Despite 13 rates rises in less than two years commercial property investors are among those with least to fear from the fallout. CreditorWatch chief economist Anneke Thompson said Australia’s commercial real estate sector remained “arguably one of the lowest risk” in the world for investors, while the Reserve Bank of Australia in its latest bulletin expressed similar views, based on the country’s limited exposure to stress in foreign CRE markets as well as banks’ conservative lending practices for CRE loans.
Even so, the RBA is erring on the side of caution, warning that “while signs of financial stress among owners of Australian CRE remain low, pressure on the asset class is likely to continue for some time.”
Watching and waiting
Likewise, CreditorWatch’s latest deep dive into the sector acknowledges that the various asset classes within CRE face vastly different fortunes. Business conditions have, for example, clearly made conditions extremely challenging for industry overall with ASIC data showing the number of business insolvencies in the three months to September 30 at their highest level since 2015. Of those companies that collapsed, 31% were involved in construction, placing the industry top of the list and prompting one liquidator to tell the media that “construction is getting totally hammered by interest rates”. Food and beverage operators also figured highly among the number being forced to shut up shop.
“It’s going to be a tough 2024 for the commercial markets,” said Vanessa Rader, head of research for Ray White Corporate. “Confidence has been rocked again after a difficult 2023.”
The lowdown for investors
CreditorWatch helps current and future property investors determine risk premiums that could accompany their investments by identifying business risk by occupier type. Industrial assets have the highest proportion of low risk-type businesses, followed by any asset occupied by an operator that falls under the ‘life sciences’ umbrella such as childcare, aged care, education and training.
On the flip side, retail has the greatest number – 23% - of businesses considered high risk, a group dominated by food and beverage. In this sub-category, which covers everything from local cafés to elite restaurants, CreditorWatch classifies 34% of businesses at high risk of falling over, compared to 17% of the retail business category overall.
It's also worth drilling down into CreditorWatch’s findings for industrial properties – as while this sector tops the list for having the most solid tenants of all, it also has the third highest number of high-risk businesses. Why? Because 20% of industrial tenants in the transport, postal and warehousing business are considered by economists as high risk. What’s more, CreditorWatch warns that all asset classes carry a large ‘medium risk’ component. Office assets are ranked as having the greatest proportion (52.8%) of businesses at medium risk.
Avoiding nightmare scenarios
Among worst-case scenarios for any landlord is being unable to remove a non-paying tenant from their premises. This kind of situation can arise when the landlord fails to pay attention to the intricacies of the lease agreement with their tenant in the first place. Commercial law and property specialist Brendan McGrath, counsel with business services company businessDEPOT, said that this was “one of the biggest mistakes” he sees commercial property owners make, a flaw that comes down to failing to take into account the considerations around third-party interests in their tenant’s liquidity.
“Chief among these third parties are banks/lenders and franchisors,” Mr McGrath explained. “Both of them can exert substantial power and control over the operations of a tenant – and when a tenant’s operations are financed the lender often has specific requirements and conditions that must be met by the tenant.
“These conditions can affect the terms of the lease and may include provisions related to the lender taking control of the tenant’s operation in the event of an insolvency… when this happens, without an express right on the part of the landlord to terminate the lease, the premises can sit in a state of operational paralysis whereby the landlord has to deal with both a loss of income and the inability to remove the tenant.”
Now for the good news
Strong population growth and recovering business confidence are the two areas that will shore up demand for commercial property as we head into the New Year. “Overall company profits are also in remarkably good shape with businesses that broadly sit within the retail and industrial sectors recording a 41% increase in gross profits between June 2019 and June this year,” said CreditorWatch chief economist Anneke Thompson. “Businesses in the office sector saw a 13% increase over the same period. This means that by and large tenants in these asset classes can meet their rent obligations.”