Lenders are perceiving retail to be the riskiest among core commercial real estate sectors as debt costs rise, according to MSCI Real Assets. 

A sharp increase in the cost of debt, propelled by the Reserve Bank of Australia’s 10 straight cash rate hikes, had been arguably one of the biggest drivers behind the slowdown in transaction activity and commercial property performance in Australia last year.  

The MSCI/Mercer Australia Core Wholesale Monthly Property Fund Index found that total deal volume fell to $63.3 billion, down 25% compared to 2021.  

While the whole market was affected, the impact was not felt equally as some sectors are perceived riskier and priced accordingly by lenders.  

The average cost of debt for retail specialist funds surged to 8.3% in Q4 2022 from 2.6% in Q4 2021 – the highest level since the series began in 2015, an analysis of the data showed.  

This compares with 5.8% for office specialist funds and 4.0% for industrial specialist funds in the same period.  

“Given the economic issues pervading the economy, it is understandable why there is concern over the retail sector’s performance in the short term,” said Benjamin Martin-Henry, Head of Pacific Real Assets Research at MSCI. 

“After all, the main aim of the central bank’s tightening is to reduce consumer spending to bring inflation down from levels not seen since the late 1980s. A decrease in disposable income will impact retail sales across all property subtypes. But the hardest hit asset types are likely to be those with a higher proportion of sales generated by discretionary spending.”  

The RCA Hedonic Series, however, has showed that yields expanded for almost all retail subtypes in Q4 2022, as pricing adjusted to the increase in the cost of debt.  

Office and industrial funds also recorded significant increases in the cost of capital in Q4 2022.  

The average cost of debt for office specialist funds more than doubled to 5.8% from just 2.7% a year prior, taking it to the highest level since mid-2019.  

Further uncertainty about the office sector remains, as office occupancy levels across Australia have yet to recover to pre-pandemic levels.  

For industrial specialist funds, the average cost of capital for industrial specialist funds increased to 4.0%, from 1.9% in Q4 2021.  

This was mainly due to the symbiotic, but not correlated, relationship with retail due to the rise of e-commerce that has fuelled industrial performance over the last few years.  

Such has been the strong performance of the industrial sector in recent years that lenders are still pricing debt well below that of the other core sectors and only marginally above risk-free rates. 

“The retail sector suffered a significant downturn in performance at the onset of Covid-19, due chiefly to write-downs in values, and so far the sector has not recouped these losses,” Martin-Henry said.  

“In light of these declines in value, it would not be a surprise to see well-capitalized investors who aren’t reliant on debt turn their attention to retail assets as some current owners face the pressure of refinancing at higher rates.”