy Until recently, the Australian economy has been a moderating influence on office market trends. The latest quarterly data for March 2007 revealed stronger growth and, with Macquarie Research Economics forecasting above trend growth to continue over 2007 at, this should provide further support to office demand levels. In 2008, economic growth is currently forecast to return to long term average levels - since 1965, it has averaged 3.5% p.a. Employment growth Employment growth is critical to the office market. Office demand is highly correlated to growth in key white-collar sectors, such as property and business services, finance and communication services. But it is not always a leading indicator. In Sydney, net absorption actually leads employment trends as companies take on more space ahead of hiring employees. Recent moderate performance from the Australian economy is also exerting an influence on employment growth trends, but should improve in line with stronger economic forecasts. US economy The US economy could still be the main moderating influence on Australian office market demand despite the broader base to the global economy. Forecasts for the US economy indicate that if the historic relationship between international office markets and the US economy holds true, Australian office net absorption would have already significantly slowed from its previous high levels. We believe we are currently at a critical transition point. There is no doubt that historically the US economy has played a significant role in Australian CBD market demand levels. But the strength of the global economy is exerting an increasing influence, which is likely to drive demand for longer than implied by the historic relationship with the US. Workspace ratio Changes in the workspace ratio are an important and often understated driver of office demand. Cyclical changes in workspace ratios are related to the economic cycle. Workspace ratios increase in downturns but decrease at the start of an upswing in the business cycle as firms take on employees in the same leased space, thereby reducing workspace per employee. The outlook is for increased workspace ratios as firms take on space for expansion. Business investment Domestically, the level of business investment as measured by the national accounts has historically provided a good indicator of the expansion intentions of companies. Business investment is forecast to slow in 2007 from its previously strong levels. This cycle, however, is different. Typically, at this stage of the cycle, business investment would be running high as firms reinvest their profits in expansion. But companies are demonstrating a reluctance to increase spending aggressively. This cycle, business investment is unlikely to be such a reliable indicator for office market performance. Submarket swings A shift between submarkets occurs largely as a result of affordability and new supply. When CBD markets are relatively affordable, a shift to city markets is evident. As we have witnessed increased rental levels in CBD markets, the opposite will occur as costconscious companies shift to more affordable outer CBD and suburban markets. SUPPLY CYCLE The primary drivers of supply are rent levels and construction costs. On average, it takes three years for a new office to come on line. The decision to begin construction is highly influenced by rental levels as higher rents make projects more feasible. Historically, a simplistic assumption appears to have been, If rents are high then build now, rather than trying to time a project to complete in a cyclical upswing. A good example was in the early 1990s when large amounts of supply hit the market just as demand waned. The build signal would have been for high levels of demand about three years earlier. Now, with less speculative development, developers are more likely to seek precommitments for new development to reduce some of the risk. Risks to the market from new supply depend on whether occupiers are vacating their current space or whether new supply is absorbed by expansion plans. One of the reasons that Melbourne CBD rents have been slower to respond to strong levels of demand is higher levels of new supply. In Perth and Brisbane, skyrocketing rental growth has made projects feasible. Despite our models forecasting solid demand levels in these markets this year, the prospect of burgeoning supply could stop rental growth rates as developers entice existing occupiers into new space at rents lower than current reported levels. Melbourne also has a significant amount of new supply in the pipeline that is likely to result in only modest improvement in the vacancy rate, despite historic high levels of demand. In contrast, Sydney has less supply under construction or at planning stage to 2009, with further new supply limited by the scarcity of sites. Construction costs have played a part in moderating the supply cycle, with higher costs evident earlier in the cycle than usual.

13 CRYSTAL BALLS We use regression analysis to build Macquarie Real Estate Office Models for major Australian capital city markets. Our models, dubbed the crystal balls, show the impact of critical drivers in each market and help form our view on market direction. Clear messages from the crystal balls: In Sydney, net absorption is expected to remain strong (certainly for 2007 and 2008). Balanced against low supply, rental growth is expected to accelerate. Sydney should be a strong medium-term performer as the state economy improves and other macro influences remain in place. Further yield compression can be justified by its stronger growth profile. Demand has been exceptionally strong in Melbourne and our models point to a continuation. Furthermore, demand could be boosted by the relative affordability of the market (Melbourne is currently cheaper than Brisbane or Perth). Continued new supply will to some extent counterbalance the high levels of demand but stronger rental growth is forecast. Further yield compression is expected investors appear to have paused until rental prospects become clearer. We believe Melbourne could surprise on the upside. Leading indicators for Perth point to significant demand for office space for 2007 and With no significant new supply expected until 2009, the vacancy rate should be close to zero for the next 18 months. This demand/supply imbalance will continue to drive double-digit rental growth this year, although moderation in the rate of growth is expected. Potential for new supply and developers seeking pre-commitments on new space at below-market rates could impact on market rents. Question mark for Perth at this stage of the cycle - how many of the 11 buildings with or awaiting approval will commence in the next 18 months. Affordability will also increasingly play a role for both Perth and Brisbane, which are more expensive than Melbourne for the first time. There is already evidence that some companies are now considering Melbourne, for example, over Brisbane for office accommodation. Strong office demand trends in Brisbane will continue to be supported by the strength of state business investment, the Queensland economy and the continuing strong world economy. Brisbane bears many similarities to Perth. Vacancy rates will edge towards zero in 2007, but inch up to around by the end of With such low vacancy rates, rental growth will remain healthy this year and next, although, as with Perth, looming new supply is likely to slow the growth rate. YIELDS Office yields have continued to firm, a trend that s likely to continue this year given the performance prospects in a number of markets. Yield spreads have continued to diminish under the dual impact of falling real estate yields and the recent rises in long-term bond yields. Last year (March 2006), 10-year bond yields were 5.5%. A year later, long-term rates are edging closer to 6.25%. From here, Macquarie Research Economics is forecasting stable 10-year bonds to mid Investors (particularly unlisted investors) at this point in the cycle are likely to be willing to weather lower yield spreads (or even negative yield spreads) as office yields become priced for growth. Negative yield spreads are actually the market norm when we look at the longterm picture. Last year, we identified the clear long-term relationship between real (inflation-adjusted) bond yields and real office yields. After adjusting for inflation, the office yield cycle has closely followed the bond cycle. In the last year, we have seen a continuation of this trend. The historic relationship between real rental expectations and yields reveals that yields haven t firmed as much as expected with the prospect of strong rental growth. Prime Office Yields and Yield Spread Comparison Mar 2007 Mar 2006 Previous cyclical low 10-Year Bond Rate 5.88% 5.53% Sydney Current Yield 5.75% 6.25% 5.25% Sydney Yield Spread -13 bp 72 bp -825 bp (Jun 89) Melbourne Current Yield 6.38% 6.88% 5.0 Melbourne Yield Spread 50 bp 135 bp -136 bp (Mar 00) Brisbane Current Yield 6.13% % Brisbane Yield Spread 25 bp 97 bp -752 bp (Mar 89) Perth Current Yield % 6.5 Perth Yield Spread 62 bp 210 bp -715 bp (Sep 89) Source: Macquarie Real Estate Research, Jones Lang LaSalle, Bloomberg LP Rental growth in Sydney CBD set to continue Source: Macquarie Real Estate Research, Jones Lang LaSalle, Bloomberg LP, Macquarie Research Economics Sydney CBD yields: no significant departure from relationship with bond yields Source: Macquarie Real Estate Research, Jones Lang LaSalle, Bloomberg LP, Macquarie Research Economics, ABS 1 Forecast 8% 6% Sydney CBD real office yield (%) Australia real 10-yr Government bond yield (%) Forecast Sydney gross effective rent (% ch. p.a.) Macquarie Real Estate rental model (% ch.p.a.) Melbourne CBD supply has limited rents reaction to exceptionally strong demand Source: Macquarie Real Estate Research, Jones Lang LaSalle, Bloomberg LP, Macquarie Research Economics 4 sq. m. p.a. 200,000 Forecast 3 150, ,000 50, , , Melbourne office rents % ch. p.a. (LHS) Macquarie Real Estate Melbourne office net absorption model (RHS) REAL ESTATE MARKET OUTLOOK 2007

14 34 Retail SOLID GROUND OPPORTUNITIES AND RISKS Opportunities Neighbourhood centres in new-release residential areas and over main rail transport stations with high-rise residential to cater for convenience and time-poor shoppers. Food-based retailing supported by strongest migration in 18 years and solid employment and wages growth. Sub-regional centres with potential for adding dominance and value through development. Investors looking to other methods to enhance returns, for example, through redevelopment. Risks In the bulky goods sector, the areas to watch are where projected population may not reach reality, such as those in certain regions in Queensland and Western Australia. (Population growth in Queensland has slowed in the last few years so investors need to ensure that centres are in growth areas.) Rising interest rates rates are likely to rise moderately in early If the rise is more than expected this would have a negative impact on retail sales, rental growth and potentially retail property yields. OVERVIEW True to form, almost every player can win a prize in the retail sideshow alley. Retail property returns should have slowed more than experienced last year. Considering the lag impact of retail sales, rents should also have moderated further and yields were expected to be on hold for another year. Instead, the slowdown in retail sales wasn t reflected in rents and investors came back to take their chances once more, pushing yields down further. Real retail property yields are closely linked to real long-term bond yields. As the weight of money into real estate continued and bond yields fell, with many countries around the world including Australia experiencing an inverse yield curve, retail property yields firmed over the last 12 months. Now, with more stable conditions expected for the US economy, long-term interest rates have risen. This year, we expect the weight of money into real estate and the influence from capital market activity to be positive influences on retail property investment, despite heightened investor interest in office markets. However, as long-term bond yields revert to the cash rate, there is limited potential for a significant firming of retail property yields this year. On the horizon, though, retail property should, be a stronger focus for investors in a few years time when the office cycle eventually slows. Investors long-term attraction to retail property is partly due to its low volatility of returns, even in economic slowdowns. Traditionally, total returns from retail property have had only a third of the volatility of returns from the share market. Furthermore, in the last 20 years, retail property returns have averaged 13.5% per annum (IPD), higher than office and industrial over the long term. However, there are times in different cycles of the non-residential property market when these sectors do exceed retail, particularly at the peak of office markets. With retail sales strongly influenced by housing construction, there was a slowdown in sales in 2005 then a pick-up in This year, there should be a continued recovery in retail sales. The recent retail sales pick-up has been a result of the positive drivers of retail sales - employment, wages, migration and consumer confidence - and a stabilisation of the negatives of the last couple of years - interest rates are now likely to be on hold in 2007, a stabilisation of the housing cycle and a greater acceptance of the high level of oil prices. Since the Commonwealth Budget, consumer confidence is the strongest in 27 years and is likely to remain a positive on retail demand into 2008, although this could also have some impact on interest rates early next year. This year, total returns will be solid rather than spectacular, with variation by sector. Solid returns from food-based retailing, for example, will be supported by the strongest migration in 18 years and solid employment and wages growth. With increased competition in the market, investors are increasingly looking for other methods to enhance returns, such as redeveloping existing assets. Internal managers with a funds management arm have a cost-of-capital advantage and are able to bid yields lower than their externally managed counterparts. This has led many external managers to redevelop their existing properties, offering them a greater return. RETAIL SALES After five consecutive years of retail sales growth, sales slowed in the second half of 2004 and Links with the housing construction downturn and higher oil prices drove a more moderate slowdown than previous cycles. In 2006, sales improved, with the Australian Bureau of Statistics (ABS) figures showing total retail sales (seasonally adjusted) increasing by 6.7% in the year to

15 35 April 2007 (on a moving six-monthly basis), 1.4 times higher than the previous year s rate, marking a return to long-term average levels. Both discretionary and non-discretionary retail sales strengthened at about the same rate. Non-discretionary spending increased by 6.8% in the year to April (on a moving six-monthly basis). Discretionary spending took longer to recover this cycle and is well below the peak of 10.6% in March 2004, but still increased by 6. in the year to April. DRIVERS Underlying retail property trends are largely driven by domestic factors what s happening at home determines peaks and troughs. This is fundamentally different to the office market, which is closely linked to the global economy. Global conditions do come into play on the investment side. Factors include the retail property yield link with global bond yields and capital market influences on the weight of money into the property sector in Australia. User demand for retail property depends on growth in retail sales turnover. In turn, retail turnover is typically reliant on population growth, disposable income and consumer confidence. We expect retail sales to continue to grow this year as the previous negative influences of housing construction, interest rates and oil price rises stabilise. Labour market Employment should continue to be a positive influence. Australia s unemployment is at historic lows at around 4.5% and, in the last few years, total employment across Australia has grown at an average of 2.6% a year compared with 1.9% a year in the last 28 years. We expect relatively tight labour market conditions in Australia, including a pick-up in New South Wales in the next 18 months as the east/west state divide narrows. Supporting this is a shift in the supply of labour, driven by the rise of baby boomers staying longer in the workforce and the strongest overseas migration, particularly skilled, in 17 years. More workers mean more spending power, reducing potential volatility in retail sales cycles. Overseas migration Migration is the key component of population growth to influence retail sales. Overseas migration is the strongest in 18 years because of two factors: employment and the government s focus on increasing skilled migration. We believe skilled migration will strengthen again next year, which should support stronger supermarket spending. Internal migration also plays a part and the narrowing of the east/west divide will influence retail sales at a state/city level. Consumer confidence Interest rates increased three times last year yet consumer confidence held up, dipping only briefly before recovering. This had much to do with the solid employment market. In 2007, the combination of a benign interest rate cycle and the influence of the Budget should keep consumer levels buoyant. Interest rates Our outlook is for interest rates to remain flat in 2007 with no rate rise until Macquarie Research Economics forecasts the cash rate to remain at 6.25% for 2007, with a moderate increase projected in the first half of Housing cycle We forecast a gradual improvement in the east coast housing construction cycle in the next 12 to 18 months, but a moderation in housing commencements in the west in around 12 months (there is still a lag due to construction labour shortages). While the recovery will not be as fast as previous cycles it should help underpin retail sales to some degree. The housing cycle typically leads retail sales growth by about nine months - a similar pattern to the rest of the globe. Oil prices Annual changes in oil prices have a marked bearing on annual growth in discretionary retail sales through the link with household disposable income. Oil prices can be volatile in times of demand/supply imbalance, as evidenced in the last three years. Now with the oil price starting from a higher base, there is likely to be less impact from an extended period of high oil prices on retail sales. RENTS The outlook is for moderate rental growth based on a continuation of the recovery in retail sales, with stronger conditions in due to the lagged impact of sales on rents. The outperformance of Perth should narrow as the east/west divide also narrows. Retail turnover has an impact on retail rents after a lag of about 12 months. The lag is due to several factors, including the gap between actual sales growth and rent review periods and the retail sector's focus (landlords and retailers) on annual, rather than short-term, sales growth. YIELDS/LIQUIDITY The outlook is for retail property yields to remain around current levels. While the weight of money significantly pushed down yields last year - from 25 to 100 basis points depending on the sector and location - we believe this degree of firming will not be repeated in the next 12 months. The extent of investor demand will hold prime yields firm, but longterm bond yields are rising. Discretionary spending growth in line with non-discretionary Source: Macquarie Real Estate Research, ABS 13% % ch. p.a. 11% 9% 7% 5% 3% 1% -1% % 7% 5% 3% 1% -1% -3% Discretionary spending (6 mth moving total) % ch. p.a. Non-discretionary spending (6 mth moving total) % ch. p.a. Consumer confidence has supported improved retail sales growth Source: Macquarie Real Estate Research, Westpac, ABS % ch. p.a Real retail sales % ch. p.a. (LHS) Consumer Sentiment Index (RHS) Housing cycle impacts on retail sales growth Source: Macquarie Real Estate Research, REIA, ABS Feb Index % % ch. p.a. % ch. p.a. 4 11% Sydney house price leads by 12 months 3 9% 7% 5% 3% 2 1 1% -1% -3% Real retail sales (moving annual) % ch. p.a. (LHS) Real Sydney house prices % ch. p.a. (RHS) REAL ESTATE MARKET OUTLOOK 2007

16 36 Oil price growth impacts on retail sales growth Source: Macquarie Real Estate Research, Datastream, ABS % 6% - % ch. p.a. INVERSE SCALE -8 Oil prices lead by 6 months Real retail sales % ch. p.a. (LHS) Oil prices % ch. p.a. (RHS) 2007 Real 10-year bond yields impact on Sydney regional shopping centre yields Source: Macquarie Real Estate Research, Jones Lang LaSalle, ABS, RBA 1 9% 8% 7% 6% 5% 3% 1% -1% Real 10-year Australian bond yield Real Sydney regional retail yield Growth in money supply supports retail sales growth Source: Macquarie Real Estate Research, ABS, RBA % 6% - % ch. p.a. % ch. p.a. 16% % 6% Discretionary spending (nominal) % ch. p.a. (LHS) Money supply (M3) % ch. p.a. (RHS) Supermarket sales impacted by migration levels Source: Macquarie Real Estate Research, ABS % 6% % ch. p.a. Persons (moving annual diff.) 60,000 40,000 20, ,000-40,000-60, Supermarket & Grocery stores sales % ch. p.a. (LHS) Australian net overseas migration (moving annual) diff. p.a. (RHS) 80,000 Retail property yields have a strong correlation with 10-year bond yields making interest rate movements an important factor in assessing their outlook. Australia still has an inverse yield curve (10-year bond rate below the cash rate), which is unwinding as bond yields rise towards the cash rate around the world. Our experience shows yields have firmed up to 75 basis points in Perth but have been relatively flat in Sydney. As we have discussed in previous years, the sheer weight of money favouring property continues to support firmer yields around the globe. The Australian retail property sector is little different, although there is a stronger link with bond yields. Liquidity is also a factor for the retail sector. There is a close positive relationship between growth in Australia s money supply (M3) and retail sales. With the money supply continuing to grow solidly (RBA figures show it increased by about 1 over the last year), this will support further retail sales growth. FOOD-BASED RETAILING Food-based retail property (including supermarket-based convenience centres) has provided solid total returns with low volatility. Supermarket and grocery sales account for almost 8 of non-discretionary sales. By drawing most of their income from nondiscretionary spending, food-based centres have the lowest exposure to spending volatility and supermarkets continue to draw spending away from specialty stores. Two key drivers of supermarket and grocery sales growth are overseas migration and wages growth. We expect net overseas migration to strengthen given the focus of the Federal Government on skilled migrants. Wages growth is subdued despite the tight labour market, but solid employment conditions should be a positive influence. Going forward, supermarket sales should continue to be solid as competition between the major players continues to reduce supply chain costs with savings passed on to consumers. OUTLOOK The outlook for retail property is solid as retail sales have turned the corner. This cycle, retail drivers such as wages, overseas migration and consumer confidence have not been strong enough to prevent a sales slowdown. This is understandable given the unsustainable high spending of a few years ago. Also, oil prices and the housing downturn have been a dampener. As a sudden, strong upswing in the housing cycle along the east coast is unlikely, retail should experience another nine to 12 months of similar conditions. The office market has a few more years to run and therefore will remain a focus for investors. After that period, investment activity will switch back to the retail property sector. We may see less volatility in future retail sales cycles due to the larger volume of workers with the spending power to support retail sales growth. The bulky goods sector on the east coast will continue to suffer from the slow housing market in the short term. Potential supply, particularly in South East Queensland, may further dampen rental growth. Differences in state economies will also have an impact. New South Wales and Victoria have been weak while Western Australia has experienced strong conditions. Now, the Western Australian economy is expected to slow, which will affect all retail property in Perth. There have been encouraging signs in the east coast housing market which will provide a boost to the New South Wales and Victorian economies. Given its close link with the retail sector, this will flow on to retail sales and rents in one or two years. As we discussed last year, the next construction cycle involves a shift from regional to sub-regional. Supply forecasts for are substantially greater for sub-regional centres. Compared with last year, forecast supply for neighbourhood centres is higher.

17 Industrial i PLANES, TRAINS AND AUTOMOBILES OPPORTUNITIES AND RISKS Opportunities Brisbane and Perth industrial to outperform over the short term but at a more moderate pace. Sydney and Melbourne to improve as their respective state economies improve. Industrial real estate located near new and emerging infrastructure. Distribution centres to benefit from improved operating and logistics efficiencies. High-tech/research and development facilities knowledge-based services and increasing importance of co-locating with similar and complementary industries. Offsite data management/disaster recovery facilities to service call centres, financial institutions and utility providers by housing telecommunication/it systems. Risks Potential supply issues in Brisbane if demand levels fall substantially. Labour and equipment shortages and rising construction costs may impede or limit demand for new/expansionary industrial space. Rising interest rates moderate rises from next year but if inflation picks up more than expected rates may have to rise further. World economy slows while not on our radar, slower global conditions would create less demand for imports and exports and slow growth in commodity prices further. OVERVIEW It s been a long ride for rents and land values in Australia s industrial real estate sector, which has already pushed the sector further along its cycle than the domestic office market. We regard 2007 as the year of industrial supply with a high level of pre-commitment. After a decade of excess demand from 1995 to 2005, the dynamics are now riding in tandem. Compared with supply levels in the last 16 years, 2007 projected supply is strong in Sydney and Brisbane, with Melbourne and Perth exceeding historical averages. With a big entry price - high land values and construction costs - developers are seeking high levels of pre-commitment. Just over half of new supply is already committed. Different state economies are the standout story, playing a key role in shaping industrial markets. It s been full tilt ahead in Western Australia and Queensland. Last year the Western Australian economy was growing at a racy 16%. This translated to skyrocketing industrial land values, with increases of between 10 and 16 in 2006, depending on location. The strength of Queensland s economy also helped ensure strong growth in Brisbane s industrial land values in the last couple of years. From these exceptional levels, Brisbane and Perth industrial markets will moderate this year and into Although showing some improvement this year, Sydney industrial has mirrored the soft state economy with land values in 2006 rising a sedate 1% to. Given industrial s strong links with the economy, New South Wales industrial land value growth is starting to recover as economic growth does the same. 37 In Victoria, state economic conditions and infrastructure will continue to be the key to land values. Since mid-2005, state economic growth has slowed from 5. to 2.9%, and this will flow on to more moderate industrial land value growth in Melbourne this year. Like New South Wales, we expect the Victorian economy to be more in line with Australian averages in the next two years. With the weight of money still flowing into industrial property and flat/moderately rising bond yields, we will continue to see further firming of industrial real estate yields in some precincts. DEMAND DRIVERS Infrastructure demand from distribution, companies, imports, state economy and, to a lesser extent, manufacturing, continue to drive industrial land values and property returns. These factors have generated strong demand for industrial stock. Transport-based infrastructure Outperforming industrial areas continue to be those benefiting from new transport-based infrastructure, especially the introduction of major new roads. Strong land value growth typically occurs in four stages, starting with the announcement of a new infrastructure project, funding approval followed by the beginning of construction, then the opening of the project. For Sydney s Westlink M7, the market priced in the improved value from the motorway with increases to industrial land values within the M7 industrial catchment about one to two years before completion. But this growth has moderated now that this project has been open for 18 months. REAL ESTATE MARKET OUTLOOK 2007

18 38 NSW state economic growth now leads South Sydney land value growth Source: Macquarie Real Estate Research, Jones Lang LaSalle, ABS % ch. p.a. % ch. p.a. 9% Economic growth leads by nine months from % Alexandria (Sth Sydney) Industrial Land Values % ch. p.a. (LHS) NSW Real State Final Demand % ch. p.a. (RHS) QLD state economic growth leads Southern Brisbane industrial rental growth Source: Macquarie Real Estate Research, Jones Lang LaSalle, ABS 2 % ch. p.a. 15% 1 5% -5% Southern Brisbane Prime Industrial Rents % ch. p.a. (LHS) QLD state final demand % ch. p.a. (RHS) 5% 3% 1% -1% -3% % ch. p.a. 16% Economic growth leads by nine months % 6% - - In Melbourne, EastLink contributed to land value growth along the industrial corridor in South East Melbourne. Longer-term capacity constraints at Port Melbourne need to be addressed to ensure efficient import/export of goods in Victoria. Recent Queensland state government initiatives promote Brisbane as a major port for receiving goods from overseas. This has strengthened industrial real estate around the Trade Coast precinct. Growth has been strong and it is no longer the undervalued market it was. Therefore, we expect the Trade Coast precinct to experience more moderate growth in the future. Distribution In recent years, the trend for distribution companies to move to outlying suburbs has intensified due to consolidation among logistics companies and a move to rationalise operation centres to achieve economies of scale. Companies are typically moving from multiple locations (including prime areas with high land values and rents) to a large facility around new infrastructure at attractive rents. Imports and state economies Imports are driven by the strength of the economy, housing sector and domestic demand. These continue to have a significant impact on distribution and logistics companies owing to their need to be stored before distribution. In contrast, exports tend to be shipped directly overseas. A higher dollar means cheaper imports. But, in Sydney, the slow housing market dampened demand for New South Wales imports and the city s industrial real estate. Import levels are heavily influenced by the strength of the economy which is in turn often driven by housing market conditions. The construction cycle remains a key driver for imports, particularly in New South Wales and Victoria, where the housing market slowdown has dampened economic growth. Here, there is a direct link between dwelling commencements and imports, with commencements leading by nine to 12 months. This has flow-on effects for industrial property with lags in demand for industrial floor space. A strong relationship also exists between imports and industrial land values and rents (with nine to 18-month lags). In New South Wales, changes in economic growth tend to affect import levels nine months later. New South Wales economic growth has been sluggish but is now picking up along with higher migration. Eventually, population growth will lead to more housing construction in Sydney and, as people furnish their homes, demand for imports will rise. This will have positive flow-on effects to industrial real estate, including the South Sydney industrial precinct. More recently, land values in this area have typically followed changes in New South Wales economic growth by about nine months. In Queensland, the effect of economic growth on imports is also felt after nine months. The local economy has been tracking well, boosted by resources demand, which is good news for Brisbane industrial real estate. There is a long-term relationship between Queensland economic activity and industrial rents. Prime industrial rental growth in Southern Brisbane tends to lag state economic growth by nine months. Solid economic growth and a lack of available space have been key drivers of rental growth. Rents will continue to rise as the economy moderates from exceptional levels (but still one of the top two state economies over the next 12 months) with rental growth likely to return to more long term levels. While changes in import levels affect land value growth, the strength of the resources boom has driven land values significantly higher in Perth, more than doubling in some precincts. Early in 2006, commodity prices climbed by 4 (Reserve Bank of Australia). Though still increasing, the rate of growth has slowed. Commodity prices tend to lead changes in Western Australia s Canning Vale industrial land values by nine months. Perth s economy Impact of infrastructure on industrial land values Location and Infrastructure Impact Industrial land value Industrial land value growth 12 months growth 12 months to Mar 2006 to Mar 2007 Sydney Wetherill Park (Westlink M7) 1% 1 Ingleburn (M5 East) 3% 3% Silverwater 9% 17% Melbourne Dandenong (Eastlink) 36% 21% Laverton North (Ring Road / Deer-Park Bypass) 17% 21% Campbellfield (Ring Road / Craigieburn Bypass) 1 19% Brisbane Eagle Farm (Gateway Infrastructure) 36% 1 Lytton (Gateway Infrastructure) 4 2 Geebung 4 11% Source: Macquarie Real Estate Research, Jones Lang LaSalle

19 39 is expected to continue to perform well, although not at such exceptional growth levels, leading to more moderate land value growth. Manufacturing In the last 20 years, the importance of the Australian manufacturing sector to the economy has declined. It now contributes only 11% to Australia s GDP (Australian Bureau of Statistics). A structural shift to knowledgebased industries and logistics/distribution services has changed the composition and use of industrial property. This is evident in the traditional manufacturing bases of Melbourne and Adelaide. SUPPLY DRIVERS Projected figures for 2007 show strong supply in Sydney and Brisbane. In Melbourne and Perth, 2007 supply will exceed historical averages. The impetus for higher supply levels is increased demand from the development of transport-based infrastructure, distribution companies rationalising operations and higher import levels creating demand for major warehousing facilities. Companies in the resources and support services sectors are also requiring additional industrial floor space for warehousing, industrial estates and high tech/research and development facilities. In Sydney, projected supply is expected to reach a 17-year peak in Even at this level, it is only 2 above long-term demand. Despite 10 years of relatively strong consecutive growth in supply, annual gross absorption has continued to outstrip annual supply on average by 1.3 times. Currently, around half of the projected 2007 supply is pre-committed. Compared with 2006, Melbourne projected 2007 supply has eased. While at this level it is still almost double the historic annual average, it is close to long-term average demand. Tenants have pre-committed to just under half of this new stock. Brisbane s projected supply is around 45% above 2006 levels. Although this is close to four times the historical supply average, in the last 10 years annual gross take-up has outstripped annual supply an average of 1.5 times. While new supply in Perth will ease from its 2005 peak, 2007 supply levels are still twice the historical supply average, but the trend remains close to long-term annual gross takeup levels. About 7 of the projected supply is pre-committed. OUTLOOK Land values and rents Overall land values have experienced exceptional growth in recent years, with Sydney limited by the New South Wales weak economy. Growth has been driven by strong demand for industrial stock, improved value derived from land around new infrastructure and a shortage of available land zoned for industrial development. In contrast, rental growth has been generally constrained but now rents are set to rise. To increase returns, institutional investors took a strategic stance in land banking and have undertaken developments to boost overall returns. However, this curbed rental growth as developers sought attractive pre-lease deals to secure longer-term tenants. There were repercussions for the wider market where landlords of existing facilities were limited in their ability to increase rents if they wanted to retain existing or attract new tenants. Now escalating construction costs and rising land values make it economically less feasible for land to be developed unless rents rise. In Perth, rising construction costs, higher land values, stronger demand from increased business activity and a shortage of quality space have culminated in the push for significantly higher rents. This will be tempered by moderating, but still strong, growth in the state economy and commodity prices. Land value growth is expected to ease from last year s height, but remain solid given demand and limited availability of industrial-zoned land. In Sydney, land value and rental growth have been constrained by the previously weak NSW economic conditions but, as the state economy moves towards longer-term growth levels, demand for industrial floor space will rise and translate into higher growth. In Melbourne, economic conditions have also been a dampener. Prime rents increased between 0-1 depending on the precinct and land values were fairly flat in the city fringe with infrastructure supporting growth in the other precincts. We expect this trend to continue in Brisbane continued to record solid rental and land value growth last year, but quarterly figures reveal the rate of growth has slowed. We expect this to continue, partly due to the high supply expected to come on line. Overall performance will still be strong thanks to record solid economic growth. Yields In the last 10 years, Australian industrial real estate has become a well-regarded institutional investment sector. Industrial yields have firmed as the weight of money, driven by large institutions and LPTs, remains strong. This has been driven by real 10-year bond yields, future rental growth expectations and the institutional re-rating of the industrial real estate sector. Industrial property yields have continued to firm alongside 10-year bond yields. With the recent moderate rises, bond yields should start to stabilise. Industrial real estate yields could firm further where there is the potential for higher rental growth. VIC state economic growth leads Laverton North industrial land value growth Source: Macquarie Real Estate Research, Jones Lang LaSalle, ABS % ch. p.a. % ch. p.a. 1 Economic growth leads by nine months 8% 6% % Laverton North land values % ch. p.a. (LHS) Vic Real State Final Demand % ch. p.a. (RHS) Resource boom having more of an impact on Canning Vale industrial land values Source: Macquarie Real Estate Research, Jones Lang LaSalle, RBA 8 % ch. p.a. % ch. p.a. 5 Commodity Prices lead 7 by nine months Canning Vale land values % ch. p.a. (LHS) Commodity Prices % ch. p.a. (RHS) REAL ESTATE MARKET OUTLOOK 2007

20 40 ABOUT THIS REPORT The Real Estate Market Outlook was prepared by the Macquarie Bank s Real Estate Research team led by Rod Cornish with the assistance of Macquarie Research Economics. Rod Cornish is Head of Research for Macquarie Bank s real estate business and is widely recognised as a leading property economist. He has helped establish the Bank's reputation as an authoritative source of real estate research and is one of the most quoted real estate sources in the Australian media. Macquarie s Real Estate Research team includes Angela Galvin, Senior Real Estate Research Manager, Julia Middleton, Senior Real Estate Research Manager and Matt Fusarelli, Real Estate Researcher. Richard Gibbs is the Chief Economist at Macquarie Bank and is responsible for the formulation and presentation of the Bank's economic scenarios and forecasts for Australia, New Zealand, Asia and the major industrial economies. The Macquarie Research Economics team members who have also made a valuable contribution to this report include Mark Tierney and Brian Redican. Macquarie Real Estate would also like to acknowledge the contributions to this report by Carden Calder and Bruce Madden, BlueChip Communication Group; Jane-Anne Lee, Splash Media; Robyn Turner, Associate Director, Macquarie Real Estate and Duncan Maclaine, Economist, Macquarie Real Estate with design by nero+rossi. Photographs were taken on location at Luna Park, Sydney, and Macquarie would like to thank Luna Park for their assistance.