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Best Markets To Invest In Right Now – It’s been a bumpy ride for real estate investors lately, but with increased fear comes greater opportunity. This is the place to invest.
In this thread, I’ll examine what’s happening in each of the property sectors and share some Quay investment ideas.
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The traditional commercial, industrial, retail and office real estate sectors each face different challenges at this interesting stage of the cycle.
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The industrial asset class has performed very well recently. During the COVID, many businesses promoted their online strategies to take advantage of lockdown-induced (artificially high) demand levels. The weakened supply response has resulted in low vacancy rates, a highly competitive leasing environment, and record rent growth over the past two to three years. Of course, the sector is very crowded, and from a valuation perspective, there are few opportunities to buy the underlying real estate below replacement cost.
The challenge for industries will be to maintain the current rate of leasing demand in light of a softening business outlook and record levels of supply delivery looming (especially in the US).
Over the long term, logistics real estate is tied to tenant performance, which is fast approaching tougher conditions, led by a more cautious consumer.
In the United States, the cracks are already starting to show. Employment growth in the warehousing sector has historically been a leading and accurate indicator of market rent growth in the US. As cost pressures have forced companies to lay off staff, we think it is unlikely that they will be able to significantly increase their monthly rental costs.
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This is happening as pockets of oversupply are emerging. For example, during Q2 2023, the Inland Empire Industrial market saw 3.6 million square feet of negative absorption (Colliers). The demand and supply imbalance is rapidly reversing, and there is a risk that rental growth will begin to slow down meaningfully.
Recent interest rate rises have led to fears of ‘consumer belt tightening’ due to cost of living pressures. Large regional shopping centers with a high number of non-exclusive specialty stores are most exposed to this theme. However, the cashflow resilience of best-in-class retail landlords is often overlooked, as evidenced by the cyclical performance of Scentre Group (ASX: SCG) below.
While past performance is no guarantee of future results, the good news is that brick and mortar retail sales have exceeded landlords’ ability to raise rent in recent years. This has resulted in significant ‘under-renting’ across the best shopping center REITs.
Even if sales growth falls to zero, we estimate that rents can still rise by 10-15% over the next few years to ‘catch up’ with past sales.
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The spike in online shopping after the COVID lockdown and generous government stimulus packages was inevitable. However, we believe the pure play online business model is under pressure amid rising customer acquisition costs, difficulty meeting price/timing expectations on deliveries, and struggling to build brand loyalty. This is reflected in the balance of online sales’ share of total retail sales in Australia.
The current solution is the omni-channel strategy, with an emphasis on being very selective in the brick and mortar stores that tenants choose to represent their brand. We believe this will drive lease demand, rents and cash flow for the large retail landlords.
The main challenge for the office is the work-from-home dynamic. On the face of it, being in the office two days a week means a 60% reduction in the need for office space, however in the absence of a highly efficient, highly restrictive rostering system (which prevents staff come in on their designated WFH day.’), businesses are limited in their ability to reduce their office space.
Data from the major global office markets suggests that Tuesday is now the new Monday, and Thursday is the new Friday, with most people preferring to work from home closer to the weekend.
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This was reflected in the leasing results for high-rise buildings in the financial hubs of London and New York, which are trending towards pre-pandemic averages. These cities can be strong leading indicators for other financially based cities, such as Sydney. That said, a wave of new supply is on track to be delivered in the Sydney CBD and we are mindful that today’s A-class office buildings will be tomorrow’s B-class.
From distressed fixed-rate mortgage cliff sales (which haven’t happened yet), to the next pundit’s prediction that Australia’s property bubble is about to burst, there’s no shortage of bearish reading material this year. Noise aside, we believe the Australian residential property market’s expected return profile is strong due to continued demand-supply imbalances.
Most houses in Australia have commodity-like features, that is, they are easily replaced when the profit equation of development favors new supply. So, let’s look at a typical commodity property cycle through the framework below.
The current problem is that the development equation generally does not work. The cost of developing residential property in Australia is high by world standards. This is mainly due to significant government taxes and charges, strict regulations, shortage of skilled labor and constant inflation of building materials.
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Since 2001, the cost of building a new home in Australia has increased by 6.1% per year, increasing to 8% per year. from June 2019.
The RBA’s recent rate hike regime has only added fuel to this fire, and the cost of funding is blowing previously plausible possibilities out of the water. In short, the decisions of the RBA (and other central banks around the world) are stopping new supply, just at a time when Australia needs it most.
Australia’s housing ‘crisis’ will not be solved until the cost of market supply is lowered, or house prices rise above (very high) replacement cost.
The challenges associated with housing market supply can be seen in the continued decline in new supply, which is now down 45% from the 2021 peak.
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This limited supply has been met with strong demand, which is evident in the residential ownership and rental markets. In the resale market, house prices are up 4.9% since February (Core Logic), and in the rental market we have seen a continued fall in the vacancy rate and strong rent growth (below).
Simply put, until developers have a financial incentive to build again, these conditions will remain, and momentum will likely increase. For long-term investors, it’s hard to be a bearish resident of Australia right now.
Listed real estate has derated significantly over the past 12-18 months, increasing the attractiveness of a range of opportunities in the global real estate market.
Looking at the spread of earnings multiples between global real estate and global equities, we can see that the relative pricing for the sector is very attractive. This broad sell-off is driven by macroeconomic volatility in bond markets. However, as we have (hopefully) learned from the Australian residential experience, falling property prices do not always lead to high interest rates.
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Ultimately, supply and demand matter. Based on company feedback and published macroeconomic data, there is little sign of any new supply for the property in the medium term. As a result, we believe that rental pressure is emerging across most property asset classes over the next few years.
With this in mind, it’s worth remembering that long-term real estate security prices follow earnings driven by rents and cash flow.
The property types that we believe are best positioned to benefit from near-term rental growth through the demand/supply imbalance are US single-family housing REITs and senior housing.
There are many similarities between the US housing market and the demand/supply imbalance occurring in Australia. One key feature of the US market is that normalized home inventory levels are about 50% below long-term averages, locking homeowners into low-rate 30-year fixed mortgages (7.75% refinance rate).
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This has pushed housing unaffordability to record highs, and with a wave of Millennials aging into their prime single family living years, we expect participation in the rental market to accelerate significantly.
Senior housing has performed poorly during the pandemic, and new complexities have been added to nearly every aspect of the business. This resulted in a 10-20% drop in occupancy levels across healthcare REITs in the US and Canada. With COVID in the rearview mirror (hopefully), and a rapidly aging population, we are starting to see a sustained recovery in occupancy rates. This has a huge impact on earnings and cash flow growth due to the operating leverage in these overseas REIT structures.
Quay Global Investors, Bennelong’s Fund Management boutique, focuses on wealth preservation and creation through innovative strategies in real estate securities. For more global property insights, visit the Quay website.
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Chris has nearly 30 years of experience working in real estate
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