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Best Sectors To Invest In Right Now – It’s been a rough ride for real estate investors lately, but with increased fear comes greater opportunity. Here’s where to invest.
In this thread, I’ll explore what’s happening in each of the property sectors and share some of Quay’s investment ideas.
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The traditional commercial real estate, industrial, retail and office sectors each face different challenges during this interesting phase of the cycle.
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The industrial asset class has performed very well of late. During COVID-19, many businesses have advanced their online strategies to take advantage of the (artificially high) demand levels caused by the lockdown. The lagging supply response has meant that over the past two to three years, there have been low vacancy rates, a highly competitive leasing environment and record rental growth. Certainly, the sector has become very crowded, and from a valuation standpoint, opportunities to purchase the underlying real estate below replacement cost are few and far between.
The challenge for industrials will be to maintain the current rate of leasing demand amid a darkening business outlook and record levels of imminent supply (especially in the US).
In the long term, logistics real estate is linked to tenant performance, which is fast approaching tougher conditions, led by a more cautious consumer.
In the US, the cracks are already starting to show. Employment growth in the storage sector has historically been an accurate leading 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 well positioned to significantly increase their monthly rent costs.
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This occurs as pockets of oversupply emerge. For example, during Q2 2023, the Inland Empire industrial market saw 3.6 million square feet of negative absorption (Colliers). The imbalance between demand and supply is changing rapidly, with the risk that rent growth will begin to slow significantly.
Recent increases in interest rates have led to fears of “consumer belt-tightening” due to cost of living pressures. Large regional shopping centers with a large number of non-discretionary specialized stores are mostly exposed to this theme. However, the cash flow resilience of best-in-class retail owners is often overlooked, as evidenced by the 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 outpaced landlords’ ability to raise rents over the past few years. This has led to significant “under-leasing” across the top shopping center REITs.
Even if sales growth falls to zero, we estimate that rents can still increase by 10-15% over the next few years to catch up with past sales.
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The surge in online shopping following the COVID-19 lockdown and generous government stimulus packages was inevitable. However, we believe the pure play online business model is under pressure due to rising customer acquisition costs, difficulties in meeting price/timing expectations on deliveries and struggles to build brand loyalty. This is reflected in the decline in the share of online sales in total retail sales in Australia.
The current solution is an omni-channel strategy, with a focus on being highly selective in the brick-and-mortar stores that tenants choose to represent their brand. We believe this will sustain leasing demand, rents and cash flow for major retail landlords.
The key challenge for the office is the work-from-home dynamic. At face value, being in the office two days a week implies a 60% reduction in the need for office space, but in the absence of a highly efficient, highly restrictive rostering system (which prohibits staff from coming in on their designated “day of WFH ‘), the ability of businesses to reduce their office space is limited.
Data from major global office markets suggests that Tuesday is now the new Monday and Thursday is the new Friday, with most people having a strong preference for working from home closer to the weekend.
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This was reflected in leasing results for top-tier buildings in the financial centers of London and New York, which are trending towards pre-pandemic averages. These cities may prove to be strong leading indicators for other finance-based cities such as Sydney. That said, there is a wave of new supply to be delivered in the Sydney CBD and we are wary that today’s Class A office buildings will be tomorrow’s Class B.
From the sell-off of fixed-rate mortgage risks (which hasn’t happened yet), to the next pundit’s prediction that Australia’s property bubble will burst, there’s no shortage of bearish reading material this year. Noise aside, we believe the potential recovery profile for Australia’s residential property market is strong given the current supply demand imbalance.
Most houses in Australia have commodity-like characteristics, ie they are easily replaced when the development profit equation favors new supply. As such, we look at the typical commodity ownership cycle through the framework below.
This current problem is that the development equation generally does not work. The cost of residential property development in Australia is high by world standards. This is largely due to significant government-related taxes and fees, strict regulations, a shortage of skilled labor, and persistent inflation of building materials.
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Since 2001, the cost of developing a new house in Australia has increased by 6.1% per year, accelerating to 8% per year. from June 2019.
The recent RBA rate hike regime has only added fuel to this fire, with funding costs blowing previously credible opportunities 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 resolved until the cost of supplying the market is reduced or until house prices rise above replacement cost (very high).
Supply challenges in the housing market are evidenced in the steady decline in new supply, now down 45% from the peak in 2021.
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This limited supply has been met by strong demand, as evidenced in both the home ownership and rental residential markets. In the sales market, home prices are up 4.9% since February (Core Logic), and in the rental market, we’ve seen a steady decline in the vacancy rate and strong rental growth (below).
Simply put, until developers are financially incentivized to build again, these conditions will remain and will likely gain momentum. For long-term investors, it’s hard to be bullish on Australian housing right now.
Listings have declined significantly over the past 12-18 months, increasing the attractiveness of a range of opportunities in the global real estate market.
Looking at the multiple of earnings between global real estate and global equities, we can see that the relative price for the sector is very attractive. This broad sell-off has been driven by macroeconomic volatility in bond markets. However, as we have (hopefully) learned from the Australian housing experience, high interest rates do not always lead to falling property prices.
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After all, supply and demand matter. Based on company feedback and macroeconomic data releases, there is little sign that there will be any new supply of property in the medium term. As a result, we believe rental pressure is emerging across most real estate asset classes over the next few years.
With this in mind, it’s worth remembering that long-term real estate security prices track incomes, which in turn are driven by rents and cash flows.
The property types we believe are best positioned to benefit from near-term rental growth through supply/demand imbalances are US residential and senior single-family residential REITs.
The US housing market draws many parallels to the supply/demand imbalance occurring in Australia. One key feature of the US market is that home inventory levels have normalized to about 50% below long-term averages, with homeowners locked into their low-rate, 30-year fixed mortgage (refinance rate 7.75%) .
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This has driven housing affordability to record highs, and with a wave of millennials aging into their prime single-family living years, we expect rental market participation to accelerate significantly.
Seniors housing has been bad during the pandemic, with new complexities added to virtually every aspect of the business. This has resulted in a 10-20% decrease in occupancy levels in 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 major impact on earnings and cash flow growth due to the operating leverage in these foreign REIT structures.
Quay Global Investors, a boutique Bennelong Funds Management, focuses on wealth preservation and creation through innovative real estate securities strategies. For more global property insights, visit Quay’s website.
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Chris has nearly 30 years of experience in real estate
