The allure of Australia has just been enhanced

In terms of the trends that we've experienced in 2020, the initial movement was a shift out of the cities. What's been your experience now as we sit here in November?

We've certainly seen a shift out to the suburbs away from CBD locations. If I look at Sydney, which has been out of lockdown for much of this year, we've not really seen a strong resurgence of office workers coming back into the CBD. Some of the latest estimates have it at about 45% return of office workers.

I personally believe the movement out of the CBD will partially represent a permanent shift out. And I think the reason for that is technology has really given people a choice of workplaces, whether that be the CBD, a suburban office or their studies at home.

I think it's also important to clarify that I'm not actually long-term negative on the population concentration of major CBD areas, but I do think that it will take some years for the CBD to go back to pre-COVID levels.

What other trends do you expect to see over the longer term?

I think we need to break it down into pre-vaccine and post-vaccine. Until a vaccine is widely accepted, I don't believe that employers will force their employees to return to an office environment. 

There's no doubt that many people have become used to working remotely. People have found that it has greater lifestyle benefits and at the same time, it has increased their productivity. Studies have shown that time previously spent by people travelling to and from work is now actually spent productively working from home or remotely on work-related matters.

Many businesses have successfully conducted their work remotely. I believe that they will see this as an opportunity to save costs by downsizing their office requirements.

I expect that what we'll see across the board is companies handing back some amount of office space. I would estimate this could be somewhere between 5 and 20% of their total office space and it will achieve savings by creating more of a flexible working environment. 

There is a strong argument that an office environment preserves collaboration, brainstorming-type initiatives and on the job learning for younger staff, I don't think that's going to require five days a week of office attendance.

In the short term, landlords will need to deal with many of the companies that will be handing back office space, but I don't think it's the start of a long-term downward trend. And I say that for a few different reasons.

Can you expand on some of those reasons?

Firstly, we're experiencing the rise of a digital economy and this new economy will bring about new businesses who will themselves require office accommodation. New supply coming into the CBD is likely to be limited for a few years. The growth of new enterprises will ultimately fill up some of that empty office space.

The second point I'd make is that large office users require contiguous space. I think those large office users will still go out into the market and tender for accommodation to suit their growing needs. Although there may be some short-term vacancy, I don't expect that vacancy is generally going to be in the form of contiguous space. So, if you're a large office user, I think you'll still go to the market and run a tender for office.

I don't think this is the death of office, far from it. But it may be so for a little while until a new equilibrium is found.

In residential, we are currently seeing an exodus from the CBD to the suburbs. Again, I don't think in itself that's a long-term trend and the more the news of a vaccine and ultimately the delivery of a safe, acceptable vaccine occurs, I do believe we will see people return back to the cities.

The lure of entertainment and retail convenience will be highly sought after once a vaccine is rolled out. And I think there'll be absorption as a result of the education sector when that starts to fire up again in a post-COVID environment.

How is it affecting your investments and are you skewing towards or away from any particular sectors?

We continue to pursue investment assets and are looking at numerous residual stock lines and land lines. We're also seeing a few more mezzanine loans. It's been a while since we deemed mezzanine acceptable, but we are currently under mandate on two significant opportunities that look absolutely fantastic on a risk-adjusted basis.

We continue to be focused on Sydney and Melbourne, working with Tier I sponsors’ in the mid-market. Typically, they're private developers that are very experienced with very strong track records. We've undertaken multiple transactions with those investors. We continue to be really positive that debt, as a means of obtaining good risk-adjusted returns in the property market, is a good way to be through the current cycle.

What's been the experience with bad debts? How does this compare to what you would consider normal levels?

We regularly report to the market on the quality of our debt portfolio in relation to our listed fund, Qualitas Real Estate Income Fund (QRI). QRI makes up about 12% of the Qualitas’ total FUM of c$3 billion as we also manage unlisted funds.

Across the group, we don't currently have any stressed loans and we're not seeing the need to take any impairments in respect of the current portfolio. We have a formal process whereby we're looking for impairments on a monthly basis. It's fair to say there are always some loans that you're more carefully watching, relative to other lines but pleasingly our portfolio has performed extremely well.

Our borrowers have also worked very cooperatively with us. Where we've required more information, that's been very much forthcoming from the borrowers. The other comment I'd make about QRI is that half of our loans are now covered by post-COVID valuations. Thankfully, for the fund and for the borrowers, there has been no notable downward movements in any of the valuations in the portfolio.

You were holding high levels of cash in QRI earlier in the year, have you found opportunities to put that cash to work?

Leading into COVID, our portfolio in QRI was 20% in cash. As we recently reported that cash has now been either allocated into transactions or it has been deployed. That is very positive for the portfolio. We also have a very strong pipeline at the moment, which puts us in a good position.

We made a conscious decision to reduce our construction loans in QRI. We've increased our investment loans and residual stock loans. And what we are finding is that we are generally able to obtain better risk-adjusted returns at the moment.

Is there an optimal duration that you're trying to achieve?

Consistent with previous quarters, we're maintaining a relatively short-dated loan book. Our typical durations remain at circa 12 to 18 months. That has served us really well in terms of the continual review of our various positions in the portfolio. We are seeing a bit better pricing in the market, but I would say it continues to be a competitive environment, particularly amongst the local alternative lenders.

The RBA reduced rates not that long ago. Does that have a material impact on the loans and the pricing of loans that you make?

It doesn't affect the loan returns, because we don't really price off an official cash rate or the bank bill swap rate. What it does do is provide more confidence to participants in the property market that the cost of capital is relatively low, in fact, at historical lows, and therefore property is a good option in the search for income. So, it does stimulate the wider property market. I think it creates activity in the market and for alternative lenders.

How are you thinking about 2021?

What I would say is that at the start of COVID, I read a lot of commentary that talked about the market falling by 30%. That was not my view and the reality has been very different. After those initial dire projections, a lot of commentators are now in the market saying that due to the slightest reduction in interest rates this is going to lead to a property bubble. In effect saying it could be a 30% inflated property bubble. A polar opposite view of what was only said a few months ago. It's also not my view that we're going to see a runaway property bubble.

I think the market has got both headwinds and tailwinds. The tailwinds are probably quite obvious but they're in the form of historically low-interest rates and historically large fiscal stimulus packages. Some of the headwinds are the predictions for significantly lower migration and higher unemployment. Obviously, the Melbourne lockdown has been a significant dampener to the economy. But I think those headwinds and tailwinds will be quite balanced.

In terms of the outlook, to have a real asset price crunch - similar to what you had in 1991 and 2008 - you need a liquidity squeeze, and that's probably the big difference. In the current cycle, it's hard to see a liquidity squeeze occurring, given the historically low-interest-rate environment and the fiscal stimulus package. Importantly, this is not a corporate recession, unlike 1991 and 2008, but this is what's been termed the “high street” recession as those effected most are those small business owners that you would usually see on a ‘high st’.

Qualitas is seeing a lot of property put to the market at the moment. I think it's being matched with a plethora of buyers who have the capital. They're wanting to invest. There's a hunger and a search for yield.

The banks in this part of the cycle remain really well capitalised. We're going through a part of the cycle where the financial system itself is exceedingly stable and, for all of these reasons, I think property continues to be in line with long-term trends. I don't think we're going to see a period of rapid price falls, and equally, I don't think we're about to see a period of huge price gains. I think we're operating in a very normalised environment, thanks to good management.

You touched on immigration, how important is that offshore buyer for property in Australia?

We really should be under no illusion at all that migration was a very significant driver of the property market. Particularly apartments and particularly new construction activity. I've got no reason to doubt the government forecast that we'll see negative migration over the next two years. Many of the people flowing out of the country are students and people on working visas. In terms of assessing the quantum of the numbers, it's important to keep in mind the nature of the people who are flowing out of Australia.

We also need to understand that people don't just land in Australia and literally go and buy a house. 

There is a lag effect and, speaking to the house and land builders, they talk about the fact that the lag effect can be up to two or three years between the time a permanent migrant arrives, to the time they commit to buying a dwelling. I think my expectation is looking out three years, so say 2024. I actually think migration will come back to Australia in earnest. And I say this for a few reasons.

Australia has done an incredible job of managing COVID, with zero to minimal cases across the country each and every day. Victoria has managed to gain control of the virus by restricting movement in the state with very severe lockdowns. But it now seems to have eliminated the virus.

The imminent arrival of a vaccine with 90% effectiveness, that should be rolled out in 2021, makes it relatively safe for me to assume that either a vaccine or a treatment plan will be readily available within the next three years. Even if that is wrong, we should assume that the government has determined a way to quarantine larger volumes of migrants to come back into Australia. 

If that occurs, I think we should expect migration numbers to bounce back to the normalised levels of 150 000 to 200,000 people a year. We should also expect there to be a catchup period of some two to three years. Given my earlier statement on the lag effect, there is a possibility that these could affect new construction activity for residential property. 

Most of the projects that Qualitas is involved in, at the moment, are projects that have been going on for quite some period of time, up to two years of pre-marketing. I think those projects will continue to go ahead.

You could see Australia becoming more appealing, post-COVID than it was pre?

I think it's a great point, and I think Australia will absolutely shine through this COVID period. It will demonstrate to the rest of the world that when you live on a massive island - and you can close your borders and exercise control - that you can really bring a disease such as COVID under control.

I think, if anything, that's going to increase the allure and appeal of people who are wanting to come to Australia.

You'll have a backlog of migration that weren't able to get here in 2020 or 2021. But many will still want to come to Australia, plus the normal migration that happens year to year. I think we should stay positive on that particular point. 

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The Qualitas Real Estate Income Fund (ASX:QRI) aims to deliver investors with a regular stream of income with the added benefit of diversification beyond shares and traditional property investments. For more of Andrew’s insights, follow him here.