Commercial property is often thought of as a hybrid asset, with total returns generated from its bond-like income earning ability combined with the scope for equity-like capital gains. In Wellington’s case, the earthquake-driven shortage of buildings (particularly offices) is likely to be good for both parts of the returns equation. Income, however, could be the real star.

Wellington’s economic backdrop is healthy. As outlined in our latest Quarterly Economic Monitor, most partial indicators have been strong, including traffic flows, residential and non-residential building consents, house prices and car registrations.
The number of Jobseeker Support recipients in the capital fell in the year to June, by contrast with the modest rise across New Zealand as a whole. At 4.6%, Wellington’s unemployment rate is as low as it’s been at any time in the past six years.  This is despite a decade-high net inflow of permanent and long-term residents of 2,785 over the past year.

Taking these indicators together, our provisional estimate is that Wellington City’s GDP expanded by 2.5% in the year to June 2017. That is comfortably above the average of 1.9% for the past decade. In other words, the demand-side of the commercial property market is strong.

Earthquake-driven restrictions on supply are simply adding to the downward pressures on vacancy rates and the upward pressures on rents and landlords’ income streams.  Estimates vary depending on which agent’s reports you look at, but the consensus is that less than 1% of prime office space in Wellington’s CBD is currently vacant. For context, this figure in Christchurch is more than 20%. Even in a less distorted market such as Auckland the prime office vacancy rate is still about 4%.

Spillover effects from the tight supply/demand balance for offices are also now evident in the industrial sector. Anecdotal evidence is that smaller tenants have had no choice but to move to the CBD fringe and convert ex-industrial or warehouse space into office use.
Respite is on the way in the form of a development upswing. But construction lags mean that this new or refurbished space won’t be available until 2019 or later. Much of the best new space has already been pre-let, although it will still help to ease upwards rental pressure because presumably those pre-committed tenants will be leaving behind space somewhere else.

Of course, growth in market rents or a reduction in leasing incentives (such as rent-free periods) are only part of the story for a landlord. It doesn’t mean very much if you don’t have a tenant. Fortunately, given the public sector’s presence, a relatively stable occupier base has always been a feature of the Wellington commercial property market. On top of that, the forecasts in our Regional Economic Profile suggest that other sectors such as ICT are set to contribute to employment and occupier demand. We expect another 1,550 ICT jobs to be created in Wellington City over the next 4-5 years.

With all of this in mind, it’s no surprise that Colliers reports high levels of investor confidence about the prospects for Wellington commercial property, which we suspect will be reflecting optimism about rental growth and income streams at least out to 2020. After all, Wellington property yields or “cap rates” (7% for a prime office) aren’t obviously too high, at least relative to other parts of the country. Therefore, the scope for easy capital gains in the form of quick yield falls is probably limited.

Even without much of a yield shift, however, Wellington property landlords still look likely to enjoy tidy returns over the next few years. On a standard measure [1], a yield of 7% and an entirely conceivable gain in rents (and hence prices) of 10% would deliver an annual total return of 17%. If anything, the balance of risks to that figure lies to the upside. On the whole, it’s a good time to own commercial property in the capital.

—————————————

[1] Total return = yield + capital gain (where capital gain = rental growth + impact of change in yield)