Real estate: still more to the storey?

By

07/03/2017

For those tasked with increasing their fund members’ life savings, property has largely been a solid bet in recent years. The question investment chiefs and asset allocation experts now is whether real estate’s dream can come true.

As interest rates and bond yields fell and demand for commercial real estate rose over recent years, global investors redirected vast sums of money into commercial property, such as office blocks and shopping centres. It worked, supercharging capital growth.

In 2016, research company SuperRatings found that commercial property (including international) recorded net returns of 9.6 per cent, slightly below Australian shares (10.3 per cent), but beating international shares (6.6 per cent) and cash (1.8 per cent).

Now, however, real-estate valuations in major cities are at historical peaks, and banks are pulling back from commercial real estate lending. There are signs that the good times for property might be coming to an end – or at least slowing.

So is the tailwind in real estate about to change direction? And if so, how are super funds preparing for the shift?

Grant Harrison, investment manager of private markets at Cbus Super, says the $35 billion industry super fund for construction workers is in a state of “heightened caution”.

He acknowledges the historic reduction in bond interest rates has boosted the value of property and infrastructure and warns, “Now that long-term interest rates may start to rise, the tailwind may cease.”

In its latest statement, on February 7, the Reserve Bank of Australia noted that while long-term bond yields had moved higher, they remained low in a historical context.

“The big question is: Will the tailwind just cease or will it turn into a headwind?” Harrison says. “Will capital values fall or will capital values now stagnate?”

As such, it’s a cautious time for Cbus, he says. “We’re looking to clearly understand all the risks inside of our portfolio and continue to focus on core – i.e. lower-risk, more defensive – assets.”

Those lower-risk assets come in the form of modern, high-demand office buildings with long-term tenants, large shopping centres and, to a lesser degree, prime industrial.

Cbus Super’s subsidiary, Cbus Property, recently completed the A-grade commercial building at 1 William Street, Brisbane. Dubbed the “tower of power”, it now houses the Queensland Government.

Cbus Property’s portfolio also includes 1 Bligh St, Sydney, where Prime Minister Malcolm Turnbull has an office. Harrison says there is a chance global capital will start to flow from property and infrastructure back into long-term bonds – that’s if US bond rates move above 4 per cent.

Even so, he doesn’t have any huge concerns about the fundamentals of the Australian property market. “But I am watching carefully in terms of the possible impact of global capital flows if,  globally, institutions start to say, ‘Well maybe there are more attractive asset classes, from a risk-return perspective.’ ”

Cbus is definitely not “ringing the bell on the property asset class”, he says. “But we’re extremely conscious of the strong pricing environment we’re in and, therefore, we have a strong focus on where the risks lie within the portfolio.”

 

Quest for resilience

UniSuper is another fund with big interests in commercial property that is taking a cautious approach against an uncertain backdrop.

Kent Robbins, head of property and private markets at the $55 billion default fund for university staff, says history shows that picking the peak in the property market is extremely difficult. But values across most asset classes are at record highs, he says, with UniSuper experiencing seven consecutive years of positive returns from unlisted Australian property.

“All we know from our end is that cap rates (yields) on, say, super regional malls – like the Chadstone Shopping Centres of the world [in Melbourne] – have never been lower,” he says. “So we’re in this territory where prices paid for assets have never been higher, which leads us to believe, OK, well maybe property is reaching towards its peak.”

However, UniSuper has no plans to start ditching property willy-nilly; instead, it’s just acting cautiously by not acquiring too many assets at current prices. Those the fund does acquire must be good quality with little or no leverage, Robbins says.

It’s all about creating a highly resilient portfolio made up of property such as Sydney CBD offices and “fortress assets” such as high-yielding malls and airports.

“With these more resilient sectors, we say, ‘OK, that’s where we want to be because we feel they will perform better if the market retreats,’ ” Robbins says. “If we don’t have much debt associated with it, then any loss we may incur won’t be magnified.”

In recent history, UniSuper has favoured unlisted trusts, he says.

“We haven’t had to incur any stamp duty on buying those and they’ve been priced at valuation … A lot of assets have been transacting in excess of their values in the open market.”

Robbins says UniSuper is steering away from non-core geared assets, which he described as the fund’s “kryptonite”. On the avoid list are poorly located, non-CBD offices and small-scale industrial sites.

“I just think if the market does correct, that would be the area most adversely hit [due to potential tenant vacancies, or falls in values],” he says.

 

Time for extra caution

Increased global uncertainty, thanks to the likes of Brexit and the election of US President Donald Trump, is leading many of the country’s biggest property investors to be extra prudent.

Spiros Deftereos, head of property at Hostplus, says there has been a “global flight to quality”, creating excess demand for institutional-grade core property.

“Investors have been chasing assets that provide greater certainty on the income side, whether that means low vacancy, blue-chip tenants or a longer weighted average lease expiry (the average time period over which all leases in a property, for example a shopping centre, expire).”

In such an environment, Deftereos says, it’s become difficult to find value opportunities, but the $20 billion hospitality industry fund continues to see merit in investing in domestic and offshore markets.

With a comparatively young member base, Deftereos says, Hostplus isn’t necessarily dictated to by short-term property cycles, taking a long-term view instead. However, he says demand for unlisted property has led to strong returns across the board in recent years.

“As we’ve seen property yields firm,” he explains, “there has been fairly strong capital growth in addition to reasonably stable income, and that’s resulted in double-digit returns.”

He doesn’t expect that to last indefinitely.

“I think at some point soon, yields will stop firming and capital growth won’t be as strong as it has been in recent years,” Deftereos says. “You then become more reliant on the income component of your return, so you want that income to be as stable and secure as possible.”

He says long-term success lies in a well-diversified core property portfolio. For Hostplus, that includes premium offices, dominant shopping centres and logistics assets.

A strong portfolio might also be complemented by non-traditional sectors, such as freehold pubs that are set up to deliver stable and secure income streams.

 

Beginning of an upswing

Ask John Dynon, head of separate accounts at AMP Capital, whether the tailwind is slowing, and his response is more upbeat than most.

“The answer is, definitely not – as a matter of fact it is quite the opposite,” Dynon says.

A low office vacancy rate in major cities is driving rent – and capital values – ever skyward, he explains.

AMP Capital is the $161 billion wealth-management arm of AMP Ltd, and controls one of the country’s biggest property portfolios.

“For Sydney and Melbourne offices, we are at the beginning of what we call a cyclical upswing, and that is driven by the demand for office buildings by tenants,” Dynon says. “What we’re seeing at the moment is there is a very, very low vacancy rate in both Sydney and Melbourne.”

In fact, he says, Sydney’s office vacancy rate is at 4.5 per cent, and he predicts it will drop to about 3 per cent in the next two years.

He says that will be driven partly by more office stock being taken from the market for residential developments and infrastructure, such as the light rail planned for Sydney’s George Street.

Meanwhile, he says, Australia’s commercial property market is becoming more international and more liquid.

He says Australia is attractive for many, including offshore funds and sovereign funds, because of a long recession-free period, real growth and the fact it fared comparatively well in the global financial crisis.

Tim Stringer, head of property at Frontier Advisors, agrees that the office market – in Australia, and in the US and UK – is still quite attractive.

“The office sector has stood out as a strong performer pretty much internationally, and that’s obviously been driven primarily through the recovery in the business cycle, reasonable economic growth, and certainly strong job growth, particularly in the US,” Stringer says.

But he predicts commercial property will moderate, and that double-digit returns can’t continue.

“The academics would say that real estate should give you a return somewhere between investing in bonds and investing in equities but, over the last 25 years, real estate has, in fact, outperformed both those asset classes,” he says. “You don’t expect it to continue todo that; it’s against the forces of nature.”

Frontier is one of the four major asset consulting groups and advises some of the country’s largest super funds on their asset allocation. Stringer says commercial property not only needs to be purchased at the right price, but also must be managed highly effectively.

He also argues that super funds shouldn’t be restricting themselves to domestic markets.

“Australia represents, in a global context, only 3 per cent of the (commercial) property market,” he explains. “If you’ve not got a more international perspective, you’re missing out on 97 per cent of the opportunities. We believe fishing in such a little pond here is not the right long-term strategy.”

It should also be remembered that while capital growth is handy, income – for example a long-term rental return of 70 per cent to 75 per cent – is also crucial, he says.

“Sometimes, that’s kind of lost on people in the enthusiasm for capital growth.”

 

This article first appeared in the March print edition of Investment Magazine. To subscribe and have the magazine delivered CLICK HERE. To sign-up for our free regular email newsletters CLICK HERE.