The Effects of the Global Financial Crisis (GFC) on the Commercial Property Sector

Discuss about the Professional Liability and Property Transactions.

Australian commercial property sector is growing strong as the economy of the country is stable and policies of the government are people-oriented. This study has its focus on the commercial property sector’s financial as well as developmental structure, from the perspective of the Commercial Property Managers (CPM). 2005 to 2010 has been a trying period for this sector due to the effects of the Global Financial Crisis (GFC). The Australian construction industry can be divided into four sectors – Material Providers; Property Developers; Construction Companies; and Real Estate Investment Trusts (REITs), assert Barnes & Doidge, (2010). The after-effects of GFC were minimal for the material providers and the construction companies, but more severe for the property developers and REITs. According to Dr Shane Oliver[1] with whom I had discussions on this topic, a big factor that provided a stabilization platform to the material providers and the construction companies was the economic stimulus package provided by the Australian government to them in the aftermath of GFC, say Emerald Gems (ed), (2015). Whereas the decreases in the value of the assets, especially the commercial properties, was responsible for reduced profitability of the property developers and REITs during and after the GFC is the view of Mr. John Hill[2] (his Business Card is appended in Appendix-1), who was interviewed on the subject by me and who became the spokesperson for other CPMs on the basis of his experience. But these sectors were quick in their recoveries from the global and domestic adverse conditions and were able to return to a more sound financial condition by the end of 2010 when the effects of GFC were diffused. Since then, the investors, in synchronized functioning with the Construction Company Managers and other construction professionals have been able to devise robust and successful financial as well as development strategies to encourage a prudent financial management which helped in weathering any future financial crises, as per Christensen & Duncan, (2004).

The reason behind GFC, which is considered to be the worst global financial crisis after the Great Depression, was the environment of low interest rates. Using this as the lever, large number of loans were distributed to US homebuyers and this set-off a housing boom which eventually went bust as soon as the interest rates went high resulting in supply glitch, says Parker, (2012). The crisis became global because the financial institutions faced losses and these losses were magnified because of gearing. This forced the investment banks and hedge funds to liquidate their fund positions for meeting redemptions. This was the time when across the world, banks were sourcing more money which was being collected from global money markets. These large amounts of funds were obtained from the expensive bank deposits which were held against the bricks and mortar properties, asserts Marsden, (2011).

The Recovery of the Commercial Property Sector from the GFC

In the opinion of Dr. Oliver and Mr. Hill, the following are the key lessons which were learned from the Global Financial Crisis (GFC) –

• High returns evidently come with higher risk (See Figure-2 in Appendix-1).
• Markets get pushed to extreme valuation as each boom-bust cycle behaves differently.
• It is necessary to be cautious of hard-to-understand financial products.
• Excessive gearing or wrong gearing must be avoided.
• Due diligence of monetary and fiscal policy must be done.

Dr. Oliver thinks that GFC highlighted to the investors how important it is to diversify their asset allocation. Mr. Hill opined that a boom is a cyclic phenomenon and it is inevitable to happen in future too but it will be different from this GFC.

This question came up in every talk with Dr. Oliver and Mr. Hill and both were of the opinion that in the post-GFC world financial environment, broad-based bubbles on the scale of the US housing/credit boom have been non-existent so far. My assessment is also that just because the global debt is rising to new high does not show signs of another global crisis. Most of the debt growth, after the GFC, in developed countries is the result of growing public debt, as stated by Spoehr (ed), (2009). Comparatively, the debt interest burden of these nations are low when taken in relation to the low interest rates of the pre-GFC period. Although, all over the world, economists are showing the concern that after the pull-back post-GFC, this is growing rather steeply in relation to global GDP (See Figure-3 in Appendix-1).

During my interaction with different CPMs in the region, I could summarize some of the key points worth considering in this context as –

• Property prices may have shown more downside in Sydney and Melbourne, but a crash is unlikely as there is absence of high mortgage rates and high supply due recent high construction activity.
• Other cities are performing better.

Many practicing CPMs in the region were of the view that Australian property prices fell by 0.2% in March and this was the fifth monthly fall in continuation and this has resulted in a fall in annual growth by 0.8% from 11.4% shown in May last year. Most of this downfall is being attributed to Sydney and less to Melbourne (See Figure-4 in Appendix-1), assert Wells (ed), (2013). This can be a concern because property price downturns have been usually effected by a significant interest rate increase and this is not evident from the table below which summarises JP Morgan’s price targets for four big banks as compared to current prices of today(See also Figure-5 in Appendix-1).

In Mr. Hill’s opinion and this was reciprocated by many other CPMs practicing in the region, there can be a further fall of about 5% in the prices of commercial real estate in Melbourne and Sydney in the coming two years period. His assumption is based on the financial institutions’ tightening in lending on the basis of increase in the borrowers’ income levels, explain Marshall Williams & Morgan (ed), (2015). However, as economy level currently stands, a drag in construction activities is likely to be at the minimal because building approvals being obtained by the industry do not point towards a slowdown in new construction plans (See Figure-6 in Appendix-1). Dr. Oliver is also of the view and he was supported by many other CPMs of the region, that negative wealth effects will not affect the consumers and in the absence of property prices crashing down, the impact on banks’ lending will be manageable, as detailed by Setten, (2009).

Current Trends in the Australian Commercial Property Sector

In the light of the above discussions, I suggest the following implications for investors –

• Firstly, the long term commercial property adjustments for costs have had returns similar to the Australian shares (See Figure-7 in Appendix-1). The lower volatility and lower liquidity has made commercial properties a good portfolio inclusions. Hence, I am of the opinion that commercial properties have an important place in any investors’ portfolio.
• Secondly, as per Mr. Hill, commercial properties still remain a cautious investment destination for new investors. This is because it remains expensive and offers low income (rental) yields when compared to the other growth assets. Hence, Mr. Hill thinks a commercial property investor has to depend more on the assets capital growth (See Figure-8 in Appendix-1).
• Thirdly, as opined by Dr. Oliver, these comments are in context to overall position of commercial real estate in Australia and it cannot be generalized for specific regions. Notable is the fact that many other cities and regions are becoming far more attractive destinations compared to Sydney and Melbourne (See Figure-9 in Appendix-1).

In this context, a very important development that came to my notice was the interest shown by foreign investors and developers in creating opportunities in Australia through certified CPMs. The Roxy Group, a hospitality sector major from USA has taken up a major development project in Sydney for a big luxury hotel to be located in Parramatta. A location and site map of the project is shown in Figures-10 and 11 of Appendix-1.

Mr. Hill agrees that an industry’s performance can be best assessed by the use of financial ratios over a period of time helps in providing reliable information about that industry’s financial health. This has been apparently found to be of significance in cases where the company’s approached failure, as explained by Erp & Akkermans (ed), (2012). Dr. Oliver has been working on a combination of ratio analysis and multiple discriminant analysis for predicting company who were on the verge of failure. The methodology used is to analyse a combination of ratios and then eliminating the possibilities of uncertainty in relying on the single ratios. Many different variations of this model have been in use for specific industry segments in various countries, including Construction in the UK and China. Dr. Oliver also pointed out that macroeconomic factors including low construction activity, rise in inflation, high interest rates and a reduction rate in consumer spending are found to be significant factors which can drive a company towards failure, as detailed by King, (2015).

The best measuring dimension of a country’s recession, next to its GDP, is the stock market. It has been established by experts that market index can be considered as a reliable tool for plotting the timeline of a country’s/region’s/company’s recession, right from start till recovery. During the GFC, Dr. Oliver points that in Australia the S&P/ASX200 fell from its peak of 6748 in October 2007 to 3145 in March 2009. This was a straight loss of 46% in its valuation. After the effects of GFC declined, markets made recoveries and have remained buoyant at 4500 level as reports came till end of 2010, asserts Hinkel, (2010).

The results, summarised in Table-1 (See Appendix-1), have shown significant decline in revenues of REITs in 2008 and 2009 and also in the case of developers. The building material sector also presented a marginal contraction of 2.8% in 2009 and this was followed by further contraction of about 7% in 2010. On the other hand, robustness was seen in revenues of building contractors, which continued to increase, by 1.6% in 2009 and 0.8% in 2010 despite all the slump in the industry starting from 2008, assert Emerald Gems (ed), (2015). This happens because in the building construction industry, the builders do not get immediately affected by a downturn as they keep working on the ongoing construction projects which are awarded couple of years earlier and professional CPMs agree with these opinions. Australian government’s contribution of funds through a number of stimulus packages to mitigate the effects of the GFC on the local construction market were at level of AUD81.5 billion and AUD75.6 billion in 2008 and 2009 respectively, as explained by Marshall Williams & Morgan (ed), (2015).

Lessons Learned from the GFC from the Perspective of Commercial Property Managers

Table-1 in Appendix-1 shows that the total net assets of all the sectors covered by this exercise increased in the period 2006 to 2010. The net assets of building contractors have shown the highest increase, having doubled in 2010 as compared to 2006 and other sectors also showed an increase averaging over 50%. The only downfall, although a small decrease, was witnesses in the net assets of property developers and A-REITs which went for revaluation of their assets in 2009 and 2010. In this table, the Net Asset shown are usually equal to the equity of the shareholders in the company’s balance sheet which is taken as total assets less total liabilities, say Christensen & Duncan, (2004).

Ratios which are used for measuring the industry’s profitability, activity, liquidity, leverage and solvency have always been accepted as significant indicators of the corporate’s performance. Table – 2 in Appendix-1 has listed at least one of these five financial ratio in each of the sectors enlisted to evaluate the performance of the sector in the building construction industry. These ratios have been weighted on the basis of the annual revenues of the respective sectors, as per Parker, (2012). The net profit margin (calculated by dividing net profit by sales revenue) for the material providers has shown reduction from 7% in 2006 to 0.8% in 2010. Similarly, the net profit margin for building contractors was also reported at low of 3-4% in 2006 and 2007 and was further reduced to the minimum level of 1.6% during the GFC, although it slightly recovered to 1.9% in 2010. The net profit margin for property developers was the highest at 30% before GFC’s onset, but was eventually turned into a 59% loss in 2009 during GFC. Similarly, A-REITs also reported a high net profit margin of 70% and 53% during the pre-GFC regime but had to come down to a massive loss of 106% in 2009, assert Spoehr (ed), (2009).

In Table-2, the Return On Average Equity (ROE), which is used for measuring the rate of return on the equity of the shareholders and also reflects the efficiency of the company in generating profits from every dollar of equity has been highlighted for all the sectors. Calculated by dividing the net profits of the sector by the average equity of the sector, a high return of 13% and 17% was shown by the building material provider sector during the period of examination but again dropped to a low of 0.2% during 2009 because the net profits were depressed by the GFC effect. Pre-GFC, building contractors were showing returns of 40% but these fell to 23.1% in 2008 and came to a low of 8.3% in 2010. This was corresponded by the drop in net profit margin from 30% pre-GFC to 20% post-GFC. The property developers also achieved an ROE of 20% pre-GFC but then suffered losses in 2009 and reported an ROE of -24% during 2009. The ROE for the A-REIT sector too fell from 21% in 2006 to -13.9% during the GFC effect in 2009, asserts King, (2015).

Implications for Investors in the Australian Commercial Property Sector

Conclusion

I found that Dr. Oliver and Mr. Hill, with their years of experience and also being in the thick of things during the period of GFC, were the most reliable source for this report, and their opinions were also echoed by other professionally acclaimed CPMs. This was also confirmed by the data that I could collect from both the stalwarts of the construction sector. In the aftermath of GFC, the property investment companies and A-REITs were relatively quick in their recoveries as compared to other sectors of the construction industry. This happened despite the drop in the value of the real estate assets held by the property investment companies and the A-REITs. Another important factor which was brought to my notice by Mr. Hill was that the functioning of the A-REITs and the property investment companies was of a similar manner and both do not report their COGS (Cost of Goods Sold), although they employed professional CPMs. It has been an established fact that the interest payments of both these sectors of the industry approximately come to about 10% as both these sectors are heavily dependent upon debt for financing their purchase of the real estate assets. Dr. Oliver revealed to me that the A-REITs were amongst those sectors of the real estate industry which were the most affected and had a reported cost structure which was approximately three times of their total revenue at the time of 2009 GFC, as detailed by Emerald Gems (ed), (2015).

On the other hand, a commercial property developer relies on its internally generated funds. These property developers in Australia were reaping healthy profits during the property boom which was in vogue prior to the onset of the GFC. They also had the comparatively advantageous position as these property developers were utilising long-term debts for financing their real estate operations. Hence, as soon as the markets recovered in 2010 and the revaluation of the properties held by them was conducted, these property developers started reporting net profits and hence reverted to healthy balance sheets as compared to those who relied on external short-term borrowings, say Marshall Williams & Morgan (ed), (2015).

Table-1
Sales Revenue & Net Assets (A$ million) of Australian Construction Industry
	2006	2007	2008	2009	2010
SALES REVENUE
Material Providers	19,926	20,961	24,454	23,775	22,136
Change in %-Year to Year		+5.2%	+16.7%	-2.8%	-6.95%
Property Developers	7,205	9,323	7,827	6,903	6,810
Change in %-Year to Year		+29.4%	-16.1%	-11.8%	-1.4%
Building Contractors	1,506	2,068	2,455	2,495	2,514
Change in %-Year to Year		+37.3%	+18.7%	+1.6%	+0.8%
A-REITs	1,636	2,762	2,294	1,331	1,493
Change in %-Year to Year		+68.8%	-16.9%	-42.0%	+12.2%
NET ASSETS
Material Providers	10,404	11,936	12,725	15,105	15,731
Change in %-Year to Year		+14.7%	+6.6%	+18.7%	+4.1%
Property Developers	13,137	17,676	18,760	18,693	19,705
Change in %-Year to Year		+34.6%	+6.1%	-0.4%	+5.4%
Building Contractors	152	248	301	329	357
Change in %-Year to Year		+63.1%	+21.2%	+9.5%	+8.4%
A-REITs	6,187	8,102	10,134	9,521	9,132
Change in %-Year to Year		+30.9%	+25.1%	-6.0%	-4.1%

Table-2
Financial Ratios of Australian Construction Industry (Weighted on Sales Revenue taken in A$ millions)
	2006	2007	2008	2009	2010
Material Providers
Net Profit Margin	0.074	0.084	0.062	0.015	0.014
Return on Average equity	0.149	0.173	0.134	0.002	0.012
Current Ratio	1.437	1.544	1.257	1.742	1.780
Working Capital Turnover	11.760	9.430	54.230	8.224	6.770
Quick Ratio	0.867	0.933	0.722	0.944	0.988
Debt Ratio	0.540	0.491	0.524	0.432	0.415
Times Interest Earned Ratio	93.172	12.231	10.252	3.604	8.059
Property Developers
Net Profit Margin	0.324	0.377	0.153	-0.587	0.144
Return on Average equity	0.203	0.189	0.069	-0.237	0.004
Current Ratio	1.393	1.725	1.656	2.306	1.460
Working Capital Turnover	-2.214	0.911	-1.684	2.270	3.459
Quick Ratio	0.454	0.778	0.602	1.367	0.726
Debt Ratio	0.534	0.479	0.502	0.463	0.428
Times Interest Earned Ratio	20.462	15.609	5.621	-15.014	8.088
Building Contractors
Net Profit Margin	0.034	0.040	0.028	0.016	0.019
Return on Average equity	0.477	0.439	0.231	0.122	0.083
Current Ratio	1.479	1.504	1.472	1.636	1.466
Working Capital Turnover	6.712	4.650	15.489	11.381	50.254
Quick Ratio	1.104	1.018	1.034	1.181	1.074
Debt Ratio	0.683	0.653	0.654	0.599	0.651
Times Interest Earned Ratio	1525	6295	10194	816	48
A-REITs
Net Profit Margin	0.707	0.776	0.581	-1.057	0.371
Return on Average equity	0.210	0.222	0.134	-0.139	0.048
Current Ratio	0.663	1.049	0.750	1.331	0.736
Working Capital Turnover	-1.227	-0.839	-0.083	-0.386	0.787
Quick Ratio	0.643	0.897	0.702	1.210	0.646
Debt Ratio	0.357	0.336	0.358	0.334	0.330
Times Interest Earned Ratio	10.663	13.324	8.294	-9.515	2.749

References

Barnes, R. and Doidge, G. 2010, Managing Your Investment Property: The Essential Guide to Property Management in Australia and New Zealand. John Wiley & Sons, Milton, QLD.

Christensen, S. and Duncan, W.D. 2004, Professional Liability and Property Transactions. Federation Press, Annandale, NSW.

Emerald Gems (ed). 2015, Built Environment and Property Management: A Focus on Australia. Emerald Group Publishing Limited, Bingley.

Erp, Sjef. and Akkermans, B. (ed). 2012, Cases, Materials and Text on Property Law. Bloomsbury Publishing, London.

Hinkel, D. F. 2010, Practical Real Estate Law, 6^th ed. Cengage Learning, Boca Raton, FL.

King, Sarah. 2015, Beginning Land Law. Routledge, Oxon.

Marsden, S. 2011, Business, Charity and Sentiment: The South Australian Housing Trust 1987-2011. Part two. Wakefield Press, Kent Town.

Marshall, A., Williams, N. and Morgan, J. (ed). 2015, Land of Sweeping Plains: Managing and Restoring the Native Grasslands of South-eastern Australia. Csiro Publishing, Clayton South, VIC.

Parker, D. 2012, Global Real Estate Investment Trusts: People, Process and Management

Real Estate Issues. John Wiley & Sons, West Sussex.

Setten, L.D. 2009, The Law of Institutional Investment Management. Oxford University Press, Oxford.

Spoehr, J. (ed). 2009, State of South Australia: From Crisis to Prosperity? Wakefield Press, Kent Town.

Wells, G. (ed). 2013, Sustainable Business: Theory and Practice of Business under Sustainability Principles. Edward Elgar Publishing, Cheltenham.