This cyclical sector may have seen the bottom, and tailwinds are quickly forming

Market conditions right now are confusing. I probably won't say much more than that. But what I would say is that a higher interest rate environment is probably favourable to the WaveStone investment process. That's because a higher interest rate environment creates viable alternatives to equities, and makes valuation a much bigger part of the investment process. 

When interest rates are zero, in my view, whoever takes the most risk is going to be successful as a fund manager. 

I think that will never be WaveStone. We're relatively conservative, and we are quite focused on valuation, both in terms of short-term cash flows, but also your terminal multiple.

I think when interest rates are a little bit higher and valuation becomes a bigger part of that process, I think it does suit a more conservative valuation-focused investor, like WaveStone. The other part of that I think, is similar for company management teams. When interest rates are zero again, and money is free, any capital project will generate your return higher than your wack. Whoever takes the most risk, or whoever can tell the best story, is probably going to perform the best. 

At WaveStone, we much prefer businesses that have sensible, disciplined returns, and focused management teams. The storytellers or the risk-takers probably don't have a huge place in our portfolio.

What is the one theme the team is debating right now?

I think at the moment we're trying to figure out where we are in the housing cycle, and obviously, underweight housing has probably been the biggest consensus trade on the Australian market, and with good reason. 

But I think anytime you see a sector that's very heavily underweight, you have to go and have a look whether things might be changing. 

Given the housing market is cyclical, it's not really if it turns, it is when. I think working in the favour of the housing market is a housing supply shortage, and immigration is about to step up so that shortage is getting worse. You've had real price declines of maybe 15 to 20%, and you've had housing turnover decline basically 40% from the peak. Which is usually about when it troughs. On top of that, you now have the RBA, who's paused.

I mean working against that, you do have the affordability issue, which remains a real problem for the housing market in Australia. No one really knows what's going to happen when the whole fixed mortgage roll-off takes place in about June. Those could be negative for the housing. But I think there have been some green shoots in the last month or two, and maybe it's time to get a little bit more constructive on housing. I'm not going to call the bottom here, but I'm just saying it might be something that is a non-consensus trade.

What is one sector where you have identified opportunities recently?

One sector that we've been having a look at from a longer-term opportunity is the multi-family sector, or we call it Build to Rent, here in Australia. Everyone's read the papers, they've seen there's a rental housing crisis in Australia, everyone's got an anecdote about rents going up 20 to 30%, and that really should only get worse as immigration comes in. That could become a real political issue I think, in Australia, both on a state and a federal level. One solution for that issue is Build to Rent, which is more high-density apartment stock. 

In the past, one of the issues there's been is the returns on Build to Rent, never really stacked up to Build to Sell. But I think there's a few reasons why that could actually be changing.

One of those is that the rent premium that people thought they could charge for Build to Rent is actually higher than previously thought because people are willing to pay up for the amenities in a Build to Rent building. The other thing is tax. We've seen a lot of governments actually hint at potential tax concessions to Build to Rent, to stimulate new supply into the market, both at a state and a federal level. Even without favourable tax treatments, operators that we speak to say they can get low double-digit IRRs on these projects. With tax, that should increase a lot. You do have natural buyers in this market, and those are the super funds. Super funds have been investing, investing a lot of money in Build to Rent offshore, but haven't really been willing to deploy capital in that space in Australia, till they see it mature.

We know that in the US and the UK, the cap rates in the multi-family sector are actually the lowest of any segment of real estate. Interestingly enough, in the UK, tax incentives started being provided to multi-family because of a housing shortage coming out of the GFC. I think that's one space that does have legs. While there have been some media articles recently, I think the sector is nascent, and you can see how it could mature and people could make some money out of it.

Can you talk to a stock that crystallises the sector opportunity you mentioned?

One stock that we do own, which is exposed to the Build to Rent sector is Qualitas (ASX: QAL), which is a commercial real estate fixed-income fund manager. They've raised about $3 billion for Build to Rent funds, both in debt and in equity with their JV partner, Gurner Group. Now, Gurner Group is a really good partner for Qualitas because they have experience in building a high-quality product, that enables them to charge a rental premium above the market. Given Qualitas is a fund manager, it's a less capital-intensive way to play the Build to Rent sector, and the revenue model is a lot higher margin than actual developers.

Now, aside from the Build to Rent piece we like Qualitas set up as a fund manager. 

It's got a really good track record. It's got inflows into the asset class because they're earning essentially equity returns, but taking debt risk. 

They've got a lot of fund flow from offshore investors into their own strategy. The fee structure is attractive because there's not as much competition, and they've invested in their cost base ahead of revenue growth. You should see incremental FUM drop-down at very high margins for Qualitas.

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