How to access competitive yield through property

Post-pandemic property and infrastructure usages are rapidly changing. Office usage is falling and demand for distribution centres is increasing. Residential property is booming but so are inflation expectations. This truly is an area that should be left to the experts. 

In an era of low-yields, one thing is clear. Aussie investors are desperate for yield. And almost as insatiable as their appetite for yield is their love of property. It's the convergence of yield and property where Freehold Investment Management and Alceon Group have made a name for themselves. 

In April, it was announced that Freehold and Alceon would be combining their businesses. The merger was the logical next step for the two property managers who already had years of association and invested in a number of ventures. 

Off the back of this, we sat down with Grant Atchison, now Head of Real Estate Funds Management for the combined businesses, to explain what the merger means for those looking for yield, the key trends developing in real estate and one idea investors need to get right over the long term. 

Can you explain the Freehold Investment approach that drives your funds?

At Freehold, our focus is unmistakably on capital preservation and delivering sustainable returns from tangible assets. We invest right across the capital structure in listed and direct markets.

We hold the view that over the long term, listed and unlisted market returns converge. However, in the short to medium term, and despite common underlying assets, the markets can move independently creating inefficiencies. Additionally, individual sectors within property and infrastructure exhibit different investment characteristics – both between them and by region.

Both factors provide the potential to derive excess returns from the allocation of capital to structures, sectors and regions that are more undervalued than others on a relative basis.

What are the key thematic trends you are currently seeing in real estate and infrastructure?

The insatiable appetite for yield is, without doubt, the biggest thematic in real estate.

While we are seeing numerous transactions in the direct market that offer secure income streams, what needs to be better understood are the risks when chasing yield. We expect the gap between prime and secondary real estate assets to widen as the risk becomes better understood or priced in.

At present, there is also price differential or arbitrage opportunities between direct and listed assets, with REITs still trading at reasonable discounts to Net Tangible Assets. The Freehold Australian Property Fund, which invests in listed and direct assets, is still overweight listed.

The Industrial sector has been the big winner from the increase in e-commerce resulting in a massive demand for distribution centres.

Earlier this month it was announced that Freehold and Alceon would be combining their businesses. What were the benefits that drove the decision to merge the real estate businesses? And what opportunities lie for the combined business?

Freehold and Alceon have had a long association and in recent years, we have co-invested in a number of assets. So, the merger made strong commercial sense as well as providing benefits for our clients.

The key benefits relate to scale, depth of skills and opportunities for investors.

• Across the two groups, there are over 20 real estate investment professionals with complementary skills, clients and the funds managed.
• For investors, we are better placed to execute and deliver superior risk-adjusted returns as we are now originating and managing across the property spectrum of direct assets, real estate credit and listed REITs and infrastructure.

To illustrate, over the last 10 years the combined group has invested almost $5 billion in over 350 transactions, generating a net IRR of approximately 16% for investors.

What is the investment topic or theme that you and your team are spending the most time debating right now? Why is it so important and how is it impacting the way you invest?

Like many investors, it’s the question of the price to buy yield and whether there are better ways to derive returns at the current point in the cycle.

We are currently able to purchase property that offers a reasonable spread between 10-year bond yields and current yields, despite the historically low yield. The challenge is finding ways to preserve these attractive metrics over the long term particularly when it is difficult to see yields compressing materially lower and there’s upwards pressure on the 10-year bond yield.

This is an important investment consideration with unlisted property in particular where you are locking in for an extended period of time. Our approach has been to blend our portfolio with both mature income-producing core assets alongside some higher-yielding value-add assets that require a higher level of asset management.

Can you highlight a specific example of how you have accessed this opportunity?

In December 2020, Freehold invested in an inner-city office building through an off-market transaction with our long-term partner, Eagle Property Group.

The 5-level office building in South Sydney at 55 Mentmore Avenue, Rosebery, is well-located in an inner Sydney growth area that is going through significant urban renewal and offers a compelling value-add potential.

With yielding office assets being expensive, the acquisition is about repositioning the asset to secure a long-term yield. Our strategy is to undertake a ‘turnaround story’ where we take some initial (manageable) risk, invest in the asset to improve it and lock in long-term tenants. The net result is value creation through the repricing of the asset.

Investors continue to seek yield given the ongoing low-interest-rate environment – what are the options in real estate?

As cap rates continue to firm and yields continue to fall, investors are seeking different ways to gain exposure to real estate.

On a risk-adjusted basis, we continue to believe that senior secured real estate credit is an attractive space for investors to deploy capital. Real estate debt offers investors superior risk-adjusted returns, or regular income, with capital secured by the underlying asset.

As an example, the Freehold Debt Income Fund focuses on high-quality assets in locations with strong supply versus demand dynamics, is conservatively geared at an average of 54%, and continues to deliver monthly net returns above its targeted 7 – 8% per annum.

Which trends that emerged during COVID-19 will stick and which ones are temporary?

Growth in both flexible working arrangements and online shopping were two clear trends that emerged during Covid that will ‘stick’, in some form, longer-term and both have had an impact on the property sector.

The obvious impact of the changing work arrangements has been for investors to question the future of the office. Our view is the office is not dead but there is still a long way to play out so it’s important to stick to good quality assets with long-term tenancies or income streams.

Another less obvious impact from flexible work arrangements has been the extraordinary demand for data centres to provide data accessibility for remote workers. In FY18 only 42% of all Australian businesses had access to paid cloud computing (1). The Australian data centre market is forecast to grow by a compound 4.5% by Mordor Intelligence in the 5 years to 2026 with SME demand a key driver.

In 2020, the level of capital issuance was up given Covid and the cautious outlook. In 2021, we expect the level of M&A or corporate activity will increase. The drivers are the availability of cheap funding, the appetite of companies to grow, coupled with the lack of good quality assets for sale, and given the vast amount of money, including private equity money, looking for a home. Just last week, for example, Dexus (ASX: DXS) announced a bid for APN Property Group (ASX: APD).

What is one key thematic, trend or idea that will be important for investors to get right over the long term?

The pricing of risk. While absolute returns are important, at what level of risk?

At a time when investors continue to hunt for yield, understanding and considering the key risks of any investment is fundamental to any decision.

For example, total return volatility is the industry-accepted measure of risk but in our view, it is in some respects nonsensical. In real estate, investors need to consider other measures such as headline yields vs net effective yields; tenant covenants; barriers to entry; earnings growth and leasing spreads, which are more likely to identify the potential risk of an investment.