Is it the end of the tailwind in traditional real estate?

Cap rates have come down; what’s next?

Qualitas is an investor that is agnostic to sector and which part of the capital structure we play in – ultimately what we are looking to do is find opportunities where there is the biggest mismatch between underlying real estate fundamentals and the capital markets pricing of parts of a capital stack for that sector.

The traditional commercial real estate sectors of office and retail have been a tough place for the past number of years in our view – underlying and fundamental tenant demand has been quite benign, outside of one off events such as the Sydney metro compulsory acquisitions, yet capital has been chasing those assets very hard right across the capital stack.  Spreads and cap rates have come down a long way.

The easy money has been made in commercial assets by riding cap rates down: the Tailwinds are at an end. From this point, asset owners will need to deliver value through real asset management – focusing on your tenants and your physical product, because the easy wins are gone.  That is often easier said than done and really requires focused on the ground management.

We anticipate there will be a period of further capital appreciation over the short term, this time driven by effective rental increases via some reduction in incentives, with cap rate compression petering away.  The question for office owners will be how far incentives will fall and how sustainable is the increased effective rent in the face of the change in cap rate direction.

Residential will offer opportunities

Residential is where we see the biggest dislocation, despite consistent market paranoia.

It’s true that certain precincts and product types having challenging supply issues, but there remains a fundamentally strong underlying demand for housing that gives us medium term confidence in the market. This is supported by a number of macro factors outlined below.

Demand

There is unrelenting net migration, coupled with the strong political will in our major cities to increase housing density.  There is also a massive change in tenure preference towards rental due to affordability and choice occurring in the market.

These are combining to provide a robust inherent demand. The fears about supply issues in the Melbourne and Brisbane CBD investor apartment market and some of the issues out in Western Sydney are well founded – however they make up a fraction of the overall housing story and outside of those hot spots demand is unrelenting.

The market is far from being in a structural surplus and if you measure supply by housing starts instead of planning approvals obtained, then this is particularly evident.  Our research suggests that the reality is between Sydney and Melbourne we need circa 65,000 new dwellings per annum – that is around 180 dwellings each and every day and the market is nowhere near suppling that.

The market is learning rapidly about what is a “good” apartment dwelling and the days of poorly designed and built apartments being fired up at record pace are as good as finished.  The occupier and buyer markets are too savvy now for that and developers are increasingly focused on the minutiae of design, which hasn’t always been the case.

Supply

Our view is that these demand drivers are robust for the medium term but will be supported by the other side of the equation, being the supply situation – particularly the factors curtailing supply.

There is currently a severe shortage of debt capital for the development of residential – it is currently as bad as if not worse than the financial crisis. Notwithstanding media hype about “postcode blacklists”, the banking sector has taken a much more generic approach to development finance –the tap is very close to being off altogether.

Our commercial estate lending market is dominated by 4 major banks with around an 85% market share versus closer to 50% share in the US and Europe.  Given the soft conditions in other sectors of the economy, the banks’ weighting to real estate is heavy and APRA has stepped up examination of commercial real estate books significantly.  The property finance departments now have negative asset volume budgets and are actively seeking to shed developer clients.

This significant pullback in credit availability is being compounded by a confusing and difficult town planning environment in both Sydney and Melbourne.

Notwithstanding the desire from government to increase density around existing amenity, there is an ongoing battle against local councils and the electorates.  It is having a direct impact on the ability for new supply to be injected in to the right areas of the market and is exacerbating shortages in the areas housing is required – again, the political environment resulting from “too many city shoebox apartments” has led to a broad-brush approach to reigning in density due to issues in one small segment of the market, much in the same way the banks have done.

This means is that the majority of the cranes that you see in the sky in our major cities are what we call 2014 and 2015 vintage cranes – there are significantly less 2016 project commencements and we anticipate 2017 and even 2018 will be similar – meanwhile, the underlying demand and net migration pushes against the supply shortage.

Where to Find Value?

So if I turn to what Qualitas is looking for in the market currently, one thing we look at very closely is what we call the “Revenue & Capital Curve”.  This is a conceptual indicator for us about where we want to pivot our investing activity. As you will see there is a clear Equity Strike Zone and a clear Debt Strike Zone – we feel that we are currently clearly in the Debt Strike Zone.

On that basis, our thesis is to focus on playing the current position of the curve as well as laying the foundations for the next inflection point on the curve:

• Filling the capital gap on “shovel ready” projects – playing the current cycle position
• Repurposing assets to focus on expected 2020 supply shortage – positioning for the next turn in the cycle.

We are currently most focused on debt or debt-like instruments as the returns available at this point are equity like in our view. The debt pull back is leaving significant holes in capital structures and the returns on offer are strong on a risk adjusted basis and akin to equity, particularly given the late entry point of the debt.

This ability to deliver strong risk-adjusted returns to our investors is part of what’s driving Qualitas’ growth. Coupled with the addition of respected senior team members, we are confident this growth will continue, benefiting not just our investors, but the partners for whom we filling the lending gap.