Property: an old asset class for a new world
Property might not have the same level of excitement and pizzazz as some other asset classes. To be sure, real estate leases are long-term and stable by nature, at least in comparison to risk assets.
But as today's guest Andrew Parsons, chief investment officer of Resolution Capital, explains, it's the reliability of the asset class that makes it such an attractive proposition as we move into this new world of inflation and monetary tightening.
This isn't just a theoretical assumption - rather, it's borne out in history.
The benefit of including property in the portfolio hasn't been lost on the Livewire faithful. In our recent reader survey, over 15% of you indicated that you're looking to increase your exposure to the asset class over the next year.
In this in-depth interview, Andrew makes the case for property in light of the headwinds here and on the horizon, namely rate hikes and inflation. And he walks the talk by naming some of the high-quality REITs in which Resolution Capital invests.
Andrew also offers a sober, unvarnished take on the risks posed by sector specific themes such as the shift to remote work. However, unlike the literal foundations it's built on, property is flexible. As the old adage quoted by Andrew goes: property will find the "highest and best use".
David Thornton: So Andrew, let's wind the clock back a bit. How did you get into the real estate space?
Andrew Parsons: Sort of in a roundabout fashion. I started off on the sell side with Credit Swiss, actually having worked at the Australian stock exchange before that. So, I was reasonably familiar with the stock market, but still early in the piece. Being the new guy, they give you the area that nobody else wants to cover, which is real estate and the REITs. And so from that, I was just in a very fortunate position in terms of the listed property trusts, as they were then known, were just starting to come into their own. It was a property crash and they were in very good standing in terms of the deal with the property crash of the early 1990s.
I just thought that this was an industry that would grow naturally because I could see some inherent advantages with listed real estate in terms of liquidity, quality of the real estate, the management capability.
And so from that, or I guess I learned an appreciation of something that's part of our everyday life, and seeing how it transforms and caters the different needs of the economy and society.
Thornton: What were the main lessons you picked up along the way, and how do those inform your investment process today?
Parsons: Well, couple of things. I think simplicity is key. We all overcomplicate things unnecessarily, and it's trying to bring things back to the core. So for me, the one thing I've learned is to try and, I guess, weed out the distractions to the extent that you can and keep it as simple as possible, and learn.
Be a student of history and also recognise the qualities and attributes of some of the world's best investors, et cetera, to then by basically learn from them. Don't try and recreate the wheel, reinvent the wheel, when it's already been done by people much smarter than myself.
So for me, it's all about recognising how much you can learn from, as I say, some of the industry titans and see if you can apply that to what you do in your everyday work.
Thornton: Who are some of those industry titans you mentioned.
Parsons: That's a good question. I don't think I put any particular emphasis on any one individual. I think it's basically absorbing bits and pieces from a whole range of different people. Over the years, I mean, of course we've all... Ben Graham and Buffett, of course that's a pretty easy stock standard one to go to, but there's been lots of other interesting characters along the way, whether it's the Walter Scotts out of Edinburgh, even Capital International, Fundsmith out of the UK. And here in Australia, look, there's numerous great investors that, as I say, are inspirational and for me, has helped me enormously in terms of be a better investor.
Thornton: The big story at the moment is inflation. The rate hikes that go along with that, then on the liquidity side, you have central banks tapering their bond purchase programmes. Why should people consider real estate in that environment?
Parsons: Yeah, isn't it funny in terms of what we're all worried about today? And when I think back at my career 25, 30 years ago, 30 years, we're always worried about something. And today it's inflation and interest rates. And I agree, this is probably the most significant set of changes that I've seen in a long period of time.
Now again, owning to how long I've been in the industry. I was starting out in the industry, in fact, when interest rates were double digit and inflation was high single digit, if not double digit, and real estate was able to provide competitive returns in that environment.
Ultimately, the critical issues you got to look at is supply and demand. If you don't have the fundamentals right, everything else really doesn't matter. And so, what we've today got, or what we've got today is a very distorted market.
It's been 10 years since the GFC, in fact, a little longer than that. And yet, we're still living with some of the outcomes of that. And most notably QE, which we're now talking about obviously hearing about tapering, but more importantly we've seen 20 plus years of declining interest rates. We've had extraordinary interference by central planners, governments, and central banks.
I think it's pretty naive to suggest that this is not going to be a pretty exciting period for investors in the next couple of years, as we come out of a pretty extraordinary period, being the COVID experience.
And as I say, all the interference associated with that and the supply chain disruption, and the consequent inflation, et cetera, et cetera, et cetera. So simple answer is, I don't know what's going to happen. And I've never pretended, or what I've learnt to do over 30 years is don't pretend that you know what's going to happen.
What you've got to do is stay focused on what matters most within your sphere of knowledge and influence. And so within real estate for me, again, let me go back. 25, 30 years ago, it was high interest rates, high inflation, and real estate performed under the thematic that it was a hedge against inflation.
Of course, when inflation all but disappeared, people changed the narrative from a hedge against inflation to a play on interest rates. So to me, it's just convenient what narrative the industry wants or investors want to put on things. At the end of the day, you've just got to look at supply and demand. You've got to look at balance sheets and you've got to look at management. And if your supply and demand is in balance, if not in fact in favour of the landlord, and you've got a strong balance sheet and you've got a line management, then you should be able to generate some competitive returns with other asset classes, particularly on a risk adjusted basis, however you want to measure that.
But ultimately, if you don't have those key ingredients, we're all wasting your time.
For us, it's all about, what is the supply and demand picture? Are you capable of having pricing power? And if so, therefore, can you beat the rate of inflation? And today, we're seeing some of those conditions present in a number of the key sectors of the real estate market.
So, this is why all of a sudden the industry has started to once again talk about the inflation hedge perspective. But again, I stress, it's meaningless if you don't have the right supply and demand characteristics.
Thornton: Of course when people think of inflation, they think of the '80s. Are there any lessons we can transpose from the '80s to today?
Parsons: Sure. So, when I think again to the '80s and the high inflation, one of the boom areas of the real estate market in those days was office, office buildings. Because you had the deregulation in financial markets in Australia, you had the big bang in the UK, and that was driving outsize demand by the "fire" areas of the market in terms of real estate insurance finance.
And as a consequence, there was extraordinary demand for office space, rents were growing rapidly, and of course, that meant that office was seen to be a hedge against inflation when construction costs were rising. So, what we take from that is that we're seeing a similar set of dynamics, maybe not for office necessarily, but in some areas of the real estate market today, in that we do have rising construction costs and therefore new development requires a higher rent to justify the new bill. And therefore, if you're an existing landlord and building owner, then you've got that protection. And that's why real estate can be a hedged against inflation because your replacement costs go up and therefore you require higher rent to justify new development. And so, that's the inflation hedge story.
So, that's the one thing we learned from the '80s. Now of course, it's also worth remembering from 1980s, there was a massive property crash. And the thing that caught people out there was too much supply and too much lax lending. And the lax lending, you had the financial market deregulation, so you saw a lot of newcomers coming to the market to lend money. The Australian banking sector thought they had to compete, so they dropped their standards. And so, there was ill-disciplined lending to commercial office buildings. And so, we saw a glut of office supply take place.
And going back to my earlier comments, this is why you've got to look at the supply and demand fundamentals.
If you've got too much supply, guess what happens? Happened in the 1980s, saw an overbuilding of office, and we saw one of the biggest property crashes that we've seen.
Now thankfully today, we're seeing a much more disciplined finance capital debt market. And so, we're not seeing anywhere near the same degree of overbuilding that we've seen in previous inflationary periods. Now it's early days, we've got to keep a monitor on that, but the good thing is we've had COVID and the supply disruptions, which means that supply coming on is very difficult. There seems to be a shortage of labour, in skilled labour terms. There seems to be difficulty in getting the building materials. We've all seen rising timber prices, et cetera.
And so again, that's one of the things to look at. We're not seeing extraordinary levels of debt being thrown at the market. Limited signs of speculative development.
Most of the development we see today is largely pre-leased. And therefore, it's a much more risk aware market.
That's not to say that there probably isn't risks lurking somewhere in the shadows, and that's what we try to identify. Because it's always there, and to pretend that everything's going to be smooth sailing I think is pretty naive. But I will say that the fundamentals are pretty reasonable.
Vacancy rates in again, many areas, not all, many areas of the real estate market aren't excessive. We're seeing a good continuation of demand in many areas, and we're seeing limited supply. And again on the capital side, we are not seeing any limited evidence of lax lending standards. So, that sets up a good period for real estate.
Now, let's get back to the interest rates story. We've never said interest rates don't matter. Of course interest rates matter. Interest rates matter to everything, right? To all investments. And to pretend otherwise, again, is foolhardy.
What we think we have to do is to identify those areas which are best placed to be able to withstand the impacts of rising interest rates. So, that means a strong balance sheet. And again, it means property fundamentals capable of generating pricing power.
Thornton: What about the work from home thematic? Does reality match up to the media headlines? Or as you mentioned, those longer leases, has that carried us through this period where people are working from home?
Parsons: Sure. Again, it's early days, and it's going to be interesting, isn't it, from COVID to see the permanent and temporary changes in behaviour from the COVID experience? Our thinking is that we probably are going to a more flexible work environment, but we know that businesses and teams operate better when they come together. Communication's better, innovation we think is better. And so, I think most businesses will come back into the office in one shape or another.
But it is going to be interesting, because already office buildings, even before COVID, were only occupied five of seven days a week. So if we now cut back to three days a week, the building sits effectively vacant for four days a week. That doesn't seem to us to be a very efficient utilisation space. So, it is going to be interesting to see how this does in fact play out.
And talk of the four day week, there's so much we don't still don't understand how the future of the office looks, but we do think that it is absolutely vital for collaboration for the most effective outcomes for a business. So we think it is still important, but we recognise that it only be different. It's going to be interesting. The innovation you see in fit outs. Open plan was taking hold. Do we see people go back into actually dedicated offices and then having breakout shared space? So look, it's a fascinating dynamic.
What we're seeing though at the end of the day is that in many markets, particularly in U.S. and Australia, despite all the optimism or the hope for a return to the office, vacancy rates are very high.
So yes, people are leasing, but the reality is vacancy rates in office markets are above 10% in many markets around the world, and that's hard for landlords to have price power.
Now, there is talk about obsolescence. So, B grade office, C grade office is not going to be able to attract tenants, and that's going to be where the majority of the vacancy sits. So, that's going to be interest to see what happens to that space. Because the old adage, the old lesson you learn in real estate, the highest and best use. What we'll see is that office will be repurposed probably to residential because residential, as we all know, there's a shortage. And so, as a consequence of higher prices, we may well see the office inventory actually contract through the conversion of B and C, D grade office space to residential, for example.
So, it's going to be an interesting dynamic. It's, I think, early in the piece. But ultimately for the next couple of years, the biggest problem for office you just can't overcome is the vacancy rate. North of 10% means it's very hard for landlords to have pricing power.
Thornton: When people think of property, they think of residential, of course. They think of, probably, offices. What are some examples of some other high quality property assets that your funds invest in?
Parsons: Yeah. That's one of the great things having a global purview in terms of, not only do you have the traditional core areas of office retail and logistics, but when we look internationally, we see, in fact, residential for rent is actually a very significant feature on global real estate investment trust markets.
We see self storage as being a pretty important area. We see healthcare, a lot of healthcare. Senior housing and life science, lab space office, as well as some other interesting areas. Data centres as examples, and probably some of the other more interesting ones. It's just also that types of retail. So we've got, again, a very interesting suite of opportunity
Thornton: Property is known as a defensive asset class, but actually historically the returns shape up quite well against equities. Is it a mistake for investors to think of property just purely as a defensive play, especially vis à vis equities?
We like the fact that people dismiss real estate. We don't want people to love it, because you then get excessive interest and therefore it leads to bubbles. We prefer to be the sector that people don't fully appreciate.
Parsons: The reality is that people do underestimate the cash flows that real estate's capable of generating, and quite often overestimate the cash flow that, for example, some technology businesses are capable of delivering. For us, it's all about location. You know the old adage, "Location, location, location." At the end of the day, that great site, that great property, will adapt to the changing needs of the economy and the need for space.
We think it's part of the diversified portfolio. That's the way we look at it.
It's capable of producing competitive risk adjusted returns if the conditions are right. And for us, the conditions at the moment is again, vacancy rates in many areas of the commercial real estate are not high. We're seeing exceptional rent growth.
I mean, I mentioned earlier about residential. U.S. residential rents at the moment are growing at over 10%. Now interestingly, that's actually feeding into the high CPI numbers, and this is something we identified probably six or nine months ago that we were starting to see rents pick up and people were underestimating the inflation story because the U.S. CPI, a big component relates to residential rents.
And so, what we're still seeing is residential rents continuing on at a very strong pace, and we think that's going to continue into 2023. So, moving off your question perhaps directly, but it is an interesting dynamic. What we are seeing in real estate is so important to the economy.
Thornton: Let's move to your investment process and the fundamentals there. How do you go about filtering your rates and your property assets?
So again, what we look for is cash flow.
Our fundamental belief is the vehicles that produce the most amount of cash flow for the least amount of risk are going to produce the best returns.
So, what we're trying to identify, again, hate to sound like a broken record but it's part of the simple approach, we look for areas where supply is limited and tenant demand is robust. That way, you have the best potential for cash flow growth.
We look at balance sheets, because at the end of the day, the one thing I have learned over 30 plus years in real estate is excessive leverage will always catch up on you.
And so, we've tended to find low leverage not only generates better to risk adjusted returns, but better absolute returns because those with robust balance sheets are able to take advantage of distress. So when there is distress, they're not forced to sell assets at the wrong time or raise equity at deeply discounted prices. They're actually able to go out and buy the distressed opportunities that are out there. So, strong balance sheets for us leads to better investment outcomes. So we look at great real estate, great locations, pricing power, balance sheets, and last but not least, we look for management alignment and capability.
At the end of the day, we are outsourcing the asset management, capital management, to third parties, to reap management, who frankly, we hope make us look smart. And it's amazing the good guys, the good operators, the best of breed operators in real estate, how much more they're able to extract from the land that the market doesn't appreciate, and how they're better able to manage the portfolio through the cycle, taking advantage of these opportunities that I mentioned before and selling it the right to time and recycling capital.
So, that's the basis of our approach to the investment in the area. We think it's pretty simple, straightforward. We only have about 45 stocks in the portfolio. So, it really is trying to identify best of breed quality opportunities globally.
Thornton: Point us to a couple of those REITs that do make your funds look good.
Parsons: Look, at the moment, our biggest position is a stock called Prologis. It's one of the largest, if not the largest logistics platforms in the world. Obviously in the local market, everybody knows Goodman Well, Goodman Group Well, and we think it's a fantastic platform. No question about it. But of course, in a limited pool of opportunity, Goodman stands out. And so, everybody's piled into Goodman the last five years.
For us, the cash flows, they derive huge amount of cash flow, in terms of reported earnings, from performance fees and development. And the market is putting, we think, an excessive multiple on those relative to Prologis. Prologis does in fact do those other activities, but it does not include promotes performance fees and development profits in its earnings. And when you strip those things out and look at the cores of the businesses, we think Prologis is outstanding value. It's generating rent growth at the moment of high single digit levels, net rental growth. It's undertaking development that is generating 50 plus margins. It's earning fee promotes, which aren't included in the earnings. And so, it's really delivering on all cylinders at the moment. So, that's one example.
Another big position we've got is in Invitation Homes. Invitation Homes owns about 80,000 freestanding single family homes in the U.S., predominantly in the Sunbelt. About 70%, 75% in the Sunbelt. And again, rents are growing at over 10%. In fact, I think they'll come out in the next quarterly, probably around about 12% to 15% rent growth, which is going to translate into earnings growth of about 15% to 20%, and we think that's going to continue on into 2023.
So, simple business. Renting in a market which has seen an undersupply, interestingly out of the GFC when there was too much supply. Of course, the compensating effect is too little supply in the subsequent decade, leading to a shortage. We've now seen a migration to the Sunbelt away from the coastal markets. We're seeing rising construction costs. We've got a great balance sheet in the form of Invitation Homes. And so, there's just two simple examples that are benefiting from the changing nature of the economy to eCommerce, and the migration shift to jobs markets, better climates, and more affordable places to live.
Elsewhere, we've got investments in life science stock called Alexandria, which is benefiting from obviously all the extra research that's now being done into virus research and a whole range of other diseases, et cetera. And this is a stock that really is the industry leader and has an amazing footprint near some of the great university and, and colleges around the U.S., for example in Boston, in Northern California, Southern California.
The quality of its cash flow is exceptional. Because people think it's research it must be high risk, but they don't recognise that these research programmes are multi-year if not multi-decade. So these businesses, when they undertake that research, they're well-funded to be able to execute the research over a long period of time. So, they've been great performers during recessions because of research into developing new drugs doesn't stop. It can carries through.
So look, there's a couple of examples there of real estate that is relevant to today today's economy and beyond.
Thornton: Now, Andrew, Res Cap's well known on the institutional side, but you've just listed Australia's only actively managed global REIT ETF on the ASX, ticker code RCAP. And it's essentially a listed version of your flagship global property securities fund. Why are you releasing this fund to retail investors?
Parsons: Well, we think we always have, what we're trying to do is to make it easier and to make it more accessible to a broader number of investors. And the way I think about it is, we've been selling through JB Hi-Fi, who's obviously a great way to "sell your a strategy", but we're now going to sell through Amazon, right, as well.
So, it's really are just trying to cater to the varying needs and wants of a broad range of investors to make life as easy as possible. I mean, we all know how challenging it is filling out forms for new applications for new funds, for withdrawals, et cetera. So, the ease of just ringing your broker and putting on a buy or a sell order and executing it that simply, I think that's an enormous appeal to a broader range of people. So for us, it's nothing new. It's literally just improving the accessibility to more investors, and to hopefully make life easier for people.
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David is a content editor at Livewire Markets. He currently hosts The Rules of Investing, a half our podcast where he sits down with leading experts across equities, fixed income and macro.