Steady in the storm, when 11% turns into 19%

Riding the wave

There is a lot of noise in the market now, with inflation numbers coming in at around 6% in Australia and closer to 8% in the USA. Although interest rate rises are putting pressure on the market, inflation is beating interest so having money in the bank as cash means a reduction in the value of that cash, or a reduction in the buying power of that cash. If you think about it in the context of cash value or buying power diminishing by the annual inflation rate, we have nailed the adage ‘cash is trash’.

I was having a coffee with a long-time investor recently who in helping children with home purchases mentioned that the Australian housing market price growth of recent years has in fact outstripped the growth from the investor’s investment portfolio, meaning purchasing power in helping a son buy his first property was significantly less than when helping older children 10 years ago. The fact is our dollar today buys us much less than in recent years, which is going to be exacerbated with record inflation, and why it’s so important to create a portfolio that leverages the benefits of compounding for growth.

As a result of increasing interest rate rises, the most recent retail spending data is below initial forecasts, corresponding with RBA research indicating that most borrowers will suffer more than30% -40% increase in debt repayments as a share of their income if the RBA fulfils its forecast cash rate increases.

Housing data has shown that Sydney dwelling values have declined by 2% in a month, which is - according to CoreLogic - the largest decline in 32 years. Since the RBA first raised rates in May this year, dwelling values have shrunk by 20% on an annualised basis, with Melbourne contracting by around 16%.

Whilst Australia as a nation is very interest rate-sensitive when it comes to housing values as detailed in the RBA’s research paper, 'A Model of the Australian Housing Market' by Trent Saunders and Peter Tullip (2019), we at MP Funds Management are of the view that given the fundamentals around new dwelling supply and our nation’s reliance on significant immigration inflows to bolster the economy, there is more complexity to supply / demand and value than just interest rates alone.

Whilst interest rates have an immediate cooling impact on values, (and thankfully so for those wanting to enter the market) the fact remains that we have c. 10.5 million residential dwellings to house a population of 25.5 million.

In 2017 the aggregate value of the Australian housing market was c. $7.2 trillion with a collective c. 25% mortgage debt. At the beginning of 2022 that aggregate housing value had increased to over $9.2 trillion. The outlook when immigration doors closed during COVID was that house values would diminish, yet as we all know now, low interest rates and record stimulus, together with purchaser cash expenditure being re-directed to the home due to lockdowns, meant record growth - something that no bank was able to forecast.

I went to a Crestone breakfast briefing just before COVID where Peter Costello (our ex-treasurer) was the keynote speaker. One of the points he drove home with vigour was that in the 10 years or so since the GFC, Australia has had many technical recessions but we were buoyed through those recessions by record immigration. He suggested that fundamentally Australia does not have the economic wherewithal to grow without huge immigration inflows, and this was without COVID-induced deficits and staffing shortages.

Australia relies on high immigration for its economic growth. More people means the need for more housing. We have fundamental supply issues as well as pricing issues which mean that as immigration opens up again, housing will retain its value due to the underlying supply issues.

When it comes to the residential market in Australia, whilst interest rates will certainly have an impact, the lack of new supply, the increase in construction prices and supply chain issues will mean that pockets of value will be maintained.

It’s not possible to look for value with a blanket approach. Like all markets the residential market has its sub-sectors and it is within those sub-sectors in which value arbitrage and investment value will be found.

Regardless of the market cycle, following a simple Buffett-style process of evaluation is our fundamental approach because markets will always fluctuate. Having a simple approach has stood the test of time for us since we first started investing in 2012 and has earned us our consistent 22% annual investment returns and continual outperformance.

A forecast 11% return turns into a c. 19% and a 2 x multiple

MP Funds Management recently cashed out of an unlisted commercial office tower investment in Sydney CBD which was acquired for $202million in 2017 and sold for c.$400m, netting an average distribution of approximately 7% (annualised) monthly and with the total return an approximately 2 x multiple and an approximate 19%. The conservative initial forecast was 11%.

For me, I would have preferred to never have sold this asset. If you have been reading The View you will know that I’m a big fan of never selling. Holding a high quality unlisted real estate asset means you generally have the benefits of income, capital appreciation and the big one: tax-deferred gain. More on this here link to previous edition of the view:

All three aspects are critical, but the tax-deferred gain comes from never selling, ie. your balance sheet grows and you don’t pay tax on your capital growth which enables the full benefit of compounding. The compounding is critical in a market like this one where investing in an underperforming sector will mean your capital, income and growth will further reduce in its buying power rather than staying at parody or outperforming.

If you look at the asset we just transacted as an example, the owner previous to our syndicate acquired the building for c. $72 million in 2012. Then in 2017 they sold it to our syndicate for $202 million and this year the building has been sold for c. $400 million, all the while providing consistent monthly distributions at around the 7% mark.

Even if the capital growth continued on a slower trajectory moving forward, the benefit is that it is still untaxed. Now the asset has been sold we need to pay tax on the gain and go and find something new to invest in with the gains that have been reduced by the tax payable. There is the cost and time to go and find a replacement asset, which combined with the tax paid on gains reduces compounding power significantly when compared to just holding an asset and enjoying the untaxed balance sheet growth.

Regardless of the market and the noise, the key is finding those assets that will deliver the risk adjusted returns over the long term and through the various market cycles. 

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