Buying below replacement cost: property fundamentals and compounding investment returns

Whilst upside is a critical focus in any investment we support, we firstly look for key elements to a deal that will provide strong structural downside risk and equity protection. From a property fundamental perspective risk can be mitigated in the following key structural ways:

1. Entry Value: a. Buying below replacement value: Buying an asset below replacement value essentially means that if you try to build a new competing asset of similar calibre, rents at the incoming asset would be uncompetitively high, considering the increased land and build cost base. Buying an asset below replacement cost also means high barriers to entry for competition.

b. Buying significantly below peer group average or comparable market data: Investment value is usually achieved on entry. Compelling entry pricing means that: i. It's more difficult for competitors and competing products to compete and ii. Further pricing arbitrage will be achieved based on exit or capital gain because of the lower entry value metric.

2. Under-rented: An asset that is under-rented when assessing against comparable rents paid at comparable assets, especially when combined with favourable supply-demand dynamics at the asset level, means a likely 'sticky' asset from a tenant tenure perspective and ability to enhance investment value via optimising and increasing rents.

3. Minimal capex requirements: Capex is complex, especially when it is structural. Cosmetic capex can help enhance investment returns; however, structural capex and value-add type capex can add complexity and risk to an investment. Depending on the market, especially when construction pricing and construction industry complexities are problematic like now, an asset with minimal capex requirements will have less risk.

4. Buying in high-growth areas with good infrastructure: All ships rise in a rising tide. Surrounding infrastructure spending, both private and government, means more density, easier access, increased amenities, better services, and more jobs in a particular area, which creates increased demand for real estate, increased real estate value and increased investment value.

5. Buying into an up-swinging market: Various sectors can provide high-quality investment exposure in the investment-grade property sector. This could be debt or equity exposure in any of the following sectors: industrial and logistics property, commercial office, retail shopping centres, large format retail or residential construction funding or build-to-rent. Based on prevailing economics at a given time, specific sectors of the investment-grade real estate markets will provide more favourable risk-reward pricing. We are always looking for what we call 'miss-priced risk', where the risk is miss-priced in favour of the investor.

6. Favourable supply-demand dynamics: In any commodity-type investment, we are looking for constrained supply, high barriers to entry, and high and growing demand for the attributes offered by a particular property..

7. Manager Alignment: This generally means co-investment from the lead Manager, which is either subordinated or parri-passu with external investors. We look for low ongoing fees, with the majority of fees to the Manager taken on performance after certain return hurdles have been achieved for investors.

8. The 'Coke" factor: As Warren Buffet says of his beloved Coca-Cola equity holding, there needs to be some ‘X-factor’ combined with a 'mote' around the asset; we usually look for this moat to be the quality of the asset, i.e. we tend only to support higher quality assets.

Two deals we have seen recently tick the property fundamentals boxes from the perspective of both downside risk elements and probability of outperformance on a risk adjusted basis. Haben's Westpoint in Bankstown forecasts a c17% IRR pa and c. 3 x cash multiple over the 7.5 year investment term with an average 6% distribution, paid monthly. Stirling Property Funds McGraths Hills Home forecasts an 14-17 IRR pa with a c.7% average monthly distribution and a tax effective return to high tax bracket investors of 18-22% pa. .

Whilst both deals are broadly classified as retail property, they are quite different in size and complexity, with Haben Westpoint being a $900 million shopping centre in the heart of Sydney's high-growth Blacktown and Stirling's' McGrath Hill a Large Format Retail centre (LFR) with an acquisition value of $55million. Both are underpinned by property fundamentals that provide in our view strong structural downside risk protection.

Both investments have compelling entry pricing reflecting a c. 40% discount to replacement cost, with the vendor of Haben Westpoint having come to the end of the tenure of the underlying fund. The vendor of Stirling McGraths Hill is a multi-billion-dollar fund and has a comparatively small exposure to the particular asset, which does not fit their broader strategy, given the asset is a legacy part of a wider portfolio acquisition. Both Haben Westpoint and Stirling McGarths Hill are being purchased significantly below the peer group average rate per sqm.

Both assets have significant infrastructure and surrounding growth factors, with Haben Wetspoint having c. $19 billion of surrounding both government and private infrastructure spend, with a main bus interchange located within the asset and on the train station. The catchment area is 60% larger than a standard catchment area, and the wealth of the demographic in the catchment area is 15% higher than the national average. Stirling McGraths Hill also has a catchment area 60% larger than the standard for an LFR centre, and the wealth within that catchment area is 8% above the Sydney metro median and growing at 7% faster than the Sydney metro. Savills also forecasts the area will increase by 30,000 homes in the coming years.

Both deals have constrained supply within their asset sector because of the dynamic around expensive construction prices, blown out time frames and land cost, meaning high barriers to entry. Both assets have significant and growing demand from both an occupation perspective as well as from an end buyer perspective; we believe on this basis, exit value has been conservatively modelled. Stirling McGraths Hill is anchored by Australian national retailers like Bunnings, Harvey Norman Repco and BCF, who have been in occupation of the centre for more than 15 years, with the tenancy base being approximately 30% under-rented, meaning significant ability to increase rents to market to enhance both investment income as well as value.

Both have strong Manager alignment from a fee perspective and manager co-investment.

Both investments are single-asset, closed-end, unlisted funds; we like this because although they are illiquid, the structure allows for transparency and the merits of the property fundamentals at the asset level to influence investment outcomes positively. Pitting the illiquidity of an unlisted fund against a listed REIT-style exposure, we tend to choose unlisted single asset deals because we like the structural transparency created by a single asset unlisted closed-end fund; we feel the structure allows for strong visibility to the particular characteristics unique to the specific asset and property fundamentals which allows an informed decision to be made of the risk-reward dynamic of the investment.