After struggling over the past couple of years, Knight Frank expects 2024 to be a year of recovery for commercial property.

This is the overarching conclusion within the property consultancy’s Australian Horizon 2024 report which makes key predictions for the commercial property market over the next 12 months.

One of Knight Frank’s key predictions relates to the re-emergence of value which is expected to make 2024 a better year to acquire assets.

While pressure on asset values, courtesy of higher rates is still playing out, Knight Frank’s chief economist Ben Burston expects the gap between sentiment and formal valuations – indicating a lack of clarity on where formal metrics will end up – to erode substantially over the next six months.

Attractive entry point

By mid-2024 he expects the picture to be clearer for buyers and sellers alike, helping to restore confidence and liquidity.

Burston reminds the market that the period immediately after the end of the rate hike cycle ending in 1994, 2000 and 2010 was in each case a very attractive time to buy, achieving above-average returns over the following five years.

If rate cuts eventuate as anticipated in 2024-25, Burston expects this to be accompanied by yield compression. Based on its current outlook for interest rates, Knight Frank forecasts average Sydney prime yields to peak in coming quarters, and then fall back by 50-75 basis points by 2026.

“Investors cannot take for granted that interest rates will fall exactly as anticipated,” Burston said.

“But careful asset selection will maximise the chances of strong performance whether it is achieved through income growth or boosted by a return to yield compression as interest rates revert in 2024-26.”

Lurch to residential ‘living’ sectors

In 2024 Knight Frank expects alternative residential ‘living’ sectors, notably build-to-rent (BTR) to become even more pronounced as a core strategy, as major institutions seek greater diversification in response to an uncertain global economic outlook.

Investors are also gravitating toward the living sectors due to the structural under-supply in rental markets and Knight Frank’s head of alternatives Tim Holtsbaum expects these drivers to remain in place in 2024.

“Investors are also gravitating toward living sectors because they offer the ability to adjust rental income streams more quickly than other sectors in response to high inflation,” said Holtsbaum.

“We expect a further expansion of interest in BTR and other living sectors to be reflected in continued growth of the pipeline and additional capital partnerships being formed.”

Nevertheless, he expects to see more variation in the strategies of different investors, with groups seeking large-scale defensive investments favouring BTR.

Meantime, groups with a higher return target are expected to gravitate to other asset types such as co-living and student accommodation.

Wide divergence in yields

According to the Knight Frank Australian Horizon 2024 report, perceived risk and rental growth prospects will heavily impact pricing in the commercial property market.

For example, core assets purporting to offer better income security are expected to trade at tighter internal rates of return (IRR). It’s also suggested that those [assets] with strong income growth prospects can achieve a given return target with a lower yield.

By comparison, weaker quality stock is likely to be perceived as higher risk and offering less income growth potential, so yields will need to be significantly higher to achieve a given return target.

While this plays out relatively well for industrial assets – currently benefitting from strong rental growth and tight supply – Burston expects a sharp divergence for office and retail, depending on asset quality and perceived growth potential.

“Prime assets that are the demonstrated preference of tenants and consumers within their local market and are experiencing rental growth associated with the recognised flight to quality will also see a reduced shift in required return targets and hence reduced yield shift,” said Burston.

“However, assets facing heightened vacancy risk and without the prospect of seeing effective rents rise in the near term will suffer a larger shift as investors demand a higher premium for risk.”

Industrial rents have further to rise

Knight Frank believes the current phase of rental growth in industrials has further run.

Knight Frank’s latest Australian Industrial Review Q3 2023 found there was a 30% increase in vacancy across the eastern seaboard cities over Q3 but vacancy was still 52% below the level of two years ago.

Sydney and Brisbane experienced the strongest prime rental growth over 2023, with Sydney seeing a 20% rise in rents, followed by Brisbane (16%), Melbourne (10%), Adelaide (10%) and Perth (3%).

Looking forward, Sydney and Brisbane are expected to experience the highest industrial rental growth in 2024 at 6%, followed by Melbourne and Perth at 4% and Adelaide at 3%.

Knight Frank partner, research and consulting Jennelle Wilson’s assessment of rental costs – as a proportion of total operational costs for a wide range of industrial space users – suggests rents are not yet presenting an unmanageable burden.

Secondly, she notes industrial rents are by no means out of whack with rents in comparable cities globally.

“While rents and other operating costs are increasing, the data indicates that in most cases companies have been able to pass through the increases to end consumers, in keeping with the wider dynamic of a high inflation,” said Wilson.

“Large companies appear to have the resources and business need to continue to absorb higher rental levels, although very tight supply levels in Sydney may drive longer-term changes to the way companies allocate their holdings across the country.”