_The flight to quality

Flight to quality across multiple dimensions

As the grip of weakening economic conditions takes hold, one of the effects will be a reassessment of priorities and an attendant shift the attitudes of businesses and of households toward risk. Whereas in times of plenty, spending and investment decisions are made with greater confidence and acceptance of uncertain payoffs, in the current climate we can expect greater reticence.

What is true for households and business is also true of investors, and many will have shifted from a ‘risk on’ to ‘risk off’ stance. But what does this mean in practice, and what does it tell us about the outlook for property?

Up until recently, we had been seeing a search for yield driving investors to accept greater risk in order to achieve the prospect of growth and higher returns. In an environment of sustained strong performance across most sectors and cities, underpinned by robust tenant demand, vacancy risk was limited and income security seemed assured, with the search for growth potential of greater concern. 

This led to convergence in pricing across different grades of property and different locations. But the advent of COVID-19 has tipped the scales back toward security and as a result the property market is set to experience a flight to quality that will sharpen the distinction in desirability and pricing between the different grades, different locations and different lease lengths.

Prime over secondary

The crisis will drive a renewed search for prime property, with reference to both quality of building and desirability of location. 

An outlook for rising unemployment implies an outlook for higher vacancy in many markets, with tenants having more choice of properties to occupy and facing less competition. This means that the best assets will win out and offer greater resilience and income security, with a sharper distinction between prime and secondary the end result.

Long income over short

In the current environment, longer leased are clearly desirable to enable investors to look through the current period of uncertainty and avoid needing to re-let properties in a period of weak demand. 

Up until recently, there hasn’t been significant distinction in pricing based on the length of income, and vacancy has sometimes been viewed as an opportunity to crystallise rental growth, but this is now shifting.

Liquid over illiquid

Another dimension is the distinction between liquid and illiquid assets. In more heavily traded markets, pricing is more certain and less subject to the vagaries of market conditions. 

For this reason, international investors will favour Australia and other major global property markets such as the US, UK and Japan over smaller, less liquid markets with less heavily traded currencies, and this preference can be expected to be even stronger during a downturn.

Similarly, within Australia it is likely that deeper and more liquid property markets will also fare better. Reflecting this, Sydney and Melbourne will continue to attract widespread investor interest in coming months. Similarly, the best locations within particular cities will be favoured, whether favoured precincts within CBDs, the most desirable urban fringes locations, or development sites offering superior accessibility to infrastructure and transport.

For further information please contact:

Ben Burston
Partner, Chief Economist
+61 2 9036 6756
Ben.Burston@au.knightfrank.com