Valore Market View - October 2022

The Game Has Changed – How to Capitalise on Volatility Through Real Estate

• Economic turmoil is creating a dislocation in pricing for all commercial real estate classes opening a window of opportunity for smart counter cyclical buying
  

• Build to core and value added strategies provide more risk control for investors, by unlocking latent value and boosting income performance
  

• Passive investment strategies linked to core assets will struggle to achieve appropriate returns in a rising interest rate and bond yield environment – active strategies will outperform in the medium term

The outlook for investments seems bearish at the moment, but with volatility comes opportunity and the global shift upwards in interest rate policy is presenting a once in a generation opportunity for investors to capitalise on the emerging pricing dislocation in the commercial real estate market.

Over the past decade, the low cost of debt and ample access to liquidity made even the most passive fund managers look like rock stars, but it is important to note that the "lower for longer" cycle that created this environment was the exception, not the norm. As we enter the next cycle, it is becoming clearer that market conditions will be characterised by more “normal” risk factors such as higher overall interest rates, greater diversification and a focus on higher yielding investments.

The good news is that investors now have a much wider suite of investment options to choose from and real estate is no exception. With emerging core sectors such as healthcare, data centres, high tech manufacturing and manufacturing emerging as growing alternatives to the traditional core sectors of office and retail.

Maximising returns, whilst mitigating risk in this cycle will be a more complex formula than buying well and waiting for the market to go up. Maximising returns will require an agile and swift approach to buying, maximising the outcome through the optimal development, leasing and capital structures.

One of the most common questions investors ask at this point in the cycle, is why there isn’t a wholesale sell off in commercial real estate, as investors seek greater liquidity in fixed income or equities. The simple answer is that these investment classes don’t offer superior returns to commercial real estate and no protection against inflation.

With interest rates and bond rates rising sharply across nearly all developed economies, the hunt for yield is becoming a more complex calculation than it has been for the past decade. The rout in equities triggered by hyper inflated technology valuations, shows no sign of abating in the near term and fixed income markets, once the safest of safe harbours, are feeling the pain of a geopolitical and macroeconomic cocktail of war, supply chain constraints and global inflation.

Real estate will not be immune from these factors either. The recent slide in Australian housing prices, point to an imminent pricing correction event for the commercial markets also. The correction in commercial valuations is already being priced in by the listed real estate market, where the S&P ASX AREIT Index has consistently underperformed the ASX 200 Index since the onset of COVID19 in 2020, and discounts between the share price and book valuations of AREITs hover between 10-15%. However, commercial real estate offers significant downside protection through capital preservation and inflation adjusted rental income that enable it to provide a more stable return over the long term.

The Real Estate Investment Model is Changing

In the lead up to COVID, commercial real estate yields for prime assets, which are typically owned by superannuation funds and large offshore investors went to their sharpest levels in over 30 years, averaging 4-5% across the major sectors of office, retail and industrial. With the cash rate now approaching 3% and set to rise further, I believe this situation is not sustainable for three reasons:

1. Demand is weakening – when vacancy rises and rents fall, yields soften and given the softer economic outlook for Australia, weaker demand looks more certain in 2023
   

2. Cost of capital is going up – rising interest rates and bond yields demand higher returns on capital, which cannot be accommodated on yields of 3-4% - something has to give
   

3. Net selling – the buyers of the last decade will be net sellers in the near term, as they take their profits and wait to buy back in when valuations look more opportunistic – tipping the scales in favour of buyers over sellers.

Asset classes that will see the lowest fall in value, will be those underpinned by strong income fundamentals, low vacancy and long lease tenure from quality tenants. Overall, the rising cost of capital will mean that assets will need to deliver higher returns to remain sufficiently attractive to investment capital.

The more traditional buy and hold model, favoured by passive/beta funds servicing the big end of town, will be more likely to deliver inferior returns in this environment. Without a repositioning or upgrade strategy, to unlock latent value and find new sources of income, valuation decreases will likely erode investor capital over the next three to five years, until the economy recovers and interest rates normalise.

Notwithstanding these challenges, some real estate sectors will continue to outperform the benchmark, delivering strong returns to investors through the current cycle and look set to continue delivering. The most outstanding sector of the past five years has undoubtedly been industrial and logistics, that have consistently delivered total returns over 10% since 2016, with their long term run looking set to continue for the medium term.

Looking beyond the sectors, the strategies that funds are employing are also evolving. In the aftermath of the GFC, real estate valuations fell sharply across all sectors and with debt less favoured as a means of financing deal flow, passive core investments surged in popularity, displacing the more aggressive value added and opportunistic strategies. This tilted the balance of sector allocation in favour of office and retail, that have less development and supply side risk and have historically delivered more rental growth due to the quality of their tenants.

However, as the global weight of capital chasing commercial real estate surged from $200bn a year in transactions in 2009 to over $1.2 trillion by 2019 according to Real Capital Analytics, a larger number of investors were chasing a scarcer pool of quality assets and had to start looking elsewhere to get exposure and appropriate yield.

This has led to the emergence of “alternatives” in sector allocations such as data centres, healthcare facilities such as hospitals and medical office, high tech manufacturing facilities, agriculture and build to rent housing developments becoming more sought after because of their compelling yield, underpinned by strong demand themes such as housing shortages, immigration, demographic change and technology adoption. One of the challenges of taking a position in these sectors, particularly in Australia, is that they tend to be small, requiring specialised development and management skills that are hard to find. They do however have significant benefits, not limited just to their return profile, but also offer greater diversification and development profit upside.

What’s Next for Real Estate? Strategies for Accessing Superior Returns

There is an old but timeless expression in commercial real estate investment, which is that you make the profit (capital gain) on the buying, not the selling. With rising interest rates and ongoing economic volatility driving lower investment demand for real estate generally, the climate is becoming more conducive to finding greater opportunities for value in the market.

Not all assets and markets were created equal, some will fare better than others, however the opportunity to find greater value in commercial assets will be greater than it has been since the GFC. According to JLL Research, the gap between Prime office cap rates and Secondary assets is opening to its widest level in over a decade, with a 150 basis spread opening up between the two classes.

Disruption can be your friend, and being in a strongly capitalised position today, to take advantage of cyclical turns in pricing and investing opportunistically will be critical to maximising returns.

The Model Portfolio for Achieving Optimal, Countercyclical Returns

Looking through the opportunistic lens, some of the factors to consider when looking for counter cyclical, value added opportunities are:

• Weak demand conditions

• Strong location, weak offering compared to peer set - B Grade office A Grade location

• A generally disliked or “unfashionable sector” - retail, CBD or city fringe office

• Challenging site conditions – contamination, zoning, terrain

• Limited availability of space or product Poorly managed and maintained assets

From a sectors perspective, we favour:

• Secondary grade office buildings, middle tier retail such as suburban sub regionals in growth corridors;
  

• Mixed used industrial, logistics and manufacturing facilities will be standout performers, with strong income profiles due to the limited supply of high quality facilities in the market to meet the growing demand from high tech manufacturing, medical and other service based industries;
  

• Hotel and leisure assets are already seeing a sharp uptick since the beginning of the year as unrestricted international and domestic travel resumed. We are forecasting returns on repurposed assets in these markets to comfortably exceed 10% delivery to investors within the next five years, followed by a period of sustained income return.
  

From a thematic perspective, sectors linked to long term demand drivers such as convenience led retail, mixed use commercial sites, technology demand led sectors, healthcare and affordable leisure and accommodation all have the right ingredients to deliver return outperformance over the long term.

Engineering value creation through redevelopment will require partnering an experienced platform and team, with a strong track record of unlocking development and income value out of a site, through deep relationships with the tenancy markets and a focus on construction cost control. The investment game has changed, and will favour those fund managers who engineer value, not those who wait passively for the market and low interest rates to deliver the returns for them.

For more information on the Valore Investment Partners funds or to discuss this article, please email us at info@valorefunds.com