Picking the winners (and losers) of the property shakeup

Spurred on by friendly government policies and generous tax concessions, the property sector is a perennial favourite of investors. But outside of buying houses and apartments, listed vehicles such as real estate investment trusts are a preferred method for investing in the asset class. As a broad sector, its commonly regarded as a defensive allocation due to the long-term nature of commercial and industrial leases, and the certainty this provides to owners.

But digging into listed property, the last 12 months have highlighted the distinctions between different parts of the sector. As lockdown measures were introduced to “flatten the curve," bustling cities became ghost-towns overnight as companies of all sizes shuttered their offices and workers bunkered down at home. 

And on the retail front, while supermarket aisles remained busy during lockdowns, shops selling discretionary goods were largely abandoned. Large mall-owners Unibail-Rodamco-Westfield (ASX: URW), Scentre Group (ASX: SCG) and Vicinity Centres (ASX: VCX) were forced to suspend rents, including with major tenants such as Super Retail Group (ASX: SUL).

In the first of this three-part series, we ask some listed property fundies how they identify the most appealing parts of the sector. As part of their response, they also explain how the tentative roll-out of vaccines in Australia and the anticipated economic recovery plays into their decision-making. The three respondents surveyed below are:

• Amy Pham, portfolio manager, Pengana Capital 
• Grant Mackenzie, senior portfolio manager, Freehold Investment Management
• Philip Ryan, co-founder and managing director, Trilogy Funds Australia

Power is shifting in the “new normal”

Amy Pham, Pengana Capital 

Looking forward, along with cyclical factors, the new normal for REITs will have to take into account the structural shifts that were already being played out before COVID-19. These shifts include the growth in e-commerce and flexible working arrangements (working from home), which continue to be headwinds for discretionary retail malls and some office assets, while benefiting logistics and data centres.

For the retail sector, even though operating metrics have improved with the collection of rents and occupancy levels have been maintained, re-leasing spreads reported over the December 2020 half-year were materially negative at -13% on average, having been flat two years ago.

The re-basing of rents shifts the negotiating power from landlords to retailers. We expect the combination of negative leasing spread and high occupancy costs (rent/sales) to continue as online retailing takes more market share from bricks and mortar. Online retailing currently represents 11% of total retail sales in Australia and is expected to increase to 20% by 2025.

The office sector has held up relatively well during COVID-19, with rent collection averaging 96%, occupancy remaining solid at 95%, and weighted average lease expiry (WALE) remaining unchanged at 5 years. But as vacancy rates increased to 12% and 14% for Sydney and Melbourne respectively, the pressure was placed on property income with rent incentive levels reaching 30% for Sydney and Melbourne and 40% for Brisbane and Perth. On the positive side, valuations for office assets have held up with demand from both offshore and domestic buyers transacting at or above book value.

As the work from home thematic continues, we believe tenants will likely consolidate their office requirements while aiming to upgrade to higher quality buildings in order to accommodate more collaborative space.

COVID-19 has had a minimal impact on industrial assets, with rent collections averaging 98% and occupancy remaining high at 98%. With leasing demand strong, driven by increased inventory levels from the growth in e-commerce and logistics, we expect both income and cap rates to be supported over the medium term.

Residential sales, particularly master-planned communities, were also very strong, boosted by the Federal Government’s Home Builders Grant. Established house prices are also performing strongly which is helping confidence, and investors have begun to return to the market. However, in the absence of immigration returning, we see downside risks from stimulus programs rolling off, decreasing affordability and macro regulations in the medium-term.

Rapid change sees “ugly duckling” become market darling

Grant Mackenzie, Freehold Investment Management

At Freehold, we have a relative value stock ranking process that considers the following:

• free cashflow;
• yield;
• three-year growth and
• our estimate of intrinsic value.

In our view, it’s still too early to gauge the medium- to long-term impacts of the last 12-months on various property sectors. However, we do know the structural changes that were already occurring in the market are continuing to accelerate. For example, online retail has grown around 30% year-on-year, and that’s demand moving from brick-and-mortar retail. So there’s no coincidence that we’ve been seeing industrial/warehouse distribution centres in strong demand and big shopping centres really showing signs of serious structural challenges via cash collection, increasing tenant churn with increased vacancies and a constantly changing tenant mix.

It’s also too early to call the long-term impacts for the malls sector, given there are still plenty of headwinds ahead and much to play out. That said, we are yet to see any major transactions and expect further asset valuation declines.

For us, the challenge is to determine what factors are already priced in. We remain underweight malls and think the market is currently underestimating some of the long-term structural changes that are currently occurring in this space.

“Once the ugly duckling, the industrial sector is now the market darling”

We’ve seen that play out in stock prices, where the emergence of e-commerce has fuelled the massive demand (and prices) for warehouses and sheds. This is illustrated by the Blackstone portfolio that is being quoted at cap rates of between 4% and 4.25% - levels previously unheard of for this asset class.

Are these prices sustainable? We think they are for the short-term, given the amount of capital still on the sidelines looking to be deployed towards the industrial asset class, only reinforced by the demand for the Blackstone portfolio.

As for the Office sector, while it’s still too early to tell, we retain the view that the office is not dead. This will no doubt continue to play out over the next year or so, and while we fully expect vacancies to increase and effective rents to decline, in our view this is more than priced-in to many stock prices.

Out of the helicopter into the balance sheet

Philip Ryan, Trilogy

Top-down approach: Trilogy decides which types of property will outperform, and which areas of the property market we want to invest in, using a top-down approach or “helicopter view”. This view is guided by a few factors, including:

• our expertise and skillset in the particular property asset class
• feedback from our network of property specialists, including valuers, quantity surveyors, real estate agents and brokers, and
• forecasting the likely performance of each property market in the upcoming few years.

Bottom-up approach: Another approach we take is a bottom-up approach, where we are driven by opportunities we see in the market. That’s been particularly relevant in a recent collaboration with Sumner Capital, where we’ve raised capital to acquire a commercial property at 3 Bridge Street, Pymble, NSW for the Pymble Private Property Trust.

In more general terms, we’re also currently exploring other opportunities where we can provide our investors with the benefit of competitive income, exposure to quality tenants, and prospects for potential capital gains by pursuing development opportunities that may increase the value of the asset(s). 

Regarding the second part of the question, there’s a degree of uncertainty in terms of potential side-effects from the vaccine, the time it will take to be rolled out and the proportion of the population that will be vaccinated. But I believe this will become clearer as we near the end of this year.

One uncertainty does arise around the cessation of JobKeeper as the effect of this will be difficult to predict. But the sectors that we operate in, predominantly residential and industrial, have been very robust, and I believe that will continue. If we were in areas such as retail or tourism, then we might have a different view.

The Reserve Bank of Australia has been quite vocal in asserting that they don’t anticipate any increases in the official cash rate until 2024. This provides a good degree of certainty as people can have a level of confidence in interest rates not increasing manifestly over that period. 

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Make sure you "FOLLOW" my profile to be notified of the upcoming entries in this series. In part two, the contributors will discuss their favourite parts of Australia's listed property sector. And in part three, our trio each reveal a specific property asset, or market, that features in their portfolios.