The Australian government: why buy our debt when uou can buy our covenant?

November 27, 2012 / By

Foreign investors are acquiring Australian government bonds in record numbers. Nearly 80 per cent of the Commonwealth’s AUD 207 billion debt on issue is now held offshore. Yet offshore investment into the largely Federal Government-occupied Canberra office market remains comparatively subdued. Two large sales to Singaporean investors at the start of the year (totalling AUD 309 million) are the only significant transactions since 2010 that Canberra has to show for the influx of foreign funds into Australia.

While the ten-year government bond yield is currently 3.30% (as of 26/11/2012), the midpoint of the prime-grade yield in the Canberra office market is 508 basis points higher, between 7.25% and 9.50%. Commercial property, unlike government bonds, offers an income return and the prospect of long-term capital appreciation. The tighter end of the yield range (7.25%) represents modern, energy efficient office buildings – often with long-term leases to government occupiers with fixed increases over the duration of the lease. These yields are significantly higher than other Australian CBD office markets – approximately 100 basis points higher than Sydney and 75 basis points higher than Melbourne. Obsolescence and depreciation are obvious risks, but are the fundamentals of the prime market in Canberra that much worse than in Sydney or Melbourne?

Currently, Canberra’s vacancy rate is the highest of any Australian CBD, at 10.5%. It is important, however, to peel back the headlines of the Canberra vacancy rate. Since 2010, a National Green Lease policy requires that all new government leases should meet a hurdle of a 4.5 star NABERS energy rating when the office space is more than 2,000 sqm and the lease term is more than two years. Currently only six options over 2,000 sqm meet these requirements in the key precincts of Civic and Barton. So unless there are major changes to the drivers of office demand in Canberra, an energy efficient property in a good location is unlikely to become obsolescent, nor is it likely to significantly depreciate in value.

Approximately 60% of Canberra office space is occupied by Federal or State Government. The health of the Canberra office market is, therefore, intrinsically linked to the public sector. Since large scale employment cuts during the first term of the first Coalition government (1996 – 1998), public service job growth has been roughly in line with population growth. So despite promises from both sides of politics to cut public sector spending if elected, the number of public servants in Canberra is unlikely to dramatically decline.

The global hunt for yield makes Australian assets attractive to offshore investors. Australia is one of only fourteen countries rated as AAA by Standard & Poor’s. The quality of covenant (and therefore security of cash flow) from a high proportion of Canberra’s prime-grade assets is amongst the strongest in the world.

Jones Lang LaSalle forecasts that prime-grade assets in Canberra will deliver an average total return of 9.9% per annum between 2012 and 2021. With ten-year government bond yields sitting at 3.30%, an investment in the Canberra office market has the potential to generate an excess annual return of 660 basis points for little additional risk.


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