Sydney real estate is not immune to the current financial crisis and market downturn. But local advisers point to signs that suggest it can emerge strong. Paul Benjamin reports

That Sydney is not the capital of Australia often catches Joe Public off guard, but it is an ignorance that can almost be forgiven. After all, Sydney is the cultural and economic frontrunner, and the nation's most iconic and heavily populated metropolis. Sydney, not Canberra, has that harbour view and played host to the Olympics in 2000.

Although it hasn't experienced the property boom and high yields of many other major cities in Asia Pacific, at present Sydney real estate seems attractive as a safer play, backed by high transparency, a lack of oversupply issues and individual sectoral strengths.

The city's pre-credit crunch success has been set against a wider story of Australian economic growth. In an increasingly globalised world, Australia's relative geographic remoteness has not held it back. And its latest run of growth was heavily fuelled by its ability to supply the Chinese with the commodities and raw materials for the goods and products they made to sell to the Americans, who put it on their credit cards.

Of course, that has all gone pop with the credit crunch-turned-financial crisis, the worsening global slowdown, and the full-blown recessions that many developed countries have entered. Australia has not been immune, and commodity demand and values have tumbled, while credit has been squeezed.

Australian GDP contracted by 0.5% in the fourth quarter of 2008 - the first fall in eight years, but still better than any of the G7 economies - and a further fall is widely expected to open 2009. The Economist Intelligence Unit sees real GDP growth falling by 1.2% this year, before growing marginally by 0.5% in 2010. The commercial National Australia Bank recently cut its forecasts to -1% for 2009 and to +0.9% for 2010. But the general view is that, for a variety of reasons, the recession here will be shallower than elsewhere.

For starters, the financial sector, which is heavily headquartered in Sydney, has not faced the hammering that its contemporaries in the US and Europe have suffered.
Matt Whitby, national director of research at Knight Frank Australia, says: "Although Sydney has been hit by the financial meltdown, economic growth has still been at a stronger pace than many of the other global cities and it is backed by a relatively strong banking system. Australia's top four banks are all ranked in the top 20 world banks list, which has and will continue to hold Australia and Sydney in good stead, even in these obviously tough times.

"We've also seen almost full pass-through of interest rates cuts over the past year. The cash rate is down 4% since September 2008 to its current 3.25%, and 95% of this has been passed to the consumer, unlike in the UK and US."

James Buckley, head of Asia property multi-manager at Schroder Property Investment Management, points out that the public finances, while worsening under the strain of economic stimuli, are in better shape than in many other developed countries. He adds: "The Reserve Bank of Australia has made significant cash rate cuts, but monetary policy headroom remains, there is a significantly lower Australian dollar - which will provide some support for the export sector - and there has been under-building in the housing sector; New South Wales is at a 30-year low."

On top of that, immigration is running at levels not seen since shortly after the Second World War, growing by 1.8% in the year to September 2008, and reflecting a need for talent to staff the commodities industry and service sectors. Australia's population stands at 21.7 million, with Sydney's at 4.1 million (Melbourne has 3.6 million residents and Brisbane has 1.8 million). While unemployment is forecast to rise this year from its current 5.2%, and consumer spending growth will weaken to counter high household debt, the need for housing and real estate to absorb a growing population should act as a stimulus.

Indeed, foreign investors have already shown strong interest, attracted by sliding capital values and a significant fall in the Australian dollar over the final half of 2008.

Simon Storry, director of international investments with Jones Lang LaSalle (JLL), sums it up: "Domestic buyers have been in retreat in the wake of the credit crisis and it has been the cashed-up and opportunistic overseas buyers who have been most active in the Australian market."

Kevin Stanley, executive director for the Pacific region with CB Richard Ellis, says: "It's quite hard to read where pricing is at, but we are seeing a gradual slide in capital values. We saw much lower volume of trading activity in 2008 and it hasn't really picked up that much in 2009. Activity that has happened has been dominated by private investors who have seized the opportunity to purchase properties that may not have been on the market when it was stronger.

"Foreign investors have been in Sydney looking to the medium to longer term. We've seen German and Asian investors in particular, and we are convinced there will be more interest from them in 2009."

And Buckley explains: "The Australian market has been very tightly held in the past. The superannuation funds have been significant holders of domestic real estate, both indirectly through investments in listed A-REITs [Australian real estate investment trusts], but also directly. There is now a denominator effect in play, with superannuation funds overweight in direct real estate, which is likely to keep them on the sidelines for the next couple of years as values readjust. In addition, A-REITs are looking to  de-lever by selling direct assets.

"So there is a window of opportunity for well-capitalised foreign investors to participate in opportunistic-style investments. Once the banking sector stabilises, though, we're likely to see the superannuation funds and A-REITs become more active and it will be harder for foreign investors to access quality stock at reasonable prices."

All real estate sectors in Sydney, and indeed across Australia, are weakening in the face of the downturn. Looking at the crucial office sector, Sydney has the upper hand on rivals Perth, which some see as over-inflated, and Brisbane, which has a number of projects completing this year at a time when they are least needed. On the downside, Sydney is by far the most exposed to the slump in financial and professional services, with 35% of all its white collar workers employed in finance and insurance, and a knock-on effect on white collar jobs and office demand is inevitable. Office space is spread throughout the city between the core central business district (CBD), North Shore, Parramatta, Macquarie Park and suburban centres.

Matt Whitby, national director at Knight Frank, says: "The clear and present dangers are corporate downsizing and contraction, which are flowing onto vacancy increases. The threat of a large spike in sub-lease space is building. The major cities around Australia are now impacted by an increase in sub-lease space, and Sydney has been one of the hardest hit due to its links to the financial sector. This will put downward pressure on market rents."

Looking at CBD grade-A, CBRE's Stanley says: "We forecast total vacancy will keep rising during 2009 and reach 7.9% by the end of the year. This is completely due to the expected further contraction of business space use. No major new office buildings will be completed this year in the Sydney CBD.

"The level of incentives offered by landlords to attract or hold tenants is also increasing. It's currently 20% of the value of a typical lease and we expect incentives to rise to close to 30% by the end of the year. This is eroding the underlying value of the income stream.

"Looking at investment, initial yield has been softening through 2008 and is now quoted at 6.31%, after reaching a cyclical low of 5.22% in December 2007. This implied process has removed 13% from capital values to date. The investment markets are now very quiet, with turnover in 2008 down 56% on the previous year and almost 70% below the long-term average. We think yields will continue to soften in 2009 in the Sydney CBD prime office market. They are likely to be somewhere between 7% and 7.5% by the end of the year, removing approximately another 10% from capital values, before stabilising."

Sydney's retail sector is mature and is characterised by several prime strips and a spread of malls and shopping centres, many in suburban settings. Oxford Street commands the highest rents, followed by Campbell Parade in Bondi and The Corso in Manly.

Simon Rooney, national head of retail investments at JLL, describes the outlook for retail in 2009 as "modest" and adds: "2008 witnessed a record year for national retail supply, with 819,000 square metres of retail supply added to the market. This said, the cycle looks to have peaked and we are likely to see a moderation in supply with 2009. New supply is constrained by strict planning and development controls, enhancing the dominance of existing centres."

Whitby says: "Malls have continued to perform well considering the environment. Most owners have looked at extensions, expansions or refurbs to existing centres, rather than major new developments. This has kept competition to a minimum, which has assisted growth in turnover in these malls. There is limited sign of retailers going broke, but we will be watching with interest throughout 2009. Sydney's Pitt Street Mall is undergoing two major refurbishments, which should open up some new opportunities for retailers."

On the face of it, a lack of credit, high household debts, falling confidence and fears over jobs will keep the residential sector cowed. But Schroders' Buckley points out that the sector moved into a downturn ahead of the others because of rate rises and worsening affordability. Conversely, the pain in office, retail and industrial was triggered by financial market woes.

Pointing to high migration, low interest rates and undersupply, he says: "Sydney residential is likely to be the first sector to stabilise, perhaps as early as 2010. Price declines will be nowhere near the extent of the US and the UK."

Other analysts say that federal government approved grants to first-time buyers are now stimulating the market, and that in some parts of Sydney prices are even rising again. High-end residential remains in difficulty, though, particularly as corporate bonuses are cut. There has been a rise in prime housing for sale in elite markets, and prices have fallen 10-30% over the past year.

The often overlooked industrial sector is significant in a country with such a strong focus on commodities and an appetite for imports. Michael Fenton, New South Wales managing director at JLL, says: "Sydney's metropolitan industrial market is primarily focused on the distribution and warehousing of consumer goods, including wholesale, retail and manufactured. Commodities, primarily coal, are exported from the Port of Newcastle and steel from Port Kembla. As the broader Sydney population is one large consumer market, the focus through Port Botany,  Sydney's main port, is the import of goods.

"Over the last five years, there has been strong growth in both new construction and demand for new, efficient space. This has been facilitated by the development of new major road infrastructure projects, creating a ring road around the Sydney metropolitan region, which has opened up vast tracts of industrial development land."

Looking to 2009, he comments: "Industrial yields are returning to historical valuation fundamentals. Recent sales in Sydney's west have confirmed that there is strong demand from private investors for properties in prime locations with secure bankable lease covenants. What is currently attracting private buyers are modern assets in a prime location, well-established tenants with long leases of over seven years and good rental returns."

Compared with other markets in Asia Pacific, a key draw of Australia is its transparency and familiarity, with many investors citing it as a relatively easy market to operate in, especially when compared with China, India and Japan. JLL's latest report into global real estate transparency puts it joint second with the US, and behind Canada, ahead of a top 10 dominated by European and English-speaking countries.

Kevin Rudd's government has kept the favour of the electorate since the downswing began, mainly because of its response to events. This included a stimulus package worth A$42bn (€23.1bn) in February, which supplements the A$44.7bn announced in September 2008. But an election looms and that might be brought forward while the going is relatively good.

However, Stanley points to the sluggish New South Wales (NSW) state government for delaying development with a lack of critical will, and frustrating the property industry.

This stands against a stronger ‘can do' attitude in Brisbane, where growth surged ahead of NSW in recent years. Projects seemingly stuck in the pipeline include the Sydney metro system, which is vital in a city where transport has become a big issue. However, the NSW government is implementing a planning reform agenda and two big developments are attracting interest - the expansion of Port Botany, and a multi-use harbourside redevelopment of 22 hectares known as Barangaroo, which should be completed in 2015.

It seems that during these difficult times Sydney's appeal, like some of the major markets in Germany and Japan, is as a ‘safer haven', to the extent that, while things are bad and getting worse, there are some upsides.

Kevin Stanley sums up the views of the more upbeat observers: "Through the Asian financial crisis and the dotcom fallout, the Australian economy kept growing, and it's only now that there's a synchronised global downturn that Australia is caught up. But the track record here is strong and there's a bias to growth. Australia will bounce back quickly."