Are we back to normal?

Despite the last few months being filled with market uncertainty and the rampaging COVID-19 pandemic, which caused full and partial lockdowns across the globe, property fund managers say the impact of the pandemic was not as bad as everyone initially expected it to be.

This was despite hundreds of thousands of office workers temporarily vacating their towers and moving to remote working, effectively shutting down foot traffic in cities for months.

But what this healthcare, financial and economic crisis stressed in the property market was a high degree of differentiation between assets in terms of resilience and cashflows. 

To help relieve some pain for businesses affected by the shutdowns of significant portions of the commercial real estate market, the Government brought in a tenancy code of conduct under which landlords were obliged to provide rental deferral or, in some cases, rental waivers.

On top of that, the start of the pandemic in Australia causing a great deal of economic uncertainty proved many property investors were still wearing scars from the Global Financial Crisis (GFC) and were concerned that once again the credit market would start to dry up very quickly.

However, Charter Hall head of direct property business, Steven Bennett, said after speaking to a number of financial advisers and their clients during the pandemic, the majority were very relaxed with the unlisted property investments their clients were in as they were comparing it to what was happening in the listed equity markets. 

“The main thing people need to understand about unlisted property or unlisted assets generally is that you need to put them in the illiquid part of the clients’ investment portfolio,” he said.

“We performed out-of-cycle independent valuations to make sure they were current in that type of market and to strengthen the communications with our clients and to provide additional investor comfort.

“Throughout the pandemic, [advisers] were looking at the unlisted portions of their clients’ portfolios, which were relatively stable, and would say: ‘OK, I don’t need to worry about what’s happening in the unlisted property market.’ At that time equities were moving 3% to 5% a day.”

THE FUTURE OF CBDs

When it came to the office sector, managers were in agreement that the question currently on everyone’s lips was how flexible working arrangements would play out going forward and how corporates would respond in terms of their space requirements. This was particularly important in central business districts (CBDs), which bore the brunt of the losses during the pandemic and which were now expected to thrive again.

Some managers stressed that, the time in which corporates could react to a changing work environment would be also a crucial factor, given that at the start of pandemic the sector saw an increase to the 20-year highs in terms of the sub-lease of office space that had been put to market.

“When you look at some other regions around the world where lockdowns were shorter, like parts of New Zealand, their CBDs have already gone back to normal, therefore I think CBDs will thrive once again but I also do think that flexibility will be something that many corporates will be offering to their employees,” Damian Diamantopoulos, portfolio manager and head of research property at Australian Unity, said.

“I think working in the office will return, but for many it might not be five days a week, it may be four or three days a week, depending on the industry that you are in and how much face time you really require in the office.”

Diamantopoulos, who managed the Australian Unity’s $275 million property income fund, said one reason why office space in CBD markets, particularly in Sydney, had felt the crisis slightly more was the ‘astronomical’ pre-pandemic level of rents in Sydney’s CBD versus fringe locations such as Parramatta, St Leonards or Chatswood.

When asked about his view on the fringe office markets, he said: “I think the answer is really in the view of the structure of listed versus direct [markets] because at the moment there is a divergence between what investors are prepared to pay in the physical market versus the listed market. And the listed market always overreacts; it overreacts in the good times and then the share prices are sky high but it overreacts on the downside as well.

“I think that, although we did see a little bit of overreaction a year ago in the listed market, as the pandemic has evolved and the handling of the pandemic has evolved and the restrictions have come off, some sensibility has come back into some of the stock prices. But I still think listed offices are probably where the value is and there will be a handful of stocks you could look at in that space.”

According to Bennett, there was a little bit more spread within the office sector but, what was even more interesting, was the emergence of a two-tier market of office space.

“You had long leased high-quality assets with strong tenants such as ASX-listed groups, government or strong corporates which went up in value in the pandemic period, and that was because investors valued those long-term secured income streams even more highly. 

“You need to remember that high-quality commercial property in an unlisted form can deliver investors 5% to 6.5% p.a. income returns and those income returns are paid out to investors typically on monthly or quarterly basis,” he said.

“The other side of the office market was your lower-quality assets, those assets which entered the pandemic with high levels of vacancy, offices with short lease terms, they were the assets that had valuations soften through the pandemic period.”

There was also interest during the pandemic from foreign buyers who were attracted to Australia’s economic strength and were undeterred by being unable to view properties in person.

Ross Lees, Centuria’s head of funds management, confirmed offshore investors had remained particularly active and continued to target the property market segments in Australia during the pandemic period.

“I think one of the really interesting things we saw last year was that in the COVID-19 period from March 2020 onwards, given the international border restrictions, we fully expected foreign purchases of commercial buildings to stop given people were unable to inspect the buildings,” he said.

“But what we actually saw in 2020 was the largest buyer cohort of Australian office assets came from foreigners. We saw investors particularly from Singapore saying that Australia looks like an incredibly attractive investment destination to them.

“I think they were looking at it from the global and regional perspective, and seeing how attractive Australia was relative to other investment destinations as [our] economy effectively limited any outbreaks of COVID-19, and despite the technical recession the economy continued to perform well.

“We had tenants who continued to pay the rent and the yields relative to other markets were attractive. The really interesting market was Macquarie Park [in Sydney] where we identified at least seven transactions in excess of $50 million in the last 12 months and that buying cohort was largely Singaporean groups.”

Bennett said: “Going forward we believe that the Australian office sector is offering good relative value compared to other sub-sectors of the market. Even throughout the pandemic, there has been buying interest from large sophisticated offshore investors who are prepared to pay up for the right office assets. However, you need to be discerning and focus on the quality assets, that benefit from strong tenant covenants on long term leases.”

RETAIL AND INDUSTRIAL SECTOR

The retail sector continued to be divided with the non-discretionary retail segment, which included neighbourhood shopping centres and specialty shops, having performed extremely well while large shopping centres had struggled.

“The large shopping malls, the big regional centres are the ones that had the most valuation softness through the pandemic, initially because foot traffic fell so significantly but also there were questions over the sustainable rental levels in those big shopping malls,” Bennett noted.

“If you look at the key sectors from the retail perspective, retail was already undergoing structural challenges with e-commerce and that was having an underlying structural impact on the retail sector and COVID-19 accelerated it. The weakness in that sector was probably expected for a long time and I think COVID-19 just brought it forward.”

“With the industrial sector, for the last three to five years people were predicting that this sector was the most in demand asset class globally and that was largely on back of the e-commerce penetration right cross the developed world,” Lees said.

OUTLOOK

Commenting on the outlook for which assets and sectors of the property markets would draw in investors and which would continue to struggle, Diamantopoulos said there were still many opportunities in the listed market because of the mispricing potential.

“The area where many have not wanted to invest over the last 12 to 24 months is that bigger shopping mall space. But for me, nothing is off limits as long as it can provide sustainable income stream and there is a value in it. It is about what that underlying asset is and how [the asset] is valued at a point in time. Even though the underlying fundamentals may not be good for a particular sector, if at the property level it has been mispriced, then we will look at it.”

According to Lees, real estate investments investors should focus on ensuring the acquired assets were in good locations in case the tenants decided to vacate them as this would determine the ability to re-lease those buildings. They should also consider the reliability and predictability of cashflows coming from those buildings. 

“While investors might still find good opportunities in the Sydney and Melbourne CBDs, the student accommodation sector will continue to see bumps in the short-term as universities are struggling to attract international students.

“My observation has been, in summary, that if COVID-19 certainly was not the catastrophe that lots of us expected it to be, it gave fund managers the opportunity to stress-test their portfolios and see how resilient their portfolios were through that crisis.”