Banking on defensible income streams and capital protection

In an environment where we have been fortunate to be the benefactor of significant and ongoing government stimulus and an economic cushion amid COVID, a question mark sits over the longer-term cash value. As with anything, when the currency supply increases significantly, value maintenance of the dollar over the long term can become an issue.

Couple these high levels of liquidity with the lowest interest rate environment ever experienced in our lifetimes, and it's the perfect environment for sharpening asset pricing across the board.

Where it could be said in the past that "cash is king", as we hit the strides of this new economic frontier, what is underpinning the value of that cash and cash flow in an investment portfolio becomes more important than the money itself.

Banking on defensible income

MP Funds Management has recently co-invested into the acquisition of an 18,400sqm A-grade commercial office building in Brisbane CBD, with the total forecast return in the low double digits.

The attributes of the deal that drew us to making an investment decision are largely defensible ones are and reflective of the current times:

With a long weighted average lease expiry to 2028/29 and 90% of the building income underwritten by an Australian Government and AA rated insurance tenant, annual rental increases are set at 3.5% and 3.75%.

The passing acquisition cap rate is reflective of a 5.5% yield, which, when geared to 55%, is a notional average annual distribution of 7-8% over the term, representing strong cash flow.

On undergoing detailed due diligence, some of the attributes we were drawn to were that the building is largely under-rented, meaning rents are below current market values.

Brisbane CBD is undergoing a $52b infrastructure spend transformation, and the building itself underwent a complete refit in 2017, bringing it to an A-grade standard and 5-star green and NABERS rating.

On a rate per square meter basis, the acquisition value reflects replacement cost, which is a good check and balance as a rule for value.

From a relative value and income perspective, the 5.5% acquisition capitalisation rate is compelling compared to markets like Sydney or Melbourne, where comparable assets would trade for cap rates of approximately four and a quarter per cent.

The benefit to this is that when geared conservatively, taking advantage of the low-interest-rate environment, the resulting cash from the defensible rental stream yields a more compelling investor distribution than comparable buildings in Sydney or Melbourne.

The incumbent leases' existing economic structure relative to the market and the building's practical attributes make it a compelling long-term accommodation solution for the incumbent tenants beyond the lease exposures in 2028/29.

All in all, the asset represented an outstanding risk-adjusted return and robust defensible income stream with a high probability of outperformance in the current market conditions.

Office as a defensible thematic

Whilst commentary focuses on the immediate work-from-home argument, a few things have been missed in that commentary at an economic and practical level.

Most that work from home are not set up to work from home and don't have home offices.

Leaving the house each morning to go to work to be around other people is about the importance of an employee's mental health. Of equal importance are the organisation's actual economic productivity and culture, requiring collaborative face-to-face office environments.

For example, the New York twin towers 9/11 disaster saw a wave of commentary that organisations would avoid high rise commercial office. However, given the fertile and productive working environments provided by these buildings, despite the tragedy, the sentiment was forgotten, and not long after, it was business as usual.

It is true that there is a considerable amount of commercial office sublease space coming to the market, but the current dynamic will also mean a stop to new supply as companies refrain from committing to prelease space in new buildings.

This means an immediate flight to quality, a short-term dislocation primarily in the B-grade, and an increase in leasing incentives across the board. But ultimately, these conditions will also create a cap on new supply will ensure the lasting value of face rents as the economy recovers.

Australia as a global investment destination

A December 2020 JLL research report highlights a survey conducted of 38 leading global investment groups, the results of that survey indicating 50% of those investment groups seeking to increase their investment exposure to Australia.

What does this mean for Australian investment-grade real estate values?

With our investment-grade real estate assets representing the highest yields available globally, our transparent governance and our strong economy and stable political environment, our relative isolation from the rest of the COVID- affected world is increasingly attractive, creating a more competitive environment for local assets. These conditions place upward pressure on pricing as a result.

Compound growth in a sharply priced market

From an investment perspective achieving compound growth in a sharply priced market, as we are in now, is more difficult than in a market with lower pricing,