Doubling down on downside risk and capital protection is the name of the game

Success can often be attributed to knowing how to navigate what you don’t know.

There are a range of divergent factors currently creating uncertainty in the global real estate markets; record-high unemployment, record low interest rates, drastically reduced immigration and overseas student numbers, not to mention the global health issue which is the biggest wildcard of all – making it impossible to accurately predict the duration and overall impact on global economies.

Geopolitically the China/South China Sea/Hong Kong dynamic is creating a further liquidity inflow to Australia. As Hong Kong investors seek out opportunities in locations with more political stability, Australia is viewed as greener pastures for offshore capital (which also comes with the complication of procedure around asset inspections in the lockdown).

Despite the resurgence of COVID-19 in Victoria and the political issues at state levels, Australia is still the star performer in how it has handled the COVID-29 crisis from both a health and economic perspective.

It was sobering to see Australia hit an unemployment rate of 7.5% last week, representing over a million people. Interest rates are below 1% and immigration is forecast to reach only 31,000 for FY20-21, compared with over 210,000 the calendar year prior.

But once the borders open up again, this should make Australia an increasingly popular immigration and investment destination on a global scale, well into the future.

The USA is creating sanctions with the UAE which will work to offset some of the other volatility, although the souring USA/China relations and pending USA election are difficult to ignore, in particular to where Australia sits as America’s position as the leader of the free world is increasingly challenged.

Whilst equities markets rally in Australia and the USA, structurally this post-COVID economic climate is not like the GFC, both due to the result of the high liquidity levels and the rising shift in global powers, which will take some years to fully manifest.

All of these conditions mean that if you need to execute on an investment right now, as a generalisation, the price of risk has gone up. In saying that, a good investment should never be made on generalisations or on markets. A good investment is made on a deal where economics and fundamentals present an anomaly, and usually a swift and deeply educated assessment needs to be made in order to identify and take advantage of that anomaly.

If the opportunity to conduct this deep analysis isn’t there, the current conditions mean it’s better to err on the side of caution.

As a case-in-point, MP Funds Management was recently offered a portfolio of service stations with brand new 10-year leases to an outstanding covenant. The portfolio of several stations had additional strategic pad sites, which enabled further infrastructure and stations to be built.

The entry cap rate was soft enough at a portfolio level to give a solid cash rental yield payable over the term of over 10% and a total return in the high teens. The business plan was to upgrade existing stations, which correlated with a contracted increase in rents on the head lease, add ancillary services, build the additional stations and sell down the combined existing upgraded stations as well as the developed pad sites as individual assets, at reasonable compressed cap rates in line with market of around 6%.

We loved the fundamentals of the deal and the downside risk protection offered in the covenant was exceptionally compelling, but the QLD border had just closed, and we hadn’t yet inspected the assets. Under the required time to close the deal, we would not have the opportunity to thoroughly inspect the portfolio or dig deep enough into Due Diligence as required by current market conditions. So we declined the investment.

For us, the absolute focus regardless of how good a deal might look is to rigorously investigate the detail to make sure downside risk is protected. If we can’t do that sufficiently we will walk away from the deal.

On a macro level the unlisted real estate markets are not as liquid as the equities markets and so have the benefit of being less volatile and major shifts take a longer period – years to manifest. On the other side of the coin however once the rollercoaster starts pointing down in a specific sector, it is one which will yield the best results if the timing is played properly.

Erring on the side of caution, value is buying below replacement cost, buying for significantly less than what an asset could be constructed for, ensuring the rental income paid by the tenant and the guarantees by the tenant are COVID proof and defensible.

The current regulatory environment and in particular the rental eviction moratorium under the national Coronavirus response places even more scrutiny over the economics of a deal in commercial and industrial real estate markets, as the question needs to be asked if they can be excused from paying rent under the current SME laws.

Even if the laws don’t apply, keep in mind that Solomon Lew’s Premier Investments Group has refused to pay rent or adhere to its lease obligations since the beginning of the crisis back in March.

So even if a tenant is obligated to pay rent, if they sit within an industry affected by COVID-19, there may murky waters ahead, so best to swim downstream to those tenants which are performing more strongly as a result of COVID: Government tenants, retailers like Good Guys, Bing Lee, Supermarkets, storage and logistics, datacentres etc. where there is surety of income, and a strong covenant in place.

For vacant development sites, assessing a good investment deal in this climate means going back to base land value and buying for a value that is reflective of that base land value without any of the modeled upside or blue sky.

In any event, given slow medium-term projections and deep recessionary conditions, any investment needs to work without the upside or blue-sky factored in, and or needs to have strong defensible attributes.

Doubling down on downside risk and capital protection is the name of the game.