Rising bond yields and uncertainty over the interest rate outlook are creating a more challenging environment for Australian listed property, reinforcing the importance of valuation discipline and balance-sheet strength, according to SGHiscock portfolio manager Grant Berry.

Berry says the impact of interest rates on property valuations extends beyond expectations for the next Reserve Bank of Australia (RBA) decision, with longer-term bond yields playing a particularly important role.

“While short-term interest rate expectations can influence earnings in the near term, longer-term interest rate expectations and real bond yields are more important drivers of property valuations.

“Real bond yields have risen to elevated levels compared with much of the post-global financial crisis period, creating a more challenging valuation environment and limiting the scope for further capitalisation rate compression.

“In this environment, investors need to be disciplined about the prices they pay for assets and focus on the underlying quality of the businesses they own.”

The latest reporting season showed differing conditions across property sectors, with strong operational performance not always translating into positive security price reactions.

Retail property continued to demonstrate resilience, supported by high occupancy levels and solid sales and leasing metrics. However, with operating conditions already relatively strong, the scope for further positive surprises may be more limited.

The office sector showed signs of improvement, with better occupancy and comparable income growth at some major landlords. However, elevated leasing incentives and upcoming lease expiries remain challenges for selected owners.

“Office property is showing some encouraging signs supported by rental growth which is very apparent in Sydney and Brisbane, highlighting a preference for prime assets. Improving occupancy and income growth need to be considered alongside leasing incentives, upcoming expiries and the financial strength required to manage those challenges,” Berry says.  This subsector is where we see some compelling opportunities.

Residential and land-lease businesses also delivered results that exceeded subdued market expectations.  

Industrial property has seen negligible market rental growth.  While positively the supply cycle has subsided from the high levels of recent years, which is good for existing assets. Rental structures are typically below market levels providing scope to increase the income from assets.

Data centres continued to offer structural growth opportunities. However, Berry cautions that attractive growth prospects alone are not sufficient to justify valuations, particularly where significant development pipelines create execution, funding and leasing risks.

“The market is becoming more discerning about the quality and sustainability of growth. Data centres have attractive long-term drivers, but investors also need to consider the capital required to deliver developments, the ability to secure tenants and the risks associated with executing to deliver that growth,” he says.

Against this backdrop, Berry says market volatility is creating opportunities to acquire quality property securities at attractive valuations, particularly where improvements in underlying operations are not fully reflected in security prices.

“We focus on property entities with attractive underlying fundamentals where the market price does not fully reflect their value, and investors need to look beyond headline earnings growth and assess the sustainability of cash flows, balance-sheet strength, capital management and valuations relative to underlying asset values.

While some property fund management businesses continued to command premium valuations, Berry says selected property owners and smaller real estate investment trusts (REITs) could offer more compelling value relative to their underlying assets and long-term earnings prospects.

“Property is a localised asset class, and understanding the quality of the underlying assets, the strength of tenants and the capability of management teams is critical.

“Periods of volatility can create opportunities, but investors need to be selective. The priority should be identifying those groups with sound fundamentals and the financial capacity to navigate a more uncertain economic and interest rate environment.”

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