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Home Interest rates and property
May 30, 2023

Interest rates and property

Stuart Cartledge

In almost every market update and investor discussion Phoenix Portfolios reminds investors that property is an interest rate sensitive sector. All else equal, if interest rates decline the value of property should go up. The opposite is also true, as has been proven recently: when interest rates go up, property prices are likely to decline. This concept is simple, but its impact is not necessarily spread evenly across different types of property. Below we cover the impact of changing interest rates on various types of property and highlight some of the ways our investment process for the Cromwell Phoenix Property Securities Fund responds to a changing environment.

 

Residential property

Owning a home is seemingly the goal of almost every Australian. It is ingrained in Australian culture that one should strive to own a home; after all, it is the Australian Dream! A common refrain is “house prices always go up”. This has seemingly been true in most Australian capital cities, but the housing market is, as the name suggests, a market. Prices in a market are determined by demand and supply. This is also true for houses.

Before discussing the demand side of the equation, let’s briefly touch on supply. Many cities across Australia have notoriously challenging property planning regimes. Any proposal to develop new residential housing, or densify existing housing, tend to be faced with local opposition, combined with long and costly planning processes. An example can be seen in one of the portfolio’s holdings, Mirvac Group (MGR), which bought an old hotel in Brunswick, in Melbourne’s Inner North in 2021. Plans to knock down the hotel to build more than 150 apartments are still going through a planning process. At best these apartments will be delivered in 2026, although delays are likely. Since 2011, the number of residential dwellings in Australia has grown at 1.7% per annum1 , with much of that growth taking place on the outskirts of existing capital cities.

As was previously touched on, demand for housing is insatiable. Furthermore, Australia’s population has roughly grown in line with new dwellings and the amount of people living in each dwelling has been consistently decreasing. In a world where supply is limited, what stops prices going up infinitely? The answer is of course people’s capacity to pay. The vast majority of home buyers make use of a mortgage to buy their homes and so the amount that they can afford to borrow, will be very closely linked to how much they are willing to pay for a house. In this context, the impact of changing interest rates should be obvious.

 

To illustrate this point. The Reserve Bank of Australia’s Target Cash Rate (Cash Rate) has moved from 0.1% to 4.10%. The monthly repayments on a $900,000 mortgage today are equivalent to the monthly repayments on a $1,420,458 mortgage when the Cash Rate was 0.1%. The change in house prices will naturally (inversely) follow changes in interest over time, albeit with somewhat of a lag. This can be seen in the chart on the right-hand side. Note how home prices accelerated when interest rates were at record lows.

Commercial property

Shopping centres, office buildings, industrial properties and other commercial property types may have bigger price tags than your average three-bedroom home, however many of the same dynamics are at play. Like residential property, most commercial property purchases are partly funded with debt. Unlike residential property, where mortgages can commonly comprise 90% of the value of the property, listed commercial property owners in Australia typically employ gearing levels of approximately 30%. Unlike many owner occupiers, commercial property investors require a financial return on their capital. In most cases, this means that debt must be “accretive” to the owner. Put more simply, the cash flow yield of the property should be greater than the interest rate on debt2. A natural relationship that comes from this is that as interest rates increase, the income yield owners require also rises. Assuming the amount of income is stable, this means that the value of the property must go down.

 

Again, much like residential property, market prices for commercial property are determined by supply and demand. The factors playing into demand are however different to residential markets. Many commercial property investors can, and do, invest across many asset classes. As a collective, their goal is to earn the best return they can in the least risky way possible. To invest in a riskier asset type they naturally require a higher return. An abbreviated list of asset classes and their risk levels can be seen below.

Asset Class Risk Level
Cash Very Low
Government Bonds Low
Corporate Debt Low to Moderate
Property and Infracstructure Moderate to High
Shares High

 

When interest rates increase, so does the income investors can earn from investing in cash, government bonds and corporate debt. That makes them relatively more attractive. When this happens the demand for property (at the same price as before rates increased) decreases. The return required from property then increases in order to make those returns relatively more competitive with lower risk alternatives.

How Cromwell Phoenix Property Securities Fund manages the impact of rising interest rates

So, with all the negative impacts of rising interest rates, does this mean investing in listed property is doomed? We do not believe so and we have been managing the portfolio for the current environment. Some ways we can adjust to investing in this environment include:

Buying securities at large discounts – The stock market is forward looking and the market prices changes in interest rates on a daily (even moment-by-moment) basis. In some cases, the market can overreact, leaving great buying opportunities. One such example we have discussed in the past is GPT Group, which ended the quarter trading at a discount of almost 30% to its net tangible asset backing.

Buying higher returning assets – Higher yielding assets are less affected by interest rates than their low yielding counterparts. For example, a 0.5% increase in capitalisation rate for an asset previously trading at 4%, represents a greater than 11% decline in value, while a similar move for an asset with a 7.5% capitalisation rate equates to only a 6.3% decline. Phoenix has invested in GDI Property Group, which owns higher capitalisation rate assets such as offices in Perth. The properties have the added benefit of being valued below their replacement cost, further adding to their relative attractiveness.

Buying assets with higher growth outlooks – When interest rates were at record lows, assets with high levels of growth were priced for perfection. This has moderated in recent times. Industrial property rents are growing at record levels, up 20% year-on-year in some domestic markets (and more than 50% in some foreign markets). In fast moving markets these assets may look optically expensive based on this year’s income yield, however are attractive if one looks forward. Phoenix has increased its stake to industrial property, taking meaningful positions in Goodman Group and Centuria Industrial REIT.

Once more it is worth reiterating that property is an interest rate sensitive sector. When we inevitably say this again in the future, hopefully the information above is useful in explaining what we mean. We are however very cognisant of the impact of interest rates along with many other extraneous factors. We will always strive to buy attractively valued securities and are constantly assessing assumptions and adjusting the portfolio to achieve this goal.

 

Footnotes

1. Source: Australian Bureau of Statistics
2. This is true in most cases, however many consider accretion to “total return”, which includes capital growth as well as income.

About Cromwell Phoenix Property Securities Fund

Read more about Cromwell Phoenix Property Securities Fund, including where to locate the product disclosure statement (PDS) and target market determination (TMD). Investors should consider the PDS in deciding whether to acquire, or to continue to hold units in the Fund.

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