Four principles for investing through uncertainty
As I speak with our investors and partners, banks, building owners, financiers, and fund managers to get insights into a COVID-affected market, some key points stand out.
While the share markets rally on what is starting to look like more normal conditions, supported by the re-opening of pubs, restaurants and beauty salons, there is a level of cautious optimism as we can head out freely once more to enjoy a meal with friends.
Some are certain we are heading for a recession, others say we are on our way to a healthy recovery, and banks and commentators are predicting V and W shaped recoveries.
In reality, it’s still too hard to predict as the ongoing $259 billion ($370 billion if you include related government agency spending) in stimulus packages are clouding visibility of the real state of the markets.
Given the most recent Federal package announced for first home buyers, there is no doubt our recovery will be significantly construction and infrastructure-led, with a heavy focus on shovel-ready development and infrastructure projects.
While there is talk of bringing manufacturing onshore, it’s unclear how the logistics of this will work, taking into consideration the enormous cost base required to do so.
We have had no recent wage growth to speak of, so increasing the price of goods produced to accommodate for the higher cost base would seem unfeasible at face value.
Additionally, the high levels of unemployment – currently at 9% with the RBA suggesting this number will likely hit double digits- would point to downward pressure on consumer spending for the time being, pending further stimulus announcements.
There is a brilliant video on How The Economic Machine Works by Ray Dalio which explains the fundamental levers available for regulators to pull on as an economy softens. I have included it here because I think it’s fascinating relative to where we stand today.
Given that we are in such a low global interest rate environment, the government cannot pull on the interest rate lever to reduce interest rates further to stimulate the economy.
It appears inevitable that government stimulus will need to continue past September to prevent spending and unemployment from falling off a cliff.
That means printing money is the name of the game at the moment; however, if this goes on unfettered for too long, it could create an inflation issue and devalue the Australian dollar.
I went to a briefing with Peter Costello, former Treasurer to the Howard Government and current Chair of the $130b Future Fund and Crestone just before COVID-19 and one of Costello’s remarks, in particular, stood out to me.
He said Australia had enjoyed a fortunate run over the last ten years and while there had been a couple of technical recessions during that period, our strong inflows of immigration and skilled tax-paying migrants had buoyed us nicely through these low periods.
Further, Costello highlighted that our economy needed these high levels of immigration due to our relatively low levels of productivity as a nation.
Low productivity was already an issue pre-COVID, and according to Bloomberg Economics, Australian gross domestic product could drop 6 per cent this year, with activity not expected to return to pre-virus levels for a couple of years.
On this basis, it would appear the post-COVID-19 economy exacerbates this key productivity issue, with productivity and immigration expected to be hit hard, it is difficult to fathom where growth and economic recovery will come from.
A construction-led recovery for the private sector means a requirement for residential pre-sales and commercial pre-lease commitments, which both rely on strong employment and a favourable business environment.
If the government chooses to pull the immigration lever to stimulate the economy, the assumption would be that India, Europe and nations other than China would be the focus, given what seems like a fractured Australia/ China relationship.
The ramifications of this fallout are yet to play out, but I think Australia could have taken a more diplomatic approach to preserve the benefits of our trade relationships with China, especially given China is home to 1.8 billion people or 18 per cent of the world’s population.
Let’s not forget the role China played in Australia’s 2013 – 2015 real estate boom, which spurred a flurry of foreign cash flowing through to existing and off-the-plan residential sales, commercial property and high-quality and agricultural farming land.
During this period of reassessment, it could also be an excellent time to consider what sort of special conditions foreign vs locally owned property may have attached, so inflows of foreign capital are still encouraged, but with better local controls.
In the short term, local Australian – Indian property ownership is becoming increasingly prevalent in the residential sector and would seem to be the lowest hanging fruit in terms of migration.
The long and the short of it is that we need inflows of skilled tax-paying migrants al to trade our way out of this COVID-recession successfully - it’s basic supply and demand. We need to increase our local demand for goods, services and housing via immigration which will, in turn, increase the supply of tax-payer dollars to recoup the new budget deficit, which is estimated to reach somewhere between $500b- $800b by mid-2021.
A new world order
When it comes to property values, there is a distinct lack of visibility currently across all fronts of the commercial real estate and residential markets.
On the commercial loan front, as the standard quarterly loan covenant checks approach in June, most banks are waiving ICR (Interest Cover Ratio) covenants and working off the most recent valuations (pre-COVID) rather than requiring borrowers to obtain a current valuation.
This comes as the New South Wales Government announces land tax relief for commercial landlords who have reduced their tenants’ rent between April and September this year.
It’s hard to say if these temporary reprieves are “kicking the can” down the road, or if this grace period will give way to a new stimulus or a new post-COVID Code of Conduct, or if the recovery will be sufficient to meet pre-COVID values and loan covenants.
What is clear, however, is that while the stimulus packages are in place, the tide hasn’t gone out yet so you can’t see who has been swimming naked, so to speak.
One of America’s most successful property entrepreneurs Sam Zell has a saying: “Real estate isn’t just about buildings as inanimate objects. It often reflects the pulse of the nation.” This certainly rings true in that the more businesses struggle, the more our economy struggles, and the faster and harder the real estate markets fall because real estate is only valuable insofar as the price the user can afford to pay for the space.
While local cafés and village retail are slowly opening their doors again, it’s easy to feel as though we are back to “normal”. However, a deeper dive reveals a changing and unstable new world order, underpinned by tenuous trade relationships that threaten to damage significant industries across exports, immigration and education.
Discretionary retail property will be the hardest-hit sector in the commercial real estate markets. Given the immense pressure on jobs, clothing stores and centres with a shallower catchment area will likely revert back to its base land value as the nation’s purse strings tighten for the foreseeable future.
This is distinct from non- discretionary retail, like Stirling’s Junction Fair Fund. The difference between the two is that non- discretionary retail is defensible and provides essential services such as supermarkets, medical centres and services to provide for daily needs.
Non-discretionary retail assets located in the right catchment area will continue to perform strongly even in the face of downward market pressure.
Taking commercial office as an example, pre-COVID, prime Sydney CDB vacancy rates had compressed to close to 3.5% and cap rates were sharp at around 4%. Prime effective gross rents ranged from $940 - $1,150 per sqm and an average of $1,045 per sqm per annum. The average prime effective rent of $1,045 increased 5.1% year on year and 50% over the last five years. Prime grade incentives were closer to 21%, up $25 per sqm year on year.
A possible outcome post-COVID as unemployment soars is increased office vacancy rates. A material increase in vacancy rates will put downward pressure on both face and effective rents which will soften capitalisation rates and ultimately affect values. It’s unclear yet what the adjustment in values will be and if the adjustment will be material. But with a softer economy and social distancing rules, it's unlikely tenants will require as much density in their tenancies, or even as much space overall, given the softening business climate.
Many of the corporates I am speaking with are extending their working from home arrangements indefinitely, with staff allowed into the office one week per month on rotation. If this becomes a longer-term trend, vacancy rates will go up, rents will go down, cap rates will soften, and this is where meeting those pre-COVID bank loan covenants may become an issue.
Our portfolio of assets is in a strong position. Entry pricing had a strong view to downside risk mitigation, and the portfolio is prudently managed, conservatively geared and with robust surplus cash reserves.
A potential drop in values is something that may become the elephant in the room for less conservative commercial property owners.
The issue will become very real if softer business conditions continue for those underlying tenants who had committed to substantial leases in pre-COVID times.
What I do find fascinating is speaking with owners of trophy Sydney CBD assets. Purchase offers are still being fielded and not at deeply discounted rates, meaning there is still a significant amount of capital looking for a good home, because keeping cash in the bank with interest rates so low, especially in what may become a higher inflationary environment, doesn’t provide a return on capital.
Where to from here?
It will be some months before we can pinpoint the clear market opportunities, given the lenience of banks to waive loan covenants pending further notice, together with government incentives, which mean ultimately downward pressure on values is simply being deferred. Only time will provide a higher degree of certainty.
Right now our take on the market from an investment perspective is largely to hold; it is time to take stock and see where the frames of reference reveal themselves, which will point to where the value is.
One of the family offices I speak with frequently, originally from a retail background, with significant real estate holdings domestically in Australia and the USA reiterates the following principals every time we catch up. These guiding principles have resonated with me deeply and have become part of our investment philosophy:
1. Protect what you’ve got
For us, we are looking for outperformance, but in the first instance, the principal position needs to be rock solid. Whereas before COVID, we were leaning into a robust and upward swinging market, so the key focus was on maximising upside, given risks were identifiable, and the market was stable. The fundamental focus during and post COVID, and leaning into this more uncertain market, is principal protection and downside risk mitigation via both structuring and sound property fundamentals.
2. Look at assets that have a “moat”
Warren Buffett’s famous saying about his beloved Coca Cola shares ring true: find those assets which have a high barrier to entry or have unique factors which are representative of value, are in high demand and difficult to replicate. Translating this into real estate, find those assets which are regarded as trophy assets: sought after, well located and with an outstanding and defensible tenancy profile.
3. Where you always make your money is on the acquisition
Buy well and buy below replacement cost. This means that replacing the asset today would cost significantly more than your acquisition price, which means a high barrier of entry for a competing owner, and translates to higher rents at the competing property to cover their higher cost base.
4. Tenancy risk
Just as the banks place additional rigour on consumer mortgage lending conditions such as employment status and predictability of income, so too will more stringent reviews of tenants and balance sheets transpire, to ensure the long term viability of that business post-COVID to cover the rent moving forward for the period of the lease.
In short, at MP Funds Management, we will look at secured debt opportunities which are lowly geared (to protect from valuation fluctuation) and acquisition of high quality, well-located assets with defensible income streams at values reflective of below replacement cost. We will look for opportunity where the risk is skewed in favour of the investor. As a value investor, we can pivot to where we can take advantage of opportunity to achieve a defensible outcome and value-enhanced risk-adjusted outperformance.
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MP Funds Management has executed more than 28 investment-grade real estate deals, an aggregate value of over 1.3 billion dollars in assets, producing an average investment return of 22 percent annually (IRR), with the lowest returning investment...