The inflation hedge hiding in plain sight

“Our vacancy rates are sub 1%, at historic lows, and affordability is a real issue in Australia. The only way to really counter that is to create more supply into the market to ease the availability. In order to do that, you need high density values, and apartments in particular, to keep pace with rising costs,” he says.

It’s not just current residents behind this push for residential developments.

Schwartz points out that immigration has always been a big part of the Australian story – and there’s every indication the government are pushing for its return to pre-Covid levels. This can only work if Australia has enough residential supply.

In this edition of Expert Insights, Schwartz discusses the macro environment and outlook for interest rates, the implications for residential property, and the opportunities in this space.

Edited transcript:

What is your view on the current macro environment and the outlook?

My view at the moment is we’re in an environment of constantly rising interest rates. Every month, the Reserve Bank has been pushing up interest rates and it’s very much focused on inflation and combating rising prices in the economy. I think we’re in for quite a sustained period of time where we’ll continue to see rising interest rates and the media focusing heavily on inflation as the goal. Clearly, that has a lot of implications for the property markets and investors, and what Qualitas does.

How high do you think central banks will move with rate rises?

I personally feel rates have a way to go. 

We’re in this inflation cycle that started with a shock to the system – the COVID shock. Then you have fiscal spend, too much aggregate demand, and low-interest rates. Inflation comes into the system. Interest rates go up. The cost of mortgages and rents go up. People start to say, ‘my cost of living has gone up. I need higher wages and salary.” As that goes up, enterprise costs go up. CPI goes up. You start the cycle again where the Reserve Bank says to combat inflation, we need to further increase interest rates. I think we’re in that cycle at the moment. 

It is going to be relatively hard to break without starting to see the economy and the aggregate demand pull back. It’s got a way to go. 

I won’t put a precise number on it other than to say there’s a lag effect from interest rates and we haven’t really started to see the pullback yet. My sense is we’ve still got a long way to go.

How does the Australian economic environment compare to overseas?

In some ways, it's very similar. 

I’ve recently come back from a trip to Europe where I met a number of CIOs and portfolio managers. I spoke to them about what’s happening in Australia and heard what’s happening in Europe. It’s very similar in terms of that inflation, interest rates and rising labour story that we’re all encountering. The big point of difference in Europe is that they’re also dealing with geopolitical issues, particularly the war between Russia and Ukraine. There’s an energy and gas crisis occurring at the same time. Both of which we thankfully don’t have in Australia. So in some ways it’s similar, in other ways, they’ve got more extraneous events hitting their economy as well. I feel that Australia is much more resilient to this inflation shock relative to what I’m seeing in other parts of the world.

Qualitas is heavily focused on residential property. What is the outlook for this market?

I think it looks very good for the long-term. I know this is a bad week to be somebody who says that because the Reserve Bank has just come out estimating quite a substantial fall in residential prices. I think people need to separate out short-term effects and distortion in capital values versus longer-term trends. 

The truth of it is the only way to really break an inflation cycle is you can do one of two things, and they’re not mutually exclusive. You can either continue to put up interest rates to a level where you pull back aggregate demand and therefore, create some unemployment in the market. That takes the heat out of wages and salary costs that are forever rising. Or you can go back to an immigration story. 

Over the last few weeks, you can see that the government has been in an active dialogue with various stakeholders to increase the immigration cap to 195,000 people in Australia. This is back to pre-Covid levels. When somebody decides to immigrate to a country, they are looking for two things. The first thing they look for is affordability of residential accommodation and availability of residential accommodation. Australia at the moment is lacking in both. 

Our vacancy rates are sub 1%, at historic lows, and affordability is a real issue in Australia. The only way to really counter that is to create more supply into the market to ease the availability of residential. 

In order to do that, you need high-density values, and apartments in particular, to keep pace with rising costs and therefore I tend to be quite positive about the market and the outlook for the market.

Will you be making any changes in your asset allocation with a potential recession looming?

It’s more about the emphasis for us. A big part of our business, just shy of 70% approximately, is private credit and we’re continuing to hone in on that as a core activity of what we do. 

We continue to feel comfortable about investing in the residential market. Real estate is a great place to invest for shelter from inflation. 

A lot of our investment activity at the moment is focused on the inflation story. I think it’s about finding those areas if there is a recession and if it became a more distressed environment which at the moment we’re not seeing, then I can see us becoming a more opportunistic investor. We run situational opportunistic funds so I can see us driving that strategy as well.

Which alternative assets typically perform best in this environment?

It’s private credit because we’re in a rising interest rate environment. 

As base rates go up, risk premiums go up. Then the returns we earn for investors go up in a commensurate way. We don’t back leverage in our private credit funds. What that means is that for every time we increase interest rates in line with the market, then our investors in our funds are the direct beneficiary of that. 

I’m quite excited about the dynamics of the private credit market, particularly the real estate private credit market at the moment. In residential property, there’s a shortage of capital, particularly on the debt capital side so our ability to be a major supplier and be appropriately rewarded for that is exciting for us. It’s taking the themes of where we see the market and exploiting the return profile that we’re able to get.

What challenges do you see for investors in alternative assets?

You’ve got to take that question asset class by asset class. In private credit, the biggest challenge is that you’ve got a slowing economy and you’ve got recalibrating equity prices. The advantage of private credit is that we don’t take the first loss of capital because we're the debt provider, it's the equity provider that unfortunately takes the first loss but hopefully gets the first gains in any underlying investment. As a lender, you need to carefully watch your equity values and predict how that asset will perform in a changing economic environment and look at the labour supply and the general economic environment which is always really important to any lending activities you undertake.

Do you seek equity-like returns with debt-style security?

If you’re looking for a new kind of opportunity beyond shares, fixed income and traditional property investments, the Qualitas Real Estate Income Fund (ASX:QRI) could help you diversify your portfolio and meet more of your goals by investing in the growing opportunities of the commercial real estate (CRE) debt market. Learn more about the fund here.

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