MIRVAC GROUP — Regulatory Filings 2003

Jul 1, 2003

Mirvac Group Multi Option Presale Securitisation (MOPS) July 2003

Arrangers and Lead Managers: Australia and New Zealand Banking Group Limited Merrill Lynch International (Australia) Limited Dealers:

Australia and New Zealand Banking Group Limited Merrill Lynch International (Australia) Limited Deutsche Bank AG

Westpac Banking Corporation

Agenda

• 1. Transaction Overview
• 1. Overview of Mirvac Limited
• 1. The Property Development Business
• 1. Overview of the Project Development Lifecycle
• 1. The Initial Portfolio
• 1. MOPS Program Features
• 7. Risks and Mitigants
• 1. The Initial Portfolio
• 1. Summary

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1. Transaction Overview

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Transaction Overview

• A\$500,000,000 Multi Option Presale Securitisation Program
• Permits issuance of MTNs rated AA/AA and CP rated A-1+/F-1+ by Standard & Poor's and Fitch respectively
• Backed by a revolving, cross-collateralised portfolio of substantially presold residential development projects
• Projects will comply with eligibility criteria at the individual project and portfolio level
• Program will comply with both Cashflow and Gearing tests at all times
• Up to A\$210,000,000 of initial issuance of soft bullet notes

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MOPS 2003-1	A\$100m	Example 10 July 04
MOPS 2003-2	A\$110m	June 05

Transaction Overview

• Mirvac will undertake to complete each project at a fixed cost and by a predetermined completion date
• Support Facility will underpin Mirvac's obligation to complete the projects
• Sufficient funding will be provided to cover project completion costs through a combination of cash escrowed, bank facilities and cash expected to be received

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Dennis Broit - Finance Director, Mirvac Group

1. Overview of the Mirvac Group

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History

• 1972 Mirvac established by Henry Pollack, Robert Hamilton and AGC Corporation (a subsidiary of Westpac). It's major activities included residential and commercial development, hotel management and property funds management (primarily through unlisted trusts)
• 1987 Mirvac floated and lists on the ASX. Company valued at \$120 million
• April 1996 Henry Pollack retires, disposes of 33% interest which allowed greater institutional representation on the share register
• October 1996 Mirvac expands commitment to the Property Trust Sector through the acquisition of the remaining 50% in Mirvac Funds and 100% of Capital Property Management. Gross assets under management exceed \$1.3bn
• June 1999 Merger of Mirvac Limited and Listed Property Trusts to form the Mirvac Group with a market capitalisation of approximately $$2.0₀$

Market Capitalisation

Relative Comparison

$(1)$ Source: IRESS

(2) Source: Merrill Lynch Research. Share prices as at 25 June 2003. SGP is pre-ADP

(3) Source: company reports

Mirvac Group - Financial Results

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48

Mirvac Group - Financial Results

Corporate Structure

Mirvae Group Board Of Directors

Menechro Hrado Robert J. Hamilton

EXECUTIVE COMMUNIST

MICK O'Brian Robert Lynch	agran Fini Chris Freeman	tan Costlev Andrew Turner	Barry New Roam Forma – Donnis Brait I
TEAR a katika matsa sa sa sa sa sa sa sa sa sa sa sa sa s	C. F. O C 6 O	0.211 $\sim$ $\sim$	TELE Finance r yeahiye
Mirvac Homes Mirwac	Miryac Fini Mirvan	Devolopment Wir tac Hotels	Warvac Director Director
Alban I Victoria	WD. Guconsland	NS V	KVestments

Average Length of Mirvac Service - 13.7 Years

Debt Funding Programmes

Capital Markets Funding

Amount	Rating Type		Raised	Security
A\$500m	AAA	CMBS	June $01$	Pool of Investment Assets
A\$300m	AA l	Presale Securitisation July 01		Walsh Bay Development
A\$190m	AA, A	CMBS	MaxO2	Pool of Investment Assets

Bank Funding

Amount	Facility Description		Established
A\$250m	Short-term working capital banking facility	$-2001$	ing and the company of the company of the company of the company of the company of the company of the company of the company of the company of the company of the company of the company of the company of the company of the
A\$300m	Project Pre-sale securitisation facility (SPA)	- 1996
	A\$250m Medium-term working capital banking facility 1992

Mirvac Group - Presale Securitisation Programs

3. The Property Development Business

Dennis Broit - Finance Director, Mirvac Group

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Property Development Business

• One of the largest and best recognised developers of quality residential dwellings in Australia. Currently operating in NSW, VIC, QLD and WA
• Developed more than 17,000 dwellings and housed more than 50,000 people over the last 30 years
• Diverse pool of 'in house' skills and resources to manage all aspects of design, planning, construction and sales with over 1,000 people directly employed
• Almost 21,000 residential lots under Mirvac control, representing over 10 years of forward supply and over A\$8.6bn of potential revenue
• Numerous industry awards. Mirvac's development of the 2,000+ dwelling Newington suburb (part of which was used for the Olympic Village) has won an unprecedented 37 design and housing awards

Property Development Business

• Other key developments include:
• Q Beacon Cove, Melbourne (1,500 dwellings)
  • Docklands, Melbourne (2,500 dwellings)
  • Waverley Park, Melbourne (1,400 dwellings)
  • D Newstead, Brisbane (500 dwellings)
• Cutters landing, Brisbane (300 dwellings)
• □ Burswood, Perth (1,100 dwellings)
• Walsh Bay, Sydney (350 dwellings)
• Raleigh Park, Sydney (500 dwellings)

Development EBIT

Development Division - Revenue

Lots Under Control

4. Overview of the Project Development Lifecycle

Dennis Broit - Finance Director, Mirvac Group

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Acquisition Process

Project Delivery Process

Critical Risk Path

5. MOPS Program Features

Stephen Rorie - Group Finance Manager, Mirvac Group

25

Key features of the Program

2 series of MTNs with 12 month soft bullet
Amount	Maturity
A\$100m	July 04
A\$110m	June 05
• Key Portfolio Criteria
	- Approximately \$8m of 30 day CP	• Transaction and Security Structure

Transaction Structure

• Issuer raises funds via MTNs or will draw on Liquidity Facility and/or issue CP as required
• Funds flow down to the Project Companies through a Debenture Subscription structure - Mirvac Limited issues Debentures to the Issuer and lends the proceeds to the Project Companies to meet construction costs for Approved Projects
• Settlements from Presales and any cash escrowed are used to repay Noteholders upon maturity

Issuer Account, Debenture Proceeds Account and Program Account are directed by the Program Manager

Security Structure

• Mirvac Limited and all Project and Construction companies will grant an all assets fixed and floating charge in respect of all Program assets. This includes security over presale contracts, construction contracts, Support Facilities, cash balances in the Program Account and all other assets required for the completion of the project
• Each Project company also provides a 1st ranking real property mortgage over Program assets which includes any unsold stock
• Mirvac Limited will provide a Completion Undertaking
• The Issuer will grant an all assets fixed and floating charge to the Issuer Security Trustee to secure its obligations under the MTNs, CP, Liquidity Facility and Swaps (if any)

Key Portfolio Criteria

• Independent Program Manager and Certifier
• Open, revolving pool with specific eligibility criteria monitored by Program Manager
• Key portfolio criteria includes:
• $-$ at least 50% of the dwellings are subject to presale contracts
• Independent Certifier Report confirming the achievability of the Completion date and CTC estimates
• Insurance Consultant report confirming required insurances
• required Support Facilities must be in place
• no single project cost can exceed 30% of the total cost of the
• $\mathsf{pool}$
• assurances of geographical diversification

Program Tests

• The Tests are calculated by the Program Manager every month
• The Positive Cashflow Test: all future inflows of cash exceed all future obligations thus ensuring funding availability
• any funding requirements are covered through cash escrowed
• and/or liquidity facililty
• Tests include results from Independent Certifier reports
• The Permissable Advance Rate Test (gearing): ensures that the Net Liabilities must not exceed 85% of eligible of presales
• If one or both Tests are not meet then Mirvac is required to deposit sufficient funds in order to satisfy the Tests. If this does not happen then a Mirvac Event of Default occurs, the Support Facility may be called and the security structure may be enforced

Program Facilities

Liquidity Facility

• Committed liquidity facility of A\$100m
• Ranks pari passu with Notes
• Covers short term funding needs and timing mismatches
• Supports issuance of CP

Support Facility

• must be provided by an appropriate rated entity
• may be the form of LC, Performance Bond or either
• calculated as 25% of the CTC of each project or 50% for those projects which are yet to reach ground floor or are conversions
• subject at all times to a minimum of \$30m
• initial committed LC Facility of \$40m

6. Risk and Mitigants

Stephen Rorie - Group Finance Manager, Mirvac Group

Risks and Mitigants

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• Legally binding unconditional obligation on purchasers to settle under the standard form Contracts of Sale
• Large and diverse pool of purchasers
• Restrictions on multiple and foreign purchasers
• 10% deposit by Purchaser
• Historical default rates on Mirvac presales are less than $1\%$
• High level of repeat purchasers
• High level of owner occupiers
• Strict control over sales and marketing procedures

Risks and Mitigants

CONSTRUCTION RISK

• Low complexity of projects
• Costs contingencies provided for and completion dates contain conservative time allowances
• Fixed price construction contract
• Independent Certifier reporting regime monitoring time and CTC
• Mirvac Completion Undertaking
• Mirvac experience in project completion
• Mirvac industrial relations record
• Support Facilities available to be drawn

Risks and Mitigants

• DEVELOPER & CONTRACTOR RISK
• Excellent 30 year Mirvac track record
• Experienced, committed, in house team maintaining a high level of involvement throughout the project
• Mirvac has strong vested interest to complete the project, both financial and reputational
• Extensive due diligence process in selecting sub-contractors
• Mirvac monitors the individual capabilities and quality of sub-contractors
• Ability to transfer developer licences, permits and sub-contracts
• Support Facility available to be drawn

7. The Initial Portfolio Stephen Rorie - Group Finance Manager, Mirvac Group

Assets - Initial Portfolio

• Initial Portfolio consists of:
• Total value of Portfolio:
• Total number of dwellings:
• Remaining Construction Cost to Complete (CTC):

Presales:

• No. of legally binding eligible Contracts for Sale:
• $-$ % of portfolio Presold
• Value of Presale contracts (incl GST) :

Remaining unsold apartments:

• No. of unsold apartments and ineligible presales:
• Value of unsold apartments:

NB: Refer Appendix 1 for Portfolio Details

6 Projects

A\$574m

A\$117m

616

556

$90%$

60

A\$503m

......................................

Initial MOPS Portfolio

Well diversified pool, both in geography and in project size 蠿

Standard & Poor's

Some key attributes S&P* look for in an investment-grade construction project MOPS Fully permitted project, including owned land M Fixed price, time certain, design and build contract with a quality building ☑ contractor who has market experience & financial capacity Contingencies to deal with suppliers of building materials M Time and cost contingencies along the critical path of construction $\sqrt{ }$ Project sponsor has ability to terminate and if necessary replace the ☑ building contractor Transaction can sustain a default of the project sponsor M Third party trustee $\sqrt{ }$ Subcontracts can survive the bankruptcy of the developer И Appropriate insurance to deal with accidents, disasters, or acts of God $\mathcal{A}$ Alignment of interests between developer and lenders

* Refer to "Residential Construction Project Financing: The Singapore Experience" by Standard & Poor's, dated Aug 14th, 2002

Mirvac Group Multi Option Presale Securitisation (MOPS) July 2003

Arrangers and Lead Managers: Australia and New Zealand Banking Group Limited Merrill Lynch International (Australia) Limited Dealers:

Australia and New Zealand Banking Group Limited Merrill Lynch International (Australia) Limited Deutsche Bank AG

Westpac Banking Corporation

Appendix 1: Initial Portfolio

	Project Name and Location	Avista Cabarita, NSW
	Type - Houses/Units	Residential Units
	Number of Dwellings	94
	No Dwellings Pre-sold	94
	Average Sale Price	\$950,000
	Aggregate Value of Pre-Sales (incl GST)	\$89,301,425
	Total Project Value	\$89,301,425
	Scheduled Costs to Complete	\$19,374,166
	Date for Practical Completion	31 January 2004
	Sunset Date	31 July 2004
	Percentage Complete	69%

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Project Name and Location	ikon Potts Point, NSW
Type – Houses/Units	Residential Units
Number of Dwellings	185
No Dwellings Pre-sold	168
Average Sale Price	\$1,380,000
Aggregate Value of Pre-Sales (incl GST)	\$211,020,703
Total Project Value	\$255,927,000
Scheduled Cost to Complete	\$40,542,397
Date for Practical Completion	30 June 2004
Sunset Date	31 December 2004
Percentage Complete	67%

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Project Name and Location	Yarra's Edge - Tower 4 Melbourne, VIC
Type - Houses/Units	Residential Units
Number of Dwellings	110
No Dwellings Pre-sold	109
Average Sale Price	\$817,900
Aggregate Value of Pre-Sales (incl GST)	\$87,478,100
Total Project Value	\$89,155,000
Scheduled Cost to Complete	\$17,873,681
Date for Practical Completion	30 June 2004
Sunset Date	31 December 2004
Percentage Complete	88%

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Initial Approved Projects

Project Name and Location	Cutters Landing - AP2 New Farm, QLD
Type – Houses/Units	Residential Units
Number of Dwellings	77
No Dwellings Pre-sold	76
Average Sale Price	\$775,000
Aggregate Value of Pre-Sales (incl GST)	\$56,365,420
Total Project Value	\$59,691,000
Scheduled Cost to Complete	\$13,438,509
Date for Practical Completion	1 March 2004
Sunset Date	1 September 2004
Percentage Complete	89%

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Project Name and Location	Cutters Landing - AP3 New Farm, QLD
Type - Houses/Units	Residential Units
Number of Dwellings	46
No Dwellings Pre-sold	46
Average Sale Price	\$713,000
Aggregate Value of Pre-Sales (incl GST)	\$32,801,900
Total Project Value	\$32,801,900
Scheduled Cost to Complete	\$9,555,941
Date for Practical Completion	15 October 2004
Sunset Date	15 April 2005
Percentage Complete	76%

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Appendix 2: Construction Performance

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Construction Performance

		Construction Costs		Construction Program (mths)
Project	Budget at Commencement (A\$million)	Actual at Completion	Forecast at Commencement of Construction	Actual at Completion of Constructions	from Actual Completion to Sunset Date
NSW
The Cavill, Milsons Point	16.5	4.8%	12	15	$+12$
Gateway, Pyrmont	47.9	0.4%	17	23	$+13$
Shoremark, St Leonards	38.3	$-0.8%$	18	$-21$	$+6$
Promontory	47.8	1.4%	18	25	$+8$
Cabarita Stage 1B	24.0	1.5%	16	18	+ 4
Queensland
Liberty - Tower 1	40.3	$-5.0%$	16	16	$+4$
Liberty - Tower 2	56.5	$-10.1%$	19	20	$+ 11$
The Arbour on Grey (Stage 1)	34.6	$-2.9%$	14	15	$+10$
The Arbour on Grey (Stage 2)	27.5	$-0.6%$	14	14	$+13$
Bulimba Townhouses (Stg 1,2,3)	16.7	$-1.2%$	40	34	$+8$
Víctoria
The Melburnian	153.1	1.5%	29	26	$+7$
South Yarra - River Building	29.9	2.7%	17	19	$+7$
South Yarra - Piazza Building	20.3	9.9%	17	23	$+3$
Beacon Cove 5A	56.5	3.7%	18	20	$+6$
Beacon Cove 7A	40.3	0.2%	18	18	$+6$
Yarra's Edge - Tower 1	65.9	$-1.9%$	26	27	$+10$

• $\upsilon$ Overruns and excesses shown above all occurred during acquisition and pre-construction phases of the above projects, which are pre-MOPS activities
• v No Mirvac residential apartment project has ever failed to complete before its sunset date

		٠
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Appendix 3: ANZ Economic Update

19 November 2002

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ECONOMICAUROCHIC

Assessing the fundamental value of Australian house prices

Australian house prices have risen sharply in recent times. As of the June quarter they are 62% higher than the corresponding quarter 5 years ago, indicating an impressive 10% average growth rate over the period, the bulk of which has occurred in the last 18 months.

These gains are well in excess of average weekly earnings growth of 4.5% per annum over the same period, and as such the ratio of house prices to average earnings is now at an all time high. With the bursting of the equity bubble still ringing in their ears, many have been promoting such metrics as evidence of a bubble in house prices and warning that the impending bust could be disastrous for financial system stability, and in turn the Australian economy.

$6.6$ ratio $6.0$ 6.6 6.0 $4.6$ $4.0$ $3.6$ $3.0$ 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 Sources: ABS, Economics@ANZ

While the run-up in house prices is indeed impressive, we caution against making the Newtonian assumption that 'what goes up must come down'. Most people recognise that at least part of the increase in house prices has been as result of the one-off structural shift from a world of high and variable inflation to a world of low and stable inflation and by implication low and stable interest rates. Many argue however that house prices have now overshot these supportive fundamentals and must therefore correct. On the contrary, our analysis suggests that in all likelihood this process, while nearly complete, has yet to run its course and we continue to expect merely a moderation in house price appreciation to between 4%% to 10%% for the next two vears, followed by returns consistent with increases in consumer prices thereafter.

At this point it would be wise to caution that the Australian property market is not one but many markets of separate sectors and geographical locations. While the following discussion centres on Australia-wide dwelling price movements, it must be recognised that prices in each micromarket are often subject to markedly different forces and moderate price gains at the Australia-wide level can mask both strong price rises and large price falls in individual markets.

Assessing the fair value of housing

While assessing the fundamental value of any asset is fraught with difficulty, assessing the fundamental value of residential housing is further complicated by its unique nature. Residential housing is driven by two distinctly separate sources of demand; owner-occupiers and ownerinvestors. Both sources of demand are driven by different (but related) factors and the benefits that accrue to the owner can take a range of forms depending on their status.

Benefits can be the imputed rent that owner-occupiers obtain by living in a house, or they can be the income derived from renting out an investment property or they can be (in both cases) the capital gain that is realised upon disposal of the house. Both sources of demand also face different taxation consequences, which will affect the price they are willing to pay for a house. However both sources of demand are inextricably linked by price. Any given residential property could be purchased by an owneroccupier or an owner-investor and as such both face the same market-clearing price.

We have used two different methods to assess the 'fair value' of housing. The first method is based on housing affordability from the perspective of the average owneroccupier, while the second is an earnings discount model from the perspective of the average residential investor. Both fair-value methods suggest that far from entering a situation of 'irrational exuberance', house prices are only now approaching fair-value and have some scope for further appreciation.

On affordability criteria, a further 5-6% average annual increases over the next two years could be easily sustained without breaching any resistance levels. From an investment class perspective, an earnings discount model suggests further price appreciation of 41/₂-101/₂% over the

Household Prices as a ratio of Full-time total earnings

next two years, the mid-point of which, 7½%, is broadly consistent with fair-values based on affordability.

Clearly, if investors remain stubbornly enthusiastic about return prospects or owner-occupiers fear the market moving totally out of reach, outcomes may move beyond this 'fair value' level, implying corrective adjustment at some later stage. A 'bursting bubble' scenario however, is only a good bet if exuberance drives prices beyond these 'fair value' parameters and if economic circumstances deteriorate sharply or interest rates move up more quickly than is currently in prospect.

Owner Occupiers

When an individual owner-occupier household makes a decision on how much to spend on a house there is a natural reaction to take out a loan as large as is comfortable to service. As a general rule banks will allow a household to take out a 25-year loan such that loan repayments are no more than 30% of income. It follows therefore that in aggregate the two factors affecting house prices are household income and interest rates. Both of these factors have recently been supporting house prices.

Real gross disposable income (before household interest payments) per house in Australia is shown in the chart below. The chart clearly shows that since the 90's recession real income per house has increased strongly, meaning that not only have households had more income to spend on consumption, but also more to spend on housing. This growth in income has been driven by a robust economic expansion underpinned by strong productivity growth and increasing female labour market participation that has seen the emergence of a greater tendency towards dual income households.

Additionally, mortgage interest rates have fallen sharply, allowing households to service a larger debt for given interest payments. Despite Australia experiencing record debt to income levels, interest payments to disposable income remain well contained by historical standards.

In assessing 'fair value' for owner-occupiers, we have constructed housing affordability indexes for the 6 major capital cities. These indexes take into account income and interest rate impacts on the affordability of home loan repayments based on the experience of first-time owneroccupiers. In the long run it is assumed that the indexes will revert to a long-term trend. City by city analysis reveals that in all major capital cities except for Melbourne, houses remain at affordable levels. The weighted average result suggests that should house prices adjust to the long run average over the next two years, Australian house-prices will rise a further 5-6% per annum over the next two years. For more information on the city-specific analysis refer to the Residential Property section of the current issue of the ANZ Property Outlook.

Residential investors

As rental properties comprise 30% of the housing stock, the effect on house prices from demand created by ownerinvestors is quite significant; as such it is also important to assess 'fair value' from an asset-class perspective. The chart below plots the earnings yield on property over the last 22 years. As can be seen house price rises in excess of earnings growth over the last five years have seen earnings vields decline markedly.

This recent run-up in house prices mirrors similar development in other assets classes such as equity and bond markets (which suffered large falls in earnings yields earlier in the decade). In a sense the housing market is playing catch up to these markets, possibly reflecting the larger number of market players, whose analysis of market conditions are by and large less sophisticated than the other two markets.

As the rental investment market is a more transparent market that that of owner-investors, assessing fundamental value of housing is somewhat easier with the use of an earnings discount model. $¹$ It can be shown that the value of a house 'P', that yields earnings 'e' that are expected to grow by 'g' per year is

$$
P = \frac{e}{(d-g)}
$$

where 'd' is the required rate of return by the investor.

This formula can be transposed to calculate the rental yield (inverse of the traditional price to earnings ratio) as follows.

$$
\frac{e}{P} = d - g
$$

Earnings yields should therefore relate to the required rate of return less expectations of growth in rental earnings. To the extent that rental growth tends to closely follow consumer prices rises and should continue to do so for the foreseeable future, the earnings yield can be thought of as equating to the real required rate of return as demanded by investors.

Questioning whether the recent fall in earnings yields is sustainable is tantamount to asking whether the real required rate of return on property has fallen. If house prices are making a structural adjustment to a lower real required rate of return for housing, then for the purposes of forecasting house prices we need to ascertain where the long run equilibrium earnings yield will settle.

In standard financial theory, required rates of return are often modelled as the risk-free rate (often best approximated as a government long-term bond yield) plus a risk premium above the risk-free rate that is demanded by the investor, due to the risks associated with investing in housing. Based on such a theory, the earnings yield on property should therefore show a strong relationship to real bond yields. While very few market participants in the residential investment market are aware of the level of real bond yields let alone a reasonable projection of yields, they will over time in aggregate behave in a manner that is consistent with real bond yields.

The chart above shows the earnings yield on property over the period of advanced financial deregulation plotted against real Australian ten-year bond yields. As real bond yields are quite volatile, and market participants' expectations change slowly, we have also included a 4-year rolling average of real yields. As can be seen from the chart, real bond yields have fallen throughout the 1990s as financial markets have adapted to a new low and stable inflation environment. Our projection for a longer run average value of real Australian dollar bond yields is 3.5% (nominal yields of 6% less long run expectations of inflation of 2%%; the mid point of the RBA's 2-3% target band).

Based on an approximation of the historical relationship between real bond yields (as represented by a four year

Conceptually it could be argued that if market rent is equal to the imputed rent derived by owner-occupiers, then this analysis extends to all dwelling prices.

rolling moving average) and earnings yields, we would estimate that residential property earnings yields will settle in a range between 3.8% to 4.3%, as markets adjust to lower long term yields.

If earnings yields adjust to 3.8%, the lower end of the forecast band within the next two years, this would imply house price appreciation of 8% in excess of earnings growth for the next two years. To maintain the 3.8% yield house price rises would then moderate to be in line with earnings growth thereafter. Based on historical experience, rental growth of 21⁄2% can be expected in that time, making 101⁄2% the upper end of our forecast for house price appreciation over the next two vears.

If earnings yields settle at the upper end of the forecast band however, this would imply house price appreciation of 2% over earnings growth for the next two years, implying house price rises of 41⁄2% for two years and 21⁄2% thereafter.

Such analysis of course assumes an unchanged risk premium demanded for investing in housing. It would be possible to arque for even lower earnings yields on the basis that the risk premium has contracted in recent years. Given that most owner-investors (and owner-occupiers for that matter) are highly leveraged, and therefore exposed to movements in mortgage rates, at least part of the equity risk premium would be related to the risk of large increases in mortgage rates (as occurred most stunningly in the early-1990s). In so far as interest rates are more stable now, investors can be more assured of their ability to service existing debt levels provided continuing rental income is assured.

Real bond yields are of course only one way of modelling earnings yields, and there are countless others. While technically the required rate of return on capital for investors is distinct from the cost of borrowing, many investors are highly leveraged in residential investments. They are therefore likely to take into account household mortgage rates when implicitly calculating required rates of return. This suggests that the earnings yield on property investment may also be related to mortgage rates.

Real mortgage rates, like real bond yields have fallen sharply over the past decade. This decline has been due to a number of factors. Not only have real cash rates fallen in the early part of the decade, but due to the introduction of low cost mortgage providers, the margin between the unofficial cash rate and owner-occupier mortgage rates has also compressed. Residential investors have received the added incentive of now facing the same interest rates as owner-occupiers. At the beginning of the decade, residential investors had to pay interest at a rate as much as 2.50 percentage points more than owner-occupiers. All of these factors have meant that the residential housing market can support lower earnings yields than previously.

The chart below replicates the earlier analysis with real mortgage rates in the place of real bond yields. Based on approximation of this relationship, the forecast band previously estimated looks reasonable, reinforcing our forecast of house price appreciation of 41/2 to 101/2 % over the next few years, before returning to house price rises of 2½%.

Property earnings yield and real mortgage rates

Caveat

Our fair-value estimations outlined above are based on the assumption that rental growth remains commensurate with consumer price inflation, which as the chart below based on historical experience is a reasonable assumption. While valuations are reasonable at this level of rental growth, there is a chance that over-investment in housing supply will act to undermine house price appreciation as record vacancy rates put downward pressure on rents. While it is too early to say that rental income growth will undermine valuations, it should be noted that rents in the September quarter rose by just 0.4% in the quarter, the lowest quarterly increase in over seven years.

Should a trend of rental underperformance establish itself, lower house-price rises should be expected. While extreme underperformance on aggregate is unlikely, there is a chance of falling rents and price weakness in those areas that have the highest vacancy rates and have experienced the fastest increases in investor funded housing supply, which as yet has not been met with an increase in tenant demand.

David Colosimo Ph: ++61 3 9273 4060

Ange Montalti Ph: ++61 3 9273 6288

Disclaimer

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ppendix 4: ANZ Property Outlook

June 2003

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LALA DE LA BILION DE LA COMPANYA

ANZ Property Outlook

is produced half yearly by Economics@ANZ

Contributors to this issue:

Frank Foley (Editor) Economist (03) 9273 5466

David Colosimo Economist (03) 9273 4060

Ange Montalti Economist (03) 9273 6288

Jasmine Robinson Economist (03) 9273 6289

Katie Dean Economist (03) 9273 6286

Economics on the Web

To view this publication, or other research products published online by Economics@ANZ, go to http://www.anz.com /go/economics to bring up the "Economic Commentary" page. NZ Economic research can be viewed by scrolling to the bottom of this page and clicking on the link to NZ.

Inside

Economic Overview

After a strong performance in 2002, Australian economic growth has lost some momentum recently and is likely to slow to 3% in 2003, a touch below trend. Growth in domestic demand, the stronghold of the economy in recent times, is expected to ease to a less vigorous pace. Household consumption growth is likely to moderate a little in the face of current high levels of household debt, while dwelling investment is also expected to slow. Prospects for the Australian economy next year remain sound, although they depend heavily on a recovery in exports. The breaking of the drought and a strengthening in the global economy are particularly important in that regard. As a result, if the global economy disappoints and continues to weigh on export growth then interest rates are likely to be moved lower in coming months. (Katie Dean: page 2)

Residential Property

Residential construction activity finally appears to have peaked. Just as activity remained stronger for longer than expected, so too, it appears, will the decline in activity be more benign than previously anticipated. The decline in approvals thus far has been moderate and a large amount of work is yet to be done. In addition, revised estimates of Australian population growth, in particular, stronger immigration, suggest that the underlying dwelling requirement is larger than previously expected.

Despite forecasts from some quarters of imminent collapse, Australian house prices have continued to rise strongly. Based on our "fair value" benchmarks, it now appears that Australian house prices, in particular those in Melbourne and Sydney, are nearing full value. We expect only moderate gains in the period ahead, and continue to believe that large-scale house price falls are unlikely. (David Colosimo and Ange Montalti: page 3)

Commercial Property

The vacancy rate for office space across Australian capital city CBDs has continued to rise, reaching 8.3% in January 2003. This has been a consequence of weak demand rather than increased supply. With office building now picking up and demand sluggish, vacancy pressures will continue. Last year's solid growth in industrial sector output has supported demand for industrial premises. Demand is likely to weaken somewhat as manufacturing and the economy slow but, buoyed by interest from investors, should hold up reasonably well.

Shop building activity is expected to stay firm in the months ahead, as reflected by healthy building approvals numbers. However, some softening in building activity is expected in 2004, coming off a strong base in 2002 and 2003. The difficult operating environment faced by the tourist accommodation sector is likely to see slower growth in building activity in the near term. A significant share of activity is likely to take the form of alterations and refurbishments. (Frank Foley & Jasmine Robinson: page 8)

Economic overview

Australian growth to slow below trend

The Australian economy grew by a strong 3.6% in 2002, as vigorous domestic demand more than offset the impact of a decline in exports. Nevertheless, against a backdrop of stalled global growth, the economy did begin to lose momentum towards the end of last year, and appears to have continued to ease in the first part of 2003.

Overall, Australian economic growth is likely to slow to a touch below trend, to 3% in 2003. After rising by the fastest rate in over 30 years in 2002, domestic demand is expected to ease to a less vigorous pace in 2003. Real household consumption growth is likely to moderate as growth in wealth begins to abate from its earlier strong pace and as households seek to rebuild current low savings rates. Dwelling investment is also set to slow, although the downturn will be smaller than in previous cycles, due to the continued low level of interest rates. While business investment remains solid, particularly in non-residential and engineering construction, growth in this sector also appears close to peaking. Exports meanwhile are likely to remain subdued in the face of sharp, droughtrelated falls in farm product, weak global economic growth, low levels of international tourism and the recent strong appreciation of the Australian dollar. Softer economic growth is likely to see employment growth also moderate, with the unemployment rate likely to edge up a little towards 61/2%.

In 2004, the pace of growth of domestic demand is likely to continue to soften, mainly as dwelling investment continues to turn down and business investment moderates. Export growth meanwhile is expected to pick up solidly, driven by a recovery in world growth and a likely strong rebound in farm production following a break in the drought. A recovery in exports should support an overall pickup in Australian growth to around trend, at 334% in 2004, although growth in the non-farm economy is likely to remain a touch below trend. The lagged impact of softer growth in 2003 will likely see employment growth remain relatively subdued in this period.

But interest rates will remain on hold

Uncertainty over the international environment has seen the Reserve Bank of Australia (RBA) keep official interest rates on hold at the low level of 4.75% since June 2002. While an expected easing in the pace of Australian growth over 2003 is likely to put some pressure on the RBA to cut interest rates to stimulate demand, the case for monetary

easing is not clear cut. Inflation is currently at the top of the RBA's 2-3% target band and monetary policy settings are already expansionary. Interest rates are presently below the "neutral" range of 51/2-6% and are stimulating double-digit growth in personal and housing credit. Having already expressed concern over the high level of borrowing amongst Australian households, the RBA will not take the decision to lower interest rates lightly. Expansionary fiscal policy, by way of the Government's recently announced personal income tax cuts, will also give the RBA a little more breathing space.

While the fundamentals would seem to be in place for a strengthening in global economic growth in the second half of the year, should it not materialise, or should the drought continue, then Australian economic growth - and inflationary pressures - are likely to be weaker than currently expected. In such a scenario the Reserve Bank may decide to lower interest rates, if it judges that the downside risks from a weaker world economy are greater than the risks from a further strengthening in household credit growth and asset prices.

House prices not yet off the policy radar

A significant cause for concern for the RBA in recent times has been the sharp increase in house prices. Strong demand has seen Australian house prices increase by 80% in the past five years. Higher house prices and strong demand for housing have seen a sharp run-up in household debt, which now stands, on average, at nearly 130% of household income. Concern that house prices could overshoot, and that the subsequent downward correction would cause significant distress to heavily indebted households, has brought some tension to the policy debate. Specifically, is there a role for monetary policy to correct asset price bubbles?

To this end, the RBA appears to have departed a little from its previous view that monetary policy cannot, and should not, be used to direct house prices. More recently, the Bank has stated, "a case might be made, on rare occasions, to adopt a policy of 'least regret' so far as asset prices are concerned."¹ House price gains continue apace, and with prices nearing, or in the case of Sydney and Melbourne around, fair value, the risk of a houseprice "overshoot" remains (see Residential Property on page 3).

^<sup>1 Stevens, Glenn, Inflation Targeting: A Decade of Australian Experience, 10 April 2003.

Residential Property

National Trends

Forward indicators of residential construction activity suggest that building activity peaked in the December quarter. Current indications however are that the coming decline in activity will be one of the most benign on record.

Without the trigger of RBA tightening that has heralded previous downturns in housing activity, the decline in building approvals to date has been less than convincing. T he decline in approvals for houses has been gradual. Approvals for the more "other dwellings" volatile component (mostly apartments and townhouses), while certainly lower than those seen in 2002, remain at elevated levels.

Still plenty of work in the pipeline Work yet to be done

Furthermore recent capacity constraints on activity have seen the amount of work yet to be done balloon to record levels, ensuring that a solid

pipeline of work will support the current downward leg in activity.

The residential construction industry should also be supported by ongoing strength in the renovations and extensions sector. With mortgage interest rates at low levels by historical standards and the ongoing positive wealth effects of recent price rises motivating buyers to upgrade their current dwellings, there is little reason for the contraction in "new" construction to extend to this sector. Indeed the increased availability of tradespeople as. construction activity declines may motivate ongoing strength in renovations and extensions.

Oversupply.... what oversupply?

Revised estimates of Australian population growth by the Australian Bureau of Statistics (ABS) over the last five years, particularly with regard to the level of immigration, suggest that previous approximations of underlying demand have been significantly underestimated. Revisions over a fiveyear period from 1997/98 to 2001/02 suggest that there has been additional net migration inflow totalling 66,000 persons over the five year period, 53,600 of which has been in the last two years alone.

The additional housing requirement implied by these ABS revisions suggests that the expected housing surplus reported in the November 2002 edition of the Property Outlook has disappeared. Further, assuming that net migration remains at elevated levels, the underlying dwelling requirement in the period ahead will also be higher than previously anticipated.

The trend in building approvals suggested an annualised "starts rate" of around 152,000² in March 2003, compared with an underlying dwelling requirement of just over 160,000³. Therefore, while the market is expected to be very close to balance in June 2003, with an estimated shortage of just 3,400 dwellings Australia wide, this shortage is expected to expand to 11,100 dwellings by June 2004.

Such pronouncements of market balance may seem at odds with recent concerns over high vacancy rates, but this is probably more an indication of the mismatch between the current sources of demand and supply of new housing than an indication of oversupply at the aggregate level. The first

^<sup>2 Assumes 95% of approvals translate into dwelling starts ³ Includes results of most recent revisions to migration data

homeowner scheme has quite successfully transformed a large number of renters into owneroccupiers at the same time that record numbers of investors have been pushing up the supply of rental properties.

Dwellings market nearing balance

This mismatch is also evident in the type of dwelling being offered, with a number of high-density innercity apartments due to come on stream in the period ahead. In Inner Melbourne for example, the number of apartments is forecast to rise by 62% within three years. While landlords may find it difficult to let these apartments at reasonable rents, the total number of apartments remains a small proportion of the total dwelling stock and the impact on the wider market will be limited.

Looking ahead, we expect the down cycle in building approvals to be nearing its end. Housing finance approvals for new construction by owner-occupiers have increased for three consecutive months. signalling that building approvals for houses should stabilise in the next few months and begin to pick up towards the end of the year.

In the longer term we expect that residential construction activity will be able to avoid the volatile swings in activity that have been previously encountered. From an economic perspective, the interest rate cycle, which traditionally has been responsible for the volatility in activity, is likely to be more muted. Further, the renovations sector, which of itself is a more stable market, is now a growing proportion of total construction activity. It already accounts for over 40% of activity and is expected to continue growing.

Prices Growth: Is the end of the boom in sight?

House price growth has continued apace over the past year, with all major capital cities enjoying healthy gains. From a national perspective, house prices are now nearing the "fair-value" price

benchmarks we outlined in November 2002, and we expect prices growth to moderate over 2003 and 2004. We are encouraged by the fact that house price growth in Melbourne, which led the current charge, has clearly slowed. While prices in the rest of the country may still be playing "catch-up" with the national leader, it is plausible that growth in these markets will also slow in the time ahead.

We use two different methods to assess the "fair value" of housing⁴ (i.e. the appropriate level based on the historical relationship between house prices and interest rates, income levels etc.). The first method is based on housing affordability from the perspective of the average first-time owneroccupier, while the second is an earnings discount model from the perspective of the average residential investor.

On affordability criteria, house prices have now reached "fair value" (See chart at the bottom of page 6), with only a further 1% average annual growth over the next two years required for house prices to reach our current fair-value targets⁵. For investors, an earnings discount method suggests that further prices growth of 1-6% over the next two years could be sustained, the mid-point of which is $3\frac{1}{2}\%$ . Given the current diverse range of forecasts for Australian house price growth, these two measures are broadly consistent.

It is important to note however that these measures are not suggesting that actual prices will rise at these rates, only that these rates would see house prices at fair value levels. Actual house prices can and do diverge from fair value for extended periods of time. Clearly, if homebuyers remain stubbornly enthusiastic about housing returns and/or remain bearish on equity market prospects, price outcomes could move beyond this "fair value" level, implying corrective adjustment at some later stage.

Adjustment does not necessarily require outright price falls, however, with the possibility that prices may grow more slowly than incomes over a number of years (as seen in the early 1990s). Large-scale price falls are only a good bet, if prices are driven "fair value" and if economic well beyond circumstances deteriorate sharply or interest rates move up more quickly than is currently in prospect.

Dwelling starts forecasts ('000): 01/02: 165, 02/03: 169, 03/04: 150, 04/05: 168, 05/06: 151

^<sup>4 For further information see our forthcoming publication Revisiting the fundamental value of house prices, Economics@ANZ, Jun 2003.

^<sup>5 This outcome would take the national market to "fair value" by December 2004.

State Trends

New South Wales

Subdued residential construction activity has quite effectively eroded the substantial dwelling surplus that emerged in NSW in 2000 and 2001. Building approvals most recently peaked at an annualised "starts rate" of 50,500 in October 2002, only barely matching underlying requirements. With building approvals now subsiding to an annualised trend "starts rate" of 41,000 dwellings, a considerable shortfall in housing is expected to have opened up by the middle of this year. As a result a healthy level of construction activity will be justified in the period ahead.

Source: ABS, Cat., No., 8731.0

While a shortage of houses looks like opening up in aggregate housing supply, the rental sector remains under extreme pressure. Vacancy rates appear to have stabilised in recent quarters but remain at historically high levels. Rental income growth has slowed sharply to only 1.2% over the year to the March quarter, and has actually been flat over the last two quarters. As rental growth tends to lag market conditions, we expect more weakness ahead.

The rental market in inner-Sydney in particular remains vulnerable. To this point, inner-city developments have quite successfully lured tenants from the middle and outer metropolitan rings (see chart below). However household formation will have to accelerate rapidly in the year ahead to absorb the supply implied by recent housing approvals, which are running at twice the rate of the late 1990s.

Despite the vulnerable rental sector, Sydney house prices continue to rise apace, growing by 20.9% over the year to March 2003. Our modelling suggests that Sydney house prices have now reached fair value. Current momentum suggests

however that Sydney house prices will overshoot "fair-value" targets. implying subsequent our adjustment once momentum wanes. Provided overvaluation remains within reasonable limits, this adjustment could be gradual and need not be reached via outright price falls. However there is an increasing possibility of this outcome the longer the current boom continues.

Sources: ABS: REINSW, Economics@ANZ.

Dwelling starts forecasts ('000): 01/02: 47.9, 02/03: 49.6, 03/04: 51.2, 04/05: 56.3, 05/06: 48.5

Prices nearing "fair value" % change 25 Average annual % change in house prices needed
to achieve 'fair value' over two years to December 2004. 20 15 $10$ "Fairvalue" range using 5 earning
discount method $\circ$ $\sim$ 5 Melb Adefaide Perth Hobart All Sydney Bris Capitals Source: ANZ measure of housing affordability, Economics@ANZ estimates

Victoria

The Victorian residential construction sector appears likely to face the sharpest contraction in activity of all the states in the period ahead. Building approvals have fallen sharply over the six months to April to a trend "starts rate" of 34,500 dwellings, after peaking at around 51,000 in the middle of 2002. This implies a contraction of activity of the order of 15% - a positive development given that approvals were running well ahead of underlying

requirements of around 44,000 new dwellings for 2003.

Melbourne's rental market remains oversupplied. While vacancy rates appear to have stabilised over the past 12 months, rental income growth is slowing sharply. Rents in Melbourne have grown by just 1.7% in the year to the March quarter, down from 3.0% in the previous year.

Inner-Melbourne in particular remains vulnerable, with a growing divergence between approvals for new dwellings (mostly high-density investment properties) and household formation. With the stock of apartments forecast to rise by 18% by the end of the year and by 62% within three years, $6a$ cultural sea change from detached housing to innercity high-density living is required to avoid serious oversupply in this sector.

Melbourne property price gains have clearly slowed in the past six months to 13.7% over the year to March. While our fair-value indicators suggest that Melbourne house prices are similarly valued to those in Sydney, we remain more optimistic that Melbourne will avoid a boom bust cycle. Momentum in Melbourne prices is clearly slower than in Sydney suggesting that the chance of overshoot will be less. We expect house prices to flatten in the near term, but large-scale falls in aggregate prices remain unlikely.

Dwelling starts forecasts ('000): 01/02: 47.8, 02/03: 45.9, 03/04: 38.0, 04/05: 46.6, 05/06: 42.6,

Queensland

The lure of the sun and surf of Queensland is once again drawing inhabitants from the southern states. Net interstate immigration has accelerated rapidly and is nearing the levels prevalent in the early-tomid 1990s, when Victorians en-masse decamped to warmer climes. This time however it is NSW that is providing the bulk of Queensland's gains. This factor, combined with growing migration from overseas, is strongly supporting ongoing activity and house price growth.

The recent fall in dwelling approvals has been minor in comparison to the other large states, particularly in detached housing, with most of the drop-off in approvals being in the high-density "other-dwelling" sector. Building approvals are currently trending at an annualised "starts rate" of 31,000, slightly below underlying requirements of 33,400 for this year, and as such the downward leg of the cycle should be reasonably benign by historical standards.

Vacancy rates in Brisbane have increased recently, but remain low by historical standards and are well below the elevated levels of 2000. Rental conditions remain the most favourable in the country, with growth in rents accelerating to 3.4% in the year to March at a time when growth in other state capitals is slowing sharply.

Tight rental conditions and strong population growth continue to drive Brisbane house prices rapidly higher. House prices have risen by 22% in the year to March and maintain considerable momentum. Scope for further gains remains, with our affordability measures suggesting that 6% over the next two years could be easily sustained.

Dwelling starts forecasts ('000): 01/02: 35.3, 02/03: 37.8, 03/04: 32.1; 04/05: 33.4, 05/06: 29.5

South Australia

The South Australian dwelling market is most at risk of moving into substantial oversupply. Building approvals peaked at an annualised "starts rate" of

^<sup>6 Charter Keck Cramer

10,500 dwellings during 2002, well ahead of underlying requirements of 7,100 dwellings. While approvals have now declined to an annualised 9,000 rate, further declines will be required to avert oversupply.

While rental income growth is quite buoyant currently, at 3.2% in the year to March, this situation is unlikely to persist, with vacancy rates already at elevated levels and with the risk of them moving higher.

SA building approvals to continue falling

Adelaide house prices have gained 20.6% over the year to March, and still contain scope for a further appreciation based on our affordability measure. To some extent however the potential for price gains will be offset by the downside risks of oversupply.

Dwelling starts forecasts ('000): 01/02: 10.0, 02/03: 9.2, 03/04: 5.6, 04/05: 6.0, 05/06: 5.5

Western Australia

While residential construction activity in most of Australia is expected to decline in the near term, it is a case of "steady as she goes" for Western Australia, with activity unlikely to fall. Building approvals are currently trending at an annualised "starts rate" of 18,400, only slightly less than underlying requirements of 19,100 dwellings, and have been broadly flat for 18 months now.

Perth rental markets have weakened, though at this stage only moderately. The loss of population through interstate migration has intensified, but remains modest in relative terms and has been offset by growing overseas immigration. Vacancy rates have stabilised above long-term averages, though rental growth has slowed from its most recent peak of 2.5% through the year to the September quarter 2000, to just 1.4% growth in the year to the March quarter.

Property prices in Perth have failed to keep pace with gains on the eastern seaboard, growing by just 12.3% over the year to the March quarter. While not quite as "hot" as the Sydney and Brisbane property markets, Perth house prices still clearly Based on our affordability have momentum. measure, prices still have plenty of room for "catchup" on the larger state capitals.

WA housing activity to remain buoyant

Dwelling starts forecasts ('000): 01/02: 19.2, 02/03: 19.9, 03/04: 18.7, 04/05: 20.8, 05/06: 19.9

Tasmania

A slowing in the drain of population to the mainland has been beneficial for Tasmanian residential activity and property prices. After falling continuously for four years from its 1996 peak, the Tasmanian population is growing once again, though it is still below peak levels. Activity levels remain well short of those experienced in the early-to-mid 1990s, in line with the very modest growth requirements of underlying demand.

Rental conditions remain tight in Hobart, however, with vacancy rates the lowest in the nation and rental income growth rates amongst the highest. Hobart has also been sharing in the recent houseprice boom, though to a much lesser extent, with prices up over 13% in the year to the March quarter. Our "fair value" modelling suggests that Hobart has the greatest scope for further price gains, though it will be difficult for this potential to be realised while population remains below 1996 peak levels.

Dwelling starts forecasts ('000): 01/02: 1.9, 02/03: 1.8, 03/04: 1.5, 04/05: 1.8, 05/06: 1.7

Commercial property

CBD office markets

Vacancy rates for CBD office space have been on a rising trend since mid 2001. The total vacancy rate across the six capital cities was 8.3% in January 2003, compared with 6.4% in July 2001, according to Property Council of Australia (PCA) data. The Sydney market accounted for nearly 70% of the rise in vacant space, with significant increases in Melbourne and Perth, also.

The main cause of the 2% decline in the level of occupied space over the 18 months to the end of 2002 was weak demand. Company collapses (such as HIH Insurance, One.Tel and Ansett), a contraction in the information technology sector; and general corporate downsizing meant fewer staff needing office space and greater focus on accommodation costs.

Vacancies rose in Sydney, Melbourne and Perth

The worst of the corporate collapses, downsizing and the I.T. shakeout appear to be behind. Official data suggest a recovery in white-collar employment got under way last year and it is expected to continue this year - although growth will be weaker in line with a slowing economy. Sluggish growth in employment, and hence demand for office space looks like continuing into early 2004. A pick-up in jobs growth will lag the forecast strengthening in the global and domestic economies later this year.

A strengthening in the supply side of the equation was initiated in 2000-01, when commencements in real terms rose by some 34%. This momentum has been sustained, with growth in the year to December 2002 of 32%. With significant additional supply developing and demand subdued, some further upward pressure on the national vacancy rate seems likely in the near term.

Industrial markets

Last year's solid growth in manufacturing and other industrial sectors of the economy has continued to support demand for new industrial premises. While factory commencements declined slightly in 2002, starts on other industrial premises rose strongly, particularly in transport and storage, communication services and wholesaling.

Approvals point to continued growth

Although decelerating during the second half, the value of industrial premises commencements grew by more than 16% in 2002. Consistent with a slowing in the economy overall, the trend in approvals growth eased back in the first quarter of this year, but it is still quite robust.

The pick-up in "blue-collar" employment that accompanied the growth in industrial activity has supported demand for industrial premises. This support will weaken as the economy slows but, since that slowing is forecast to be moderate, so should be the effect on employment. An additional factor supporting demand has been the increased interest of investors in the sound yields characteristically generated by industrial property. This interest will continue for at least as long as confidence in the sharemarket remains shaky.

On these considerations, construction of industrial premises should hold up reasonably well in the near Beyond this, the negative impact on term. manufacturing et a/ of a return to more normal levels of housing activity should be at least partially offset by a lift in demand for manufactured exports as the global economy recovers. The combination of continued low interest rates and moderate demand for industrial products and services should sustain a positive growth trend for industrial construction.

Retail markets

Shop building activity is expected to stay firm in the months ahead, as reflected by healthy building The real value of building approvals numbers. approvals surged by 73% in the second half of 2002 compared with the same period in 2001. This was accompanied by a rise in the real value of work done of 29% during the same period. According to the. Construction Forecasting Council, some softening in building activity is expected in 2004, coming off a strong base in 2002 and 2003.

Retail trade is expected to stay relatively healthy in 2003 although growth is forecast to ease from the high rates achieved over the past two years. Income tax cuts are likely to lift consumer sentiment and spending but the latter is likely to be tempered by a moderation in wealth gains and the small size of the cuts.

Building activity is likely to feature the construction of bulky goods stores and homemaker centres. Demand for household related goods has returned to more reasonable rates of growth in recent months following the double-digit rates in previous years; but the draw of these large centres with "everything under one roof" is expected to continue to sustain customer traffic.

Other work in pipeline includes: the the redevelopment of retail centres in some CBD shopping precincts so they will be better able to attract the growing inner-city residential population, refurbishment of strip shopping areas and the redevelopment of suburban shopping malls. Prospects for retail building activity have also been lifted by strong investor interest in retail property, with the trend towards tenants becoming owneroccupiers less attractive residential and -a investment market fuelling competition among buyers.

Tourism accommodation markets

Building activity in the hotel, motel and holiday apartments segment continued to strengthen in 2002 with the real value of work done rising by 52% compared with 2001. The real value of approvals picked up strongly in the second half of 2002, providing further momentum to building activity in the first half of this year. However, a slower pace of growth is envisaged later in the year.

The conflict in Iraq and the spread of the SARS virus has taken its toll on international visitor arrivals. Tourist arrivals were down 5.8% in the first four months of 2003 compared with the same period in 2002. A sharper decline is expected for the rest of the second quarter with forward bookings from some markets to Australia down by 20-30% from the previous year. The latest forecasts from the Tourism Forecasting Council point to a 5.3% decline in inbound tourists in 2003, the third successive year of negative growth, but a rebound of 9.8% is expected in 2004. Domestic tourism, however, is likely to pick up, as some Australians, initially planning overseas trips, opt instead to holiday at home.

Hotel/motel/serviced apartment accommodation market (2002 vs 2001)

With the hotel industry, in particular, reliant on business travel and international tourist traffic, occupancy and room rates are likely to come under Nevertheless, for some hotel further pressure. chains, this is an opportunity to spruce up facilities in anticipation of an uptum in demand and the prospect of higher returns in the medium term. Overall, the difficult operating environment is likely to see slower growth in building activity in the tourist accommodation sector in the near term. A fair share of activity is likely to take the form of alterations and refurbishments.

Melbourne

After bottoming at 5.1% in mid 2001, the total office market vacancy rate rose to 6.7% in mid 2002, remaining stable in the final six months of the year. The increase in new supply since mid 2001 has been particularly modest, and has been eclipsed by withdrawals from the stock of space. Nevertheless, Melbourne has not escaped the downward pressure on rentals. Prime effective rents (i.e. for top quality space and factoring in rental incentives) fell by some 7% during 2002, on Jones Lang La Salle research, and probably weakened further in the March quarter.

Even with an improvement in white-collar employment, Melbourne is likely to continue to have an imbalance between supply and demand for office space. Committed construction is expected to see a substantial rise in supply hitting the market in the next few years. Accordingly, upward pressure on vacancy rates, with downward pressure on rents, is expected, as a gradual pick-up in demand tries to absorb this strong increase in supply.

After two years of declining activity, industrial construction in the Melbourne region rose sharply during 2002, bringing some new supply to the Along with the increase in available market. premises, strong competition for tenants in the face of a growing preference for "owner occupation" meant that rents were fairly flat during 2002. Sales of industrial properties were particularly strong in 2002, which kept downward pressure on yields. Competition for tenants is expected to keep rents flat this year. The Construction Forecasting Council (CFC) has projected a declining trend in the value of work done on industrial premises through mid 2004, pointing to fower supply.

Weak tourist arrival numbers and the coming-onstream of new supply are likely to exacerbate
occupancy levels and already-competitive room rates. Some winding down of building activity is envisaged following the completion of some major hotel and serviced apartment projects in late 2003 and 2004.

Major CBD projects such as the QV complex, redevelopment of Melbourne Central and the GPO development are scheduled for completion in late 2003 and 2004. While this sharp increase in retail space is likely to put some pressure on rents, the extent would be limited by the large precommitment of space at the QV, niche marketing programmes and strong offshore and local demand.

Sydney

Sydney has borne the brunt of the recent weakness in business services employment that has raised

vacancy rates. After bottoming at 4.5% in July 2000, the total market vacancy rate rose to 8.4% in January 2003. The increased pressure in the leasing market over the past 12 months has led to strong competition to "tie up" tenants and a rise in rental incentives. Annual prime effective rents declined by 3-4% in 2002, and likely continued to ease this year.

The amount of office space scheduled to be completed in Sydney over the next three, or so, years, is relatively moderate, according to PCA
projections. Accordingly, the market outlook is mainly a question of demand, or the extent of improvement in service-related businesses. Once white-collar employment resumes a more normal growth path, absorption of expected additions to the supply of office space would not appear to pose a significant problem for rents.

The Sydney region's post-Olympic recovery in industrial construction continued last year, with the value of work done rising by 21%. At the same time Sydney experienced good tenant demand. although it was slower towards the end of the year. Some areas experienced a modest increase in rents for top properties in the second half of the year. As with Melbourne, sales were relatively buoyant. With an improvement in supply, increases in sales prices were generally confined to areas where commercial and residential interests are in competition for land. On the outlook for supply, CFC forecasts for industrial construction activity point to more modest growth through the year to December 2003 and a softening in the first half of 2004.

Building activity is expected to be lifted by a growing number of hotels planning to refurbish their premises to better position themselves ahead of an anticipated pick-up in demand over the medium term. Renovation projects underway include the Sheraton on the Park, Inter-Continental and Sydney Hilton.

Current building activity has featured the construction of a number of bulky goods centres (eg. Ikea, Bunnings) and suburban shopping malls, as well as the extension and/or refurbishment of retail centres such as Westfield Shoppingtown at Bondi Junction. The outlook is for further strength in retail building activity, following a sharp increase in shop building approvals in NSW in the six months to April 2003.

Brisbane

In contrast to Sydney and Melbourne, the Brisbane office vacancy rate, at 6.8% in January 2003, is only slightly above its low point of 6.4% in July 2001. This reflects relative buoyancy in the property and business services industries and generous rental

incentives from landlords. There is little vacant space in the better quality end of the market. However, with landlords' incentives, prime effective rents failed to improve in the second half of 2002, after falling by around 11% in the first half.

New completions in 2003 and 2004 are projected to be some 45% higher than new supply during the previous two years. This additional supply is likely to place some upward pressure on the vacancy rate and delay any significant increase in effective rents.

Reflecting a weak first half, industrial construction was down nearly 10% for 2002 as a whole. Tenant demand was modest and rents were generally flat during the year. Excess supply continues to overhang the market dampening the prospects for improvement in rents. (However, the "Trade Coast" area has outperformed other Brisbane industrial areas.) Investors chasing the limited properties for sale have depressed yields. Construction activity is forecast to remain firm through the year ahead.

Building activity in the tourist accommodation sector is likely to hold steady in Queensland, with further resort development in the pipeline ahead of an expected upturn in demand in the medium term. Despite the current weak inbound travel market, Queensland is expected to benefit from higher domestic tourist traffic.

Shop building activity in Brisbane is expected to stay strong, reflecting increasing expectations of healthy retail demand coming from a growing CBD
residential population as well as from tourists. MacArthur Central shopping complex in Brisbane's CBD opened in November 2002, and a \$300 mn Queens Plaza shopping centre project, housing 90 specialty stores and a supermarket, was announced in February 2003.

Adelaide

Vacancy rates in Adelaide's CBD moved counter to the national market trend, falling from 11.9% to 10.8% over the 12 months to December 2002. The premium market continues to tighten due to the lack of new building. Increased incentives from landlords saw effective rents dip by around 5% during 2002. With little new supply on the horizon, the market should begin to favour landlords once the economy begins to pick up.

The value of work done on industrial premises in the Adelaide region edged up by 7% in 2002. Tenant demand was flat but rents rose marginally. Investor interest was relatively good, and yields edged downward. Construction activity is expected to increase modestly in 2003, slowing thereafter.

The value of work done in the hotels sector in South Australia more than doubled in 2002 compared with the previous year. Building activity is likely to stay firm, although expanding at a slower rate, following the previous year's strong performance.

Shop building approvals were up by 51% in the first four months of 2003, compared with the same period in 2002. This included the construction of a number of bulky goods and homemaker centres.

Perth

Perth's CBD office vacancy has been adversely affected by a migration out of the CBD. The vacancy rate bounced from 9.1% in July last year to 11.6% in January this year. Prime effective rents have edged downward during 2002. PCA data indicates the new Woodside building will add nearly 50,000 square metres to the market this year, which should contain rents in 2004. Beyond this, no new major office space has been projected.

After a weak start, industrial construction activity picked up throughout 2002, but still finished 12% Tenant demand for newly down on 2001. constructed premises was modest and, overall, rents were lower in 2002 than in 2001. Sales activity was limited and yields were generally steady. The CFC forecasts the value of work done to continue to rise through most of 2003, steadying in the first half of 2004, keeping pressure on demand.

The real value of work done in the hotel sector in Western Australia amounted to \$48 mn in 2002, up sharply from \$24 mn in 2001. Building activity is likely to remain firm, as indicated by strong approvals data in the first four months of 2003, compared with the same period in 2002.

Shop building activity in Western Australia, as gauged by the real value of work done, was weaker in 2002 than in the previous year. Firmer approvals figures in the first four months 2003, compared with January-April 2002, point to a pick-up in activity in the months ahead.

Hobart

The office vacancy rate in Hobart declined from 10.5% in January 2002 to 9.5% in January 2003. No significant supply increase is projected through 2005, and so the vacancy rate could decline further.

The value of work done on industrial premises peaked at \$3.9 million in the March quarter 2002, before declining over the rest of the year. The CFC projects a declining trend through mid 2004.

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