Talk to most clients about property as an investment and they will automatically think about the building. Ask them to name a quality property investment and they might mention a state-of-the-art office building in Melbourne’s CBD, or a brand new shiny apartment with views of Sydney Harbour.
However, at Quay Global Investors, we look at the best long-term property investment in a somewhat different way.
Several years ago, I took my daughter to see her first movie, Up, about an elderly man, Carl, who tries to re-capture his youthful passion for adventure with a new friend. It was a great movie, with many valuable messages for both young and old. And for me, there was also an important message about real estate.
At the beginning of the movie, Carl is holding out from selling his home to developers, despite the rest of the houses around him being knocked down and replaced by skyscrapers.
I’m sure for the majority of viewers the main theme here is of greedy developers (is there any other kind?) trying to bully an old man out of his home, where he and his recently-deceased wife had shared their entire life together.
But there is a real estate message here too. The developers were offering anything they could to convince the old man to sell. Why? The building itself had no real value for the developers (although as a home it had enormous sentimental value to the old man). No, the property was valuable because of the land the house sat on.
When Carl and his wife initially purchased the house, it was rundown and located in a nondescript neighbourhood. But with the passage of time, and the benefit of demographics, this once simple home became very desirable (high-quality) real estate.
Land vs building
One of the most important lessons I learnt at the start of my career was that it is in land where investors generate growth, and eventually their total return. The problem is that, by itself, land is hard to finance and therefore difficult to hold for a period of time.
Improvements are a necessary way of earning income, which allows the land to be financed and held for a long period of time. Ultimately, however, the improvements are a cost of ownership via economic depreciation.
Ten years later, Up only helped to reinforce this idea.
The trick, it seems, is to identify very high-quality land with a very low build cost (or at least a low cost to maintain) and generate enough current income that can attract appropriate finance (debt and equity).
Viewed through this prism, let’s look at two different styles of commercial real estate – on one hand, an office tower located in London called ‘The Shard’, owned by the State of Qatar, and on the other hand a storage facility also located in London, owned by listed REIT Safestore.
Most investors see the Shard as very high quality: a prominent, well-located asset, with an institutional quality tenant roster and located in one of the most economically important cities in the world. It would also look great on an investment brochure.
However, at Quay, we believe an argument can be made that the storage facility is of higher investment quality. Why?
As previously mentioned, the improvements in real estate are really just a vessel in which to hold the land. In the long run, low-cost improvements represent a low economic cost of holding the land.
The Shard already represents the ‘highest and best use’ – the only real upside is from land appreciation, and the land represents a relatively small proportion of the asset’s value.
Like the old man’s house in Up, the storage facility is probably not the highest and best use; hence its current value is likely to be understated.
If land is to increase by (say) five per cent per annum, there will be a better total return for assets where the land/build ratio is high (i.e. the value of the property is dominated by the value of the land). That is clearly true for the storage facility, where the value of the improvements (per square metre of land) are miniscule compared to The Shard.
Finally, office tenants generally require significant capital contributions and incentives to sign or renew a lease, which further adds to the capital intensity of ownership – although, to be fair, we do not know enough about The Shard to know to what extent it applied in this specific case. Storage facilities have near zero capital commitments to new or existing tenants.
Identifying the opportunities
The idea is simple enough, right? We just need to find storage facilities in major cities at a cheap price.
Sadly, that’s easier said than done. But there are other strategies we can use – that is, to identify real estate where the maintenance capital expenditure (what we call “stay in business CAPEX”) is low.
One of the great inefficiencies in real estate valuation (of which there are many) is the application of a capitalisation rate (multiple) to pre-tax and pre-depreciation property income. And while we accept that at times valuation multiples try to encapsulate ongoing depreciation, the approach tends to be blunt and sometimes clumsy. Applying a more quantitative approach, we believe, leads to better investment decisions.
The chart below demonstrates how this inefficiency has played out over time. US REITs operating in sectors with high ongoing CAPEX (Hotels, Industrial, Office, Retail) have historically generated lower total returns versus sectors with low CAPEX. For long-term investors, we believe these inefficiencies continue to exist.
So, while some sectors may not look pretty for the purposes of a glossy brochure (e.g. Storage, Manufactured Homes, Healthcare), they have a powerful investment advantage: low ongoing CAPEX means more free cash for dividends and re-investment. For Quay, that means higher quality real estate.
We believe that a different approach to defining asset quality is the best way to invest in property. This includes:
Thinking of land as the growth asset, and the improvements a vessel and a cost to allow owners to finance the land – thereby effectively land-banking over the long term; and
Viewing REITs through the prism of an operating business, where low ongoing CAPEX allows more free cash flow for re-investment – and knowing that over time, this is a powerful investment advantage.
To us, asset quality is more than just an attractive building. It’s about attractive total returns.
Chris Bedingfield is a portfolio manager at Quay Global Investors.