Over the past year the economic drivers of real estate have shifted. Residential property prices in 2018 fell at the fastest rate since the Global Financial Crisis, driven by tighter credit conditions. This is exacerbating the difficulties faced by retailers, as weak wages and the rise of online spending weighs on in-store sales. The industrial sector faces a mixed performance. Drought and rising energy prices challenge farming and manufacturing demand and the shift to online retail supports wholesaling activity. On a positive note, office space is benefitting from strong white-collar job growth, but is likely to slow. Australia is expected to continue its long run of uninterrupted economic growth, albeit at a slower pace than previously experienced. Business conditions remain well above average, and the low inflation environment is keeping official interest rates on hold and limiting debt servicing costs. Businesses are investing in their workforce, with large job gains in 2017 and 2018. This has supported consumer spending, even as wage growth struggles. Looking forward, economic conditions are expected to remain broadly supportive, but the household sector is likely to face headwinds from slower employment gains and declining wealth. Residential price fall of a decade Once the darling of the real estate sector, residential asset prices are in decline. National house prices fell 4.8% in 2018, with Sydney and Melbourne driving the fall. The decline in prices was faster than we expected with tighter credit conditions and higher global interest rates dampening demand. Chart 1: Capital city house price growth Source:CoreLogic Deloitte House prices are falling, led by Sydney and Melbourne Following the Royal Commission into Misconduct in Banking, Superannuation and Financial Services, Australian banks are less willing to lend, especially for interest-only investors and high LVR loans. This has led to a slowdown in lending activity, with the value of residential lending falling 17% in 2018. With property prices in decline, it’s unsurprising that building approvals have also turned, falling 25% in 2018. The decline is stronger in the unit segment of the market, driven in part by a fall in international investment. Chart 2: House prices compared to income Source: ABS, Deloitte House prices are currently 17% higher than the national income index Looking forward, the residential property market is likely to experience further moderation before growth returns. Historically, house prices have tracked closely with national income growth. In the height of the housing boom, prices were 26% above income, but this gap has already started to close and now sits at 17%. Steady population growth will provide support to the market in the long run, but tightening credit conditions and ongoing stress on the household budget positions may drive prices lower in the coming 12 months – reducing the gap to national income. Headwinds for retail The retail property market has performed relatively well in the face of difficult conditions, but underlying demand faces challenges moving forward. Household budgets are under pressure, and many consumers are cutting back on retail goods. Where rising wealth once offset the drag from weak wage growth, it now adds further downward pressure on spending as house prices fall. Online spending continues to capture market share, rising from around 5% in early 2011 to 9% in November 2018. The rise of online spending has prompted a number of retailers to invest in digital rather than bricks and mortar. This is flowing through to the real estate market, with building approvals declining in the year to November 2018 and vacancy rates edging higher. Chart 3: Household savings rate Source: ABS, Deloitte The savings rate only has to fall another 2.4 percentage points until households are spending more than they earn The outlook for the retail sector is mixed. The drivers of spending are shifting from house prices towards wage growth, with spending moving away from consumer durables towards necessities. This is likely to limit retail spending over the coming year, with retail volumes expanding just 1.6% in 2019 before accelerating slightly to 2.2% in 2020. This outlook is dependent on stronger wage growth, which will stem the decline in the household savings rate. Currently sitting at 2.4%, any further decline in the savings rate is likely to result in a much sharper pull back in spending. Mixed fortunes for the industrial sector Industrial property demand is driven by performance in a number of Australian industries, including manufacturing, transport, and wholesaling. Conditions in these industries are mixed, providing both opportunities and risks to the outlook. Some parts of manufacturing are enjoying a cyclical lift that’s the best it’s experienced in years, in part thanks to the fall in the Aussie dollar and strong global conditions in early 2018. However, low wage competitor countries still have a distinct advantage over Australian-based producers, and high gas prices remain a challenge for energy-intensive manufacturers. While the drought weighs on farm activity, wholesale trade growth is set for solid but unspectacular growth in coming years. Demand for consumer goods is benefiting from ongoing population growth, and the rise in online direct-to-consumer retailing provides further support. Meanwhile, wholesalers of cars face headwinds due to declining wealth, and it’s a mixed picture for wholesalers of machinery and equipment as the drought hurts demand from the agriculture sector. Slower growth in workers pose risk to office space Office sector performance is closely linked to trends in the business cycle. Traditionally as white-collar employment growth rises, so too does office floor space demand. Australia added just over 330,000 jobs in 2018, many in white-collar industries such as financial and insurance services, public administration, and professional services. The rise in white collar jobs has resulted in strong demand for office space, especially in the job hubs of Melbourne and Sydney. This has pushed down vacancy rates and encouraged investment in the sector. Chart 4: Employment Growth Source: ABS, Deloitte Employment growth has exceeded the average rate in 2017 and 2018 However, there are risks to the outlook. Job growth is expected to slow in the next few years as spare capacity in the labour market is absorbed and the price of labour (wages) start to rise. What’s more, the rise in flexible working arrangements may further dampen demand for office space from traditional white-collar businesses – but it also provides opportunities for new businesses focused on delivering co-working solutions.