FEATURED IN: The Australian – Volatile markets drive opportunities for experienced property players
9 February 2023
By Andrew Schwartz, Group Managing Director and Co-Founder at Qualitas
Until this past year, it had been one-way traffic for interest rates since the global financial crisis. That made it a good time for property, with cheap money and investors willing to accept lower capitalisation rates as property continued to offer better yields than other investment classes.
The rapid interest rate rises of the past year as the Reserve Bank has battled runaway inflation have brought that period to an end. We know that rate rises have a lag effect on property because it is not a liquid asset class, such as listed equities.
And while the past year has been marked by a degree of disruption – with construction company failures caused by a combination of rising costs and unsustainable contracts, the withdrawal of liquidity and a recalibration of asset values – we know that property markets are yet to fully absorb the brunt of the lag.
Even in this volatile environment, however, there are still growing categories and great opportunities for nimble and experienced alternative investment managers – particularly in private credit as traditional sources of finance accelerate their retreat from a sector they no longer have the risk and analysis expertise to operate in.
Given the momentum in employment and discretionary spending, we expect interest rates to continue to rise as we move into 2023. What we will have to watch very carefully is the interest rate peak and the start of the turn. This is a zero-gravity, in-between market characterised by a bit of everything – steam coming out of the market, inflated cap rates, unemployment, illiquidity and, for some, insolvencies. This peak is coming, and it will catch out those investors not paying attention.
The great uncertainty is whether the economy is heading for a hard landing (recession) or a soft landing (orderly slowdown). There are mixed views.
In contrast to the pace of rate hikes in the US and NZ, the RBA’s approach appears sensible. Although there are arguments that it should have moved earlier to engineer a recession and shorten the duration of the recovery, my view is that the RBA is acting prudently. It is aware of the lag effect of its actions on consumer and business spending and confidence and the need to get the pace of rate movements rights. Australia’s forward yield curve is flatter than the inverted yield curves in the US and NZ, pointing to recessions offshore and a milder economic reversal here in the medium term.
Inflation will be very sticky in Australia, and it will take a while to break it, particularly with the gentler approach being taken by the RBA. Even then there will be a lag until it is felt in the wider economy and helps households and businesses regain lost confidence.
What we do know is that the construction industry is likely to slow markedly over the next 12-18 months. The scrapping of projects and resulting loss of construction jobs will drive unemployment, ultimately relieving pressure on construction costs and helping to turn the inflationary tide.
We will need to continue monitoring the impact of rising construction costs on builders. After the failure of a number of commercial builders earlier this year, I was initially confident that we were through the worst of it. This was because most pre-COVID construction contracts, with fixed budgets that had become near-impossible to meet, were coming to an end. However, the unprecedented 20-50% rise in construction costs over the past six months, has caught many builders by surprise, even those on post-COVID contracts, and I believe this story has more to play out in 2023.
With both construction costs and interest bills soaring, developers sitting on land (particularly infill) – and their financiers – are reluctant to commit. I expect many developments will be mothballed and some developers be forced to sell as their capital structures will not be conducive holding an asset. There will be opportunities here for those with a strong balance sheet and long-term conviction in Australian property, particularly residential.
Unfortunately for the one third of Australian households who rent, we don’t see any immediate relief. Record low rental vacancy rates, which are driving rent increase, may worsen in 2023 given the low levels of new inventory coming into the market at the same time as population growth picks up with the post-COVID return of international workers and students.
Market values of new or near-new apartment stock are most likely trading below replacement costs at this point of time. Once this stock is absorbed and rents continue to increase, there should be market adjustment upwards in order to keep pace with replacement values. Unless this scenario happens – and it has happened every time we’ve seen such low vacancy rates in the past – there will be no development, no new accommodation and ultimately a serious rental crisis.
At the same as these shorter-term forces play out in the economy, several megatrends are expected to intensify in the year ahead.
Of critical importance to our industry is Australia’s unique demographic profile, with a growing population and an acute shortage of houses to put them in. That reinforces our long-term conviction around property, particularly residential and sectors such as multifamily and build-to-rent.
More recently, the passage of the Government’s new industrial relations laws will create some uncertainty as business – and workers – take time to figure out whether they will lead to the promised real wages growth and what that may mean for productivity and the economy.
One workplace trend that will be challenged in a slowing economic environment is the embrace of working from home – or working from anywhere but the office. As job insecurity rises, human nature tells us workers will want to be more visible, with implications for commercial real estate.
In a world of uncertainty, we can be certain about some things: commercial real estate debt continues to offer solid risk-adjusted returns; equity with inflation-hedged income and solid escalations should outperform; and multifamily residential property developments will perform well given rising rents, especially those with already-fixed construction costs.
Quality investment managers will understand the opportunities in the current climate and how to navigate the macro risks by being micro in their analysis of individual transactions.
As featured in The Australian (subscription required) – 8 February 2022.
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