Q&A for the July/August 2020 Special Australia Section of the Institutional Real Estate Asia Pacific (IREAP) journal. Written in late May 2020 in the expectation that excerpts would be published.
1. Given governmental interventions, how well do you expect Australia’s economy and property markets to hold up during the pandemic? Please explain.
Australia will do comparatively better than most OECD countries because it entered the COVID-19 crisis in a good economic position, because the health crisis was handled relatively well (with less than 105 deaths in a country of 25 million at the time of writing), and because Australia is now in the process of robustly reviving what was a strongly performing economy.
On the latter, the Australian Budget was back in balance for the first time in 11 years. In the December 2019 quarter Australian GDP rose from 1.8 per cent to 2.2 per cent. The IMF forecast that the Australian economy would grow faster than the United States, United Kingdom, Japan, France, and Germany in both 2020 and 2021.
This is still likely.
But it is all relative, of course, with damage to many sectors, the tourism, education and hospitality sectors especially, potentially long-lasting.
The IMF is now forecasting the world economy to contract by 3 per cent this year. In contrast, during the Global Financial Crisis (GFC), the global economy shrank by just 0.1 per cent in 2009.
Australia’s largest trading partner, China, saw its GDP fall in the March quarter by 9.8 per cent, its first quarterly fall on record.
The Australian Treasury Department now forecasts the Australian GDP will fall by over 10 per cent in the June quarter; the country’s biggest fall on record.
At the time of writing, Treasury predicts unemployment to double to around 10 per cent, or 1.4 million unemployed.
COVID-19 had the potential to chloroform the economy. Hence the need to get the right balance, both with health and economic management, and to ensure key sectors are anaesthetised not euthanised, with the overwhelming bulk of the economy brought back to health.
The Treasury Department advised the government, as it did during the GFC of 2008/9, to go early, go hard, go cash, to support the economy.
All arms and levels of government acted in concert — reducing interest rates, reducing certain bank lending regulation, and with direct fiscal measures to support businesses and individuals.
In March, the Reserve Bank of Australia cut the cash rate to 25 basis points, targeting a yield of 25 basis points for 3-year Australian government bonds and making a Term Funding Facility available to the commercial lending banks to support credit to businesses, especially small and medium size businesses (SMEs). The banks reduced their lending rates to record lows, with interest rates for small business declining the most.
The Australian government’s economic support package announced at the end of March of AUD259 billion, represents fiscal and balance sheet support across the forward estimates of 13.3 per cent of annual GDP.
Part of the package is the JobKeeper Payment scheme, a temporary subsidy for businesses significantly affected by coronavirus (COVID-19). Eligible employers, sole traders and other entities apply to receive $1,500 per eligible employee per fortnight. The payment is paid direct to employers, and is expected to remain in place until September 2020, and might well be renewed in modified, more targeted form; though this is currently uncertain.
Additionally, the government effectively doubled unemployment benefits with the introduction of a temporary $550 coronavirus supplement for jobseekers.
On banking and lending rules, the Australian Prudential Regulation Authority (APRA) provided a regulatory approach to Authorised Deposit Taking Authorities (ADIs) with regard to their COVID-19 support packages.
Where a borrower chooses to take up the offer not to make repayments as part of a COVID-19 support package, the bank need not treat the period of the repayment holiday as a period of arrears.
Similarly, loans that have been granted a repayment deferral as part of a COVID-19 support package need not be regarded as restructured.
This regulatory approach on loans where payments are deferred does not require them to be “downgraded”, avoiding banks needing to raise more capital.
This has allowed banks to give relief in the following ways:
- Waiver of interest cover ratio (ICR) covenants by up to 6 months;
- Defer interest by up to 6 months (interest is capitalised);
- Defer principal and interest by up to 6 months (principal and interest capitalised).
It is important to note that while the above is not legislated, APRA’s relaxation in capital adequacy requirements is enabling banks to work with clients who may be in breach of covenants, without the requirement to hold additional capital.
All those actions were designed to put a floor under the economy.
With bi-partisan support, the government legislated to provided tax free early access to personal superannuation accounts (where in Australia 9.5% annual contributions are compulsory) of up to $10,000 this financial year and up to $10,000 next financial year.
To date, about $13.5 billion has been released, with an average withdrawal of $8,000, mostly by under 35-year olds in vulnerable industries, drawing on their savings.
Directly affecting the property market, the government announced a temporary no-evictions policy for 6-months, both for commercial and residential properties, to be guided by The National Code of Conduct.
EG’s house view is that COVID-19 will trigger a market correction due to the weakening economic backdrop.
Changes in business and consumer habits post COVID-19 will create new opportunities for specific real estate sub-sectors.
Bear markets typically go through three phases:
- In the first phase, investors view it as temporary
- In the second phase, investors are surprised by how long and severe the correction is.
- In the third phase, investors’ decision making can be dominated by negative sentiment and downward trending market evidence as they begin to question if the downturn will ever end.
We are currently approaching the end of phase one of the bear market and the best buying predominantly occurs in phase three.
We expect to see more compelling buying opportunities now with the onset of phase two. The duration of the bear market in large part depends on confidence about minimising the spread of disease, the continuation — and the degree — of targeted economic stimulus measures, and the speed of return to “normality”.
EG’s current house view regarding the health and economic crisis associated with COVID-19 can be summarised as follows:
- “Calibrated easing” of social distancing has started to occur and will progress over the next 6-18 months, with some continued restrictions, until a vaccine is discovered and/or herd immunity is achieved.
- Full functioning of the economy, including international travel to Asia, North America, and Europe (but not to the developing world), full sporting stadiums and normal patronage at restaurants, is only likely towards the end of 2020.
- Negative impacts to all real estate sectors as GDP contracts and unemployment rises. This is particularly so given the government’s desire to protect commercial tenants from eviction during the quarantine period.
- Long term shopping habits are likely to adapt further in favour of online shopping vs “in store” shopping, placing further pressure on bricks and mortar retail. This acceleration in ecommerce will likely lead to greater demand for well-located industrial property.
- To a lesser extent, in the medium-term structural demand for office space may decline for some industry sectors as space ratios per employee increase, and as a result of a more prevalent adoption of work from home (WFH) and flexible working practices. This may also lead to increased in demand for suburban “satellite” offices where individuals can minimise their commute while staying connected virtually.
- Collaborative working spaces and hotels will not be able to fully operate normally until a vaccine is discovered (defined broadly, including medication, such as prescription medicine used to treat influenza in its earliest stages) and developed to limit severity of infection. Some of the smaller owners/operators are likely to collapse.
2. What strategies are Australia-based institutional real estate investors in the current environment to address risk in their portfolios?
The key assumptions used in assessing asset fundamentals and their management need to be reassessed to allow for the impact of COVID-19.
This will include the reliability of rental income, the potential for that income to grow (or decline over time), whether tenants are likely to renew occupational leases and the cost to landlords of retaining existing tenants or attracting new ones.
The potential for decreased income security will also affect the pricing of assets and this may place stress on owners who have high debt levels.
Regarding opportunities in the real estate sector:
- Consistent with Phase 1 behaviours, EG is not yet seeing consistent evidence of distress selling from COVID-19, as the economic impact of the crisis is not yet fully felt. Government fiscal support measures are providing interim relief. We are, however, already seeing specific examples of increased vendor flexibility and motivation to engage for select opportunities.
- EG does not expect to see much distress selling by most institutional owners as they deleveraged during and after the GFC and presently maintain comparatively low gearing levels compared to other international markets. The exception might be unlisted funds with unmet redemption requests and some superannuation funds seeking to dispose direct asset holdings in pursuit of short-term liquidity.
- EG expects to see some distress selling from private owners, particularly in retail and student accommodation, but this is likely to be 6-18 months from today.
- Businesses seeking short to medium term liquidity to address the changing landscape may also seek capital injections via sale and leasebacks assuming they own the properties they occupy.
- EG also expects a significant rationalisation to occur in the retail sector with some shopping centres ceasing to be viable and trading essentially at underlying land value. This is likely to occur 12-24 months from today.
- EG expects to see opportunities in the first mortgage, senior debt space for investment grade assets as private owners seek liquidity to address portfolio valuation effects. This opportunity is likely to emerge in 12-18 months and we expect will endure for at least 3 years.
- EG has a positive medium-term outlook for co-working and sees potential for distress acquisitions in this sector from vendors with significant exposure to this use. Distress acquisitions are likely to present themselves in 9-18 months from today.
3. Which property types are best-positioned to withstand current market turmoil, and in which cities/locations? Please explain.
We believe that the economic circumstances resulting from the COVID-19 virus will provide the opportunity to buy assets within a market which heavily favours those with available capital and clearly defined timelines and decision-making processes.
Our view is that the industrial sector will be the least impacted as there has been only limited temporary closures, and the demand has been maintained for logistics in respect of on-line retail and the supply chain for essential goods such as groceries and pharmaceuticals.
On the manufacturing side, we have seen food and other goods (remember the toilet paper panic) result in local manufacturers operating at levels far above normal.
For investment, we still advocate caution and favour the larger deeper markets, being the eastern seaboard capital cities of Sydney and Melbourne and to a lesser degree Brisbane.
Income security will remain key over the next 2-3 years and hence we seek a reasonable lease term with well rated tenants preferably providing essential services, non-discretionary products, including those exposed to emerging trends such as “last mile” logistics operators.
We see the office sector as being impacted as a result of tenant stress due to temporary closure as well as the potential for re-assessment of space requirements due to social distancing on the one hand and increased working from home on the other.
On the pricing side, the gap between the capitalisation rates for prime and secondary office tends to narrow significantly during a strong market and the reverse occurs when the tide turns. This means that as the market corrects opportunities will arise in the secondary office sector but this needs to be approached with caution. Some of the key considerations are:
- Primary focus on Sydney and Melbourne with secondary focus on Brisbane
- Assets with capex requirements but the potential to transition to Core
- Income coverage and covenant confidence for minimum 2-year period, preferably 3 years
- Strong focus on location and future amenity, adequate allowances for impact of the pandemic on market rental levels, downtime, incentive and future rental growth assumptions
- Adequate assumptions for assets with genuine rental performance exposure over the short to medium term
- Limited income exposure to discretionary retail tenants within mixed-use acquisitions
In terms of withstanding current turmoil now, it is noticeable that Canberra, the national capital, with a high concentration of public servants, is insulated due to a large portion of public sector staff occupying space. Property owners there with long WALE and government tenants are so far not greatly affected.
4. Which property types are best-positioned to withstand current market turmoil, and in which cities/locations? Please explain.
Like most people in property, EG sees the retail sector as likely to undergo further pain.
Pre-COVID-19, the retail sector was already undergoing significant change. Capital values had not seen the increase experienced in the industrial and office markets, particularly for large sub-regional shopping centres with a high proportion of specialty retailers reliant on discretionary spending. Larger neighbourhood shopping centres with average to underperforming anchor retailers and a relatively high proportion of specialty retailers were also being negatively impacted.
The corporate failure of several high-profile brands such as Jeanswest, EB Games, Kiki-K, Harris Scarfe, Ed Harry, Dimmeys, Top Shop and Toys ‘R’ Us to name a few highlighted the need for lower, sustainable rents to allow shopping centres to survive. This, coupled with the rise of online retailing, has seen lower rental growth and cap rate decompression for most retail assets, but most notably for sub-regional and large neighbourhood centres.
COVID-19 has effectively required many retailers (who already had a marginal business model due to the factors mentioned above) to temporarily or permanently close stores and will have a significant impact on short term income (via rent abatements). In March we saw Premier Investments which includes brands such as Just Jeans, Portmans, Smiggle, Peter Alexander and Jay Jays temporarily close 900 stores across its network and notifying landlords it won’t be paying rent during the downturn. Although some of their stores re-opened in May, most have not.
We have also seen Wesfarmers announce a major restructure of its Target stores including up to 75 closures, and David Jones has also signaled closure of some of its stores.
In contrast, Coles, Woolworths, IGA, etc., are performing well, hiring new staff, as the public stocks up on essentials and does more home cooking (no longer able to go to restaurants) in this period of lockdown.
Over the next 3-9 months, as social distancing and lockdown rules are relaxed and customers are encouraged to return to shopping centres without restrictions, patronage is unlikely to revert immediately to pre-COVID-19 levels. A significant number of shoppers are likely to remain reluctant to attend densely occupied spaces, at least until a vaccine has been discovered. EG expects this transition period to pre-COVID-19 patronage to take 2-3 years.
Currently in Australia, online sales account for approximately 9% of total retail turnover, which is relatively low compared to the US and UK (16% and 19% respectively). EG expects Australia’s adoption of online retail to be accelerated by COVID-19, as the virus compels vast numbers of previously online resistant customers to adopt online shopping habits.
The combination of the above trends is likely to place additional downward pressure on retail values.
The Student Accommodation sector will experience acute short-term pressure as overseas students are prohibited from entering the country to study. This sector was performing relatively strongly pre-COVID and over time, is likely to revert to long term growth as education is a major Australian export. However, the income squeeze on some assets may present compelling acquisition opportunities in the short term????, particularly for older style student accommodation located on large landholdings. These facilities are typically located close to social infrastructure and could be repurposed or rezoned to allow for a mix of uses.
5. Given the pandemic, what do you think is in store for Australia’s economy, real estate markets and/or connections with the rest of the world in the coming years that institutional investors may not have considered yet?
The faster that restrictions are lifted safely, the sooner and stronger the economic bounce-back, and the less the economic scarring in Australia.
Australia may emerge as a more secure, stable, long term bet in the property sector for these reasons:
- First, economic fundamentals are comparatively robust.
- Second, savings in Australia are relatively strong. Superannuation savings to April 2020 is equivalent to the GDP of the country (around AUD2.7 trillion). Growth in the total savings pool is likely to be impaired in 2020, but Australia is regularly ranked 3rd or 4th in the world for its post retirement savings system.
- Third, ironically, Australia in 2020 is experiencing strong trading surpluses. Iron ore and other trading products have increased both in value and in the quantum of exports.
- Fourth, the relative success of Australia in handling the disease could make Australia even more appealing as a destination for migrants.
Interestingly, the major political parties, union movement and the government, have been co-operative and non-ideological during this crisis, without the nasty point-scoring typical of many countries.
It is likely that Australia is viewed favorably by foreign investors compared to other Western nations, who have not managed/fared as well during the COVID 19 period.
The risks to the Australian economy and therefore property markets are:
First, whether the immigration rate, historically at around 200,000 per year, is significantly reduced. This year a fall of over 80% is expected because of travel restrictions.
The government, however, is predicting a return to “normal” and an even stronger focus on the intake of the highly skilled.
Historically, immigration has been a key component of Australia’s economic growth.
Second, China is proving to be a wild card, at least so far as rhetoric is concerned.
The Australian government, supported by the Labor Opposition, was in the lead in proposing an independent World Health Organisation (WHO) study on the origin of the virus. This led the local “wolf warrior” Chinese Ambassador to Australia to publicly call for sanctions against Australia and visa restrictions of Chinese citizens studying or coming to Australia as tourists.
The Australian government has been restrained, not answering in kind.
Impositions of steep tariffs on beef and barley products from Australia in May 2020 by China is widely seen here as retaliation.
Even so, the links between the two countries (economically, overwhelmingly to the advantage of Australia) are mutually beneficial. Should antagonisms worsen, the risk to tourism and student numbers returning to 2019 levels is real.
Third, no one knows how robustly getting back to “normal” will take. Winter 2020 (June to August here) could be the turning point.
Complacency about the second wave is fueling optimism. As the Prime Minister said, it might be time to get out from under the doona.
In terms of property opportunities not so far mentioned, “green” and “smart” are the watchwords.
The discomfort about human interaction with the environment causing this pandemic has fostered an even greater appetite for clean solutions and approaches to the property sector.
EG, for example, is promoting a Zero Carbon property fund.
Associated with this is the deployment of smart technology to read the environmental health of a building. An Australian company, Willow Technology Corporation is now deploying its software to gather all the applications and uses of a building onto one platform. “Know your world to save our world” is one of its sayings. That sounds like the future.
This was written with assistance of key members of the EG Funds Management team, including Dan Farley, Michael Noblet, Roger Parker, Mark Turner, Gemma Moulang, and Catherine Harding.