The industrial market development cycle in Australia has come full circle following the Global Financial Crisis (GFC) and post-GFC recovery. We recently analysed the metrics that an institutional developer would adopt in the feasibility analysis for a warehouse and office development in Western Sydney. We identified the four key ‘levers’ in the development model and how they have looked at each stage of the cycle between 2007 and 2012.
In 2007, a developer would have adopted a land rate of around AUD 350 per sqm, cap rate of 7.0%, very low profit target (including compensation for risk) of 5.0% and pre-lease rent of AUD 110 per sqm p.a. net.
In 2009 land rates fell to around AUD 250 per sqm, cap rates eased to 9.0%, profit and risk normalised at around 20% and pre-lease rents remained around AUD 110 per sqm p.a. Clearly in this environment investment hurdles were much higher. While asking rents held up, very few new pre-lease development deals were recorded.
Enter 2012, and the cycle has turned again. An institutional developer now assumes land prices have remained flat at AUD 250 per sqm. Cap rates have tightened: a cautious developer would assume a cap rate of around 8.0% on a 5-7 year term or as low as 7.5% on a 10-15 year term. Profit (including risk) has decreased to less than 10% and is being squeezed further by some developers. Meanwhile, pre-lease asking rents have increased to around AUD 115 to AUD 125 per sqm p.a.
What are the dynamics for development heading into 2013?
The current spread between existing and pre-lease rents in Outer Central Western Sydney is the highest in ten years at AUD 8 per sqm p.a. Pre-lease rents typically carry a positive spread over existing market rents but existing and pre-lease rents general move together over time. However, when the spread between existing and pre-lease rents is narrow or even negative, strong tenant pre-lease activity has often occurred. A construction response from developers then results in some backfill or speculative development vacancy, which can temporarily depress existing market rents.
We are in the latter stage of this cycle.
What happens to rents now will depend on how quickly existing vacancy is absorbed and how responsive developers are in 2013.
A range of lead indicators, such as container traffic and inventory growth, point to rising demand for space in 2013. A number of pre-leases remain in the market. Meanwhile, the forward supply pipeline indicates a significant slowdown in 2013 pointing to low vacancy in core locations.
So which of the four ‘levers’ in the development model will move in 2013?
Land values appear unlikely to be bid up, with limited new developer interest in land currently. Cap rates have room to tighten. Though our base case implies only around 50 basis points of tightening through the cycle, this may occur more rapidly than forecast. Profit and risk has already tightened, with very little room to be squeezed further.
We expect to see prime grade existing market rents increase in 2013 to close the gap on pre-lease rents in a low supply and rising demand environment. This will ignite another mini-cycle of pre-lease activity and a supply response from developers as the rental pulse increases.