Why construction development is set to rise, and how you can benefit

Spotting property assets that are beneficiaries of rising inflation and hiking interest rates is the key to success in this asset class, says Andrew Schwartz, Group Managing Director of commercial real estate-focused alternative investment manager Qualitas.

Reflecting on the last two years, while COVID has been a devastating medical emergency for millions of people worldwide, the economic consequences haven’t been as dire as most expected. For Qualitas, the office sector is a prime example, so far withstanding the “work from home” effects that many predicted would be catastrophic.

Schwartz also explains how the alternative investment manager is currently positioned on mezzanine debt – a higher-returning category of credit that sits lower in the capital structure – and how its allocations are likely to shift in the months ahead.

“We've got increasing confidence in the market. Two years on from March 2020, people understand significantly more about the virus than two years’ ago,” Schwartz says.

“I believe we're on the cusp of the next stage of the development cycle, particularly as it relates to residential. And if you look at the various vacancy rates in Melbourne and Sydney, they’re below pre-COVID levels.”

In this fund manager Q&A, Schwartz outlines which property sectors are likely to benefit from rising inflation and how Qualitas is positioned.

Does the new ASX listing for Qualitas have much impact on the company or your role?

Andrew Schwartz: It's changed a little, but not as much as people generally perceive it to have. Since listing, we've raised our assets under management to $4.22 billion, the vast majority of which is institutional and high net worth capital. We've always been very accountable to third party capital in the way how we invest. We learned very early the importance of having strong governance, reporting and accountability in respect to dealing with other people's money.

When I tell people that it was only nine weeks from making the decision to actually going public – they are amazed by that. The reason it was only nine weeks is because we had all the processes, governance, charters, policies already in place. The ASX listing of the company (ASX:QAL) was just another layer of capital and reporting, it wasn't something that we had to retrofit to the organisation.

So, it's changed a little bit because the ASX has its own regulations and reporting requirements, but it hasn't changed substantially.

We’ve already been operating the Qualitas Real Estate Income Fund (ASX:QRI), a listed fund for three years now. We’re regularly undertaking investor meetings, reporting and presentations, so we're not a stranger to the listed market. 

How have you been deploying the capital raised during the IPO?

Andrew Schwartz: We did the IPO for two reasons. One was because we needed underwriting capital. We were being shown incredible opportunities that were live in the market, and Qualitas was always saying, "We've done our due diligence. We really like the assets, but we're bidding subject to a capital raise." When there are others in the market who don't need to raise capital because they've got a balance sheet, it meant understandably that vendors were favouring those parties that had the certainty of settlement ahead of Qualitas. We felt we needed to fix that problem.

And the second reason we raised capital was that we were increasingly being asked to co-invest with our major institutional shareholders. That was starting to create a limitation where an institutional shareholder would say, "Here's a $500 million mandate and we assume you, Qualitas, are going to invest between $25 million and $50 million side by side." And when you're a Pty Ltd, that's just a mathematical limitation to being able to do that.

Right on the IPO date, we announced the purchase of the Runaway Bay Shopping Centre in Queensland and that Qualitas was using its new balance sheet to underwrite the equity for that acquisition. That capital raising has gone particularly well and is a great example of where we've done exactly what we said we're going to do in terms of the cash raised from the IPO.

And in our half-yearly results, we announced one new fund and reaffirmed two other funds for Qualitas. One of these is the Qualitas Real Estate Opportunity Fund 3, a private equity real estate fund.

And the two other funds, which we had previously announced on the IPO date, one is the Qualitas Diversified Real Estate Fund, which is focused on property that's got strong income attributes and we believe will have good capital upside going forward.

The other is the Qualitas Senior Debt Enhanced Fund, an enhanced credit fund. You may recall, 70% of our total activities are in private credit. As part of the recent announcement, I noted that $50 million of our balance sheet we’re looking to co-invest across those three funds.

When do you see RBA lifting rates and why? Is there any change in your outlook since the RBA’s latest announcement?

Andrew Schwartz: There's been a lot of debate in the market around transitory versus permanent inflation. To really understand interest rates, you need to form a view around inflation because in my view one follows the other. Without really getting into that particular debate, because my personal view is that permanent inflation is a follow on from transitory inflation.

Leaving that aside, what we're experiencing we can safely conclude is inflation and it’s been caused by a couple of factors. One is around our unemployment rate being at historical lows of around 4.2%, which means we're in a very tight labour market at the moment.

Many organisations are facing employee wage increases. I'm conscious of the fact that wage raises were a bit softer in the last statistics that came out, but I hold a personal view that this somewhat lags the market. So, you're seeing upward-movement occurring in wages and salaries.

The other aspect to this is that with COVID, we're seeing a lot of supply-side disruption and price increases for raw materials. When you put those two things together, it means the cost side for organisations is increasing and firms will look to pass that on by way of higher prices. As soon as we get into a higher price cycle, interest rates will follow with a higher interest rate environment.

You only need to look at the interest rate swap curve and look at how that's been behaving for quite some time. It's not a new phenomenon. Over the last few months the target rate for the RBA has been 0.1% and yet the two-year rate is 1.5% and the 10 year rate is 2.5%. This is showing you that the expectation is that we're in for rate increases and that the market is holding that view.

Following on from talking about the official rates, how does that play into the different sectors of the property industry that you watch very closely?

Andrew Schwartz: Qualitas manages private credit, which comprises around 70% of our investment. We're the lender, not the borrower. If interest rates go up, all things being equal, the returns on our funds ought to increase in line with rising interest rates.

Our funds are not leveraged, so we've got no cost of capital that we have to contend with. This means our investors benefit directly from higher interest rates, which is good news.

We do take mortgages over property, and they have a value. And some property reacts adversely to higher interest rates. So, you need to look at the property on a sector by sector basis and ask, "Will this be a beneficiary of inflation or higher interest rates? Or is this a class of property that is likely to suffer under higher interest rates?" There’s no single answer to that question. An experienced private credit manager can navigate Loan to Valuation Ratios to cater for the movement in asset values in a more inflationary cycle.

How do the labour figures play into this?

Labour has become quite an issue within Australia. And certainly, with our borders closed, it's been quite difficult for the shortage of labour to be met. You're seeing it across many industries from the small cafe operator or accommodation provider who just can't get casual staff because we don't have the same level of overseas tourists and migrants that we've traditionally had coming into Australia, and for some construction companies where clearly labour has been an issue. And this at the subcontractor level too, not just for the head contractors. During shutdowns, many construction companies were unable to get people on sites and there has been a lot of uncertainty in the last couple of years. Combining that with rising costs of raw materials and the global logistical issues of container costs, it's been quite a difficult time for the construction industry.

Qualitas prides itself on being one of the larger construction lenders in Australia outside of the major trading banks. Staying close to the industry and understanding the dynamics it's going through is very important. And certainly, our investor returns are excellent, and we get paid to stay really close to that part of the industry.

There are some property classes that may come under pressure in a higher interest rate environment. For example, property that's encumbered with very long-term leases where the cash flows go out long periods of time, with very low rates of annual escalation below the inflation rate, their valuations could suffer in a higher interest rate and inflation environment. Their cost of capital is increasing, the share of the income's going down and that income's not worth as much in an inflationary environment, because discount rates are higher in that context.

We try to ensure we've got the loans against the right properties, those we believe are inflation-hedged and will benefit in this type of environment.

For example, if you've got $100 of available income from a property and the cost of the debt is going up, then the lender is going to receive more of the $100 than they previously were going to receive. And again, all things being equal, the equity receives less. In that context, you'd rather be the lender earning more of the income than somewhat of the equity. Particularly if the equity's not inflation-linked.

Did the onset of Omicron at the end of last year prompt any adjustment in Qualitas’s strategy?

Omicron didn't have the large-scale effect on the market that we thought it could have. I say that because one of our funds, the opportunity fund, can also look at distressed situations. Back in March 2020, I thought we may see some distress in the market and may position our opportunity fund into that part of the market. However, by and large, we didn't see any major distress coming through the market. I would say that even two years later, we haven’t really seen that.

There's a variety of reasons why the market continued to be very liquid. The banks are very well capitalised and dealt with any situation with a degree of patience. Many of the very significant trophy properties are now owned by institutional capital, which is lowly geared and therefore very patient capital as well. So, you didn't really see any significant distress, especially at the wholesale institutional end of the market.

I was surprised that the office sector didn't suffer as much as many were expecting given the work from home environment, where around 95% of CBDs were emptied out. The reality is that most significant office buildings have medium-term leases. While many were vacant during the working week, you still had tenants that were largely paying their rent to the landlord. So those income flows continued.

In my view, it's still playing out, with many office tenants committed to five-year leases that we're just two years into. Then each year that goes by there are lease maturities coming up. The CEOs I’ve asked about their long term lease plans usually respond along the lines of, "We're looking to reduce some level of office space." It might only be 10% or 20% and they're looking to locate into buildings that have flexible offices, co-working, co-sharing type areas. If they have a surge of employees in their office on a certain day, they can put people into overflow areas, which is more common space in the buildings they occupy.

I’m generalising, but if every tenant gave back 10% of their office space, that's actually an enormous amount of vacant office across Melbourne and Sydney. It’s not a contiguous space, so it doesn't mean you can pick up six floors in a prime building, but you can get little bits of space on each floor. That’s got a way to play through.

It’s not going to be horrible in terms of the impact, because in my view the ultimate owners of trophy property can ride through that type of variability in rent. But thankfully our economy is growing, and though it needs a bit of GDP growth and new entrants and new office occupiers to take up the vacancy created by people reducing their office space, that's just the market finding a new equilibrium.

It’s going to take time to reach a new equilibrium, but I believe that will happen in an orderly manner. We're probably one-third of the way through that at the moment.

In retail and hotels, which are more patronage-based, there were some issues. But again, they're held predominantly by institutions and well-capitalised funds that saw it as a shorter- to medium-term issue. They fared quite well all through the COVID environment.

How are your portfolios positioned now in terms of senior debt versus mezzanine debt? And has this shifted since the end of last year?

Andrew Schwartz: In relation to QRI, our listed vehicle, we currently have an 11% exposure to construction. And in terms of senior and mezzanine splits, our senior exposure at the moment is 93% of the total portfolio. And our mezzanine debt is 7%. We've taken a conservative stance over the last few months, particularly lowering our construction to only 11% and being 93% senior debt.

We will likely be looking at increasing our allocation to mezzanine debt in the portfolio as we’ve got increasing confidence in the market. Going back to March 2020, we just stopped and said, "We don't know what's hit us. It's certainly nothing we've ever seen before. This is a health crisis. It's not an economic crisis. One could follow the other. You could have an economic crisis about to occur. Let's just understand what this is all about."

Two years later and people understand a significant amount more about this. We understand the lockdowns, vaccines, boosters and the risks around virus mutation. This is a personal view, but it's unrealistic to say Australia's borders are going to stay closed forever.

I believe we're on the cusp of the next stage of the development cycle, particularly as it relates to residential. And if you look at the various vacancy rates in Melbourne and Sydney, our vacancy rates now are below pre-COVID levels, which is a really interesting data point. Rents haven't quite caught up to pre-COVID, but the vacancy is now less than it was pre-COVID, and rents in Melbourne and Sydney are rising as well.

If you add migration to that, then we've got a housing shortage in Australia. For example, if you look at what developers are doing - they are looking to buy and fill sites again. I'm getting more comfortable in respect to where we are in that cycle, and our view is that we can afford to have more mezzanine than we do currently.

On a blended basis across senior and mezzanine, we think we could get a higher return to our investors on the blend. And the fund was set up to take mezzanine. We put a maximum in there of 20% total cap, and we know we're not near that at 7%. The more we take on, on a blended basis, it means we should see a higher return in the fund. And that's why we'd never go overweight mezzanine. It's not a mezzanine debt fund. It’s predominantly a senior debt fund, but I believe we can afford to take more than just 7%.

Would you like 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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