Introduction:
Before we begin this Bennelong Funds Management podcast, we would like to acknowledge the traditional custodians of the land on which we are recording and pay our respects to elders past, present, and emerging. We celebrate the stories, culture and traditions of Aboriginal and Torres Strait Islander communities who work and live on this land, and we commit to an ongoing journey of reconciliation and respect.
Jodie Saw:
Hello, and welcome to our latest Quay Global Investors podcast. My name is Jodie Saw, an account director with Bennelong Funds Management, and I'm pleased to be joined today by Justin Blaess, the portfolio manager and principal at Quay Global Investors. Welcome, Justin. It's great to have you with us today.
Justin Blaess:
Thanks, Jodie. Great to be here.
Jodie Saw:
Justin, the past 18 months has been difficult for global real estate markets. We've experienced a sharp rise in global interest rate and bank failures in the US which have tainted investor sentiment towards listed global real estate. So can you talk us through how the high rates have impacted REITs?
Justin Blaess:
Yes, I guess the way we think about it is there's three different levels at which higher rates have impacted REITs. There is the higher discount rate via 10-year bond yields, which increases the required return on an investment. There's how higher short-term interest rates flow through the profit and loss statement. And then I guess the purpose of raising rates is to slow the economy, and so will that translate into a tougher operating environment.
And so to address each of those three points: if we think about the 10-year bond yield increase, the fact is that most or all of that increase has actually been in the real bond rate, and therefore the long-term expected inflation has remained pretty much constant around that 2-2.5%. And so what that theoretically means is that the expected return hasn't changed, yet the required return has increased. So, all things being equal, if the expected return is the same but the required return is greater, then you'll actually pay less for an asset. So hence, on that basis, the share price declines seem completely rational. But it does, however, ignore some particular nuances of real estate and something that we believe will play out over the longer term. And that is if values are falling, it actually means development doesn't make sense. And if development doesn't make sense, supply drives up, and this is actually positive for rental growth, which then ultimately becomes positive for value. So it sort of has a self-correcting mechanism to it.
Now, if we think about how higher interest rates impact the P&L, obviously the levered cash flows decrease, which impacts the dividend returns that you can expect from the REITs. But it's also important to remember that this is actually a slow process, as most REITs have balance sheets or debt with staggered maturities. It also means that when interest rates are falling, the opposite holds true.
And another consideration is what is the absolute level of gearing in the balance sheet. For our investees, we target below-average leverage and well-laddered maturities. Therefore, while rising rates
are a headwind, it isn't sudden, but it also needs to be considered relative to rental growth rates being achieved, and which for many of our investees remain strong and are actually accelerating.
Now, as I said, the purpose of raising rates is to slow the economy, which should translate into a tougher operating environment. But to be honest, to date this really hasn't materialised that way in a broad sense. Unemployment around the world generally remains low and recession talk seems to be waxing and waning. And the reality is each economy is structurally different and likely to have different growth rates. We don't forecast macro factors, nor are they part of our investment process. Our focus is very much bottom up and we very much favour sectors where there is good secular, non-cyclical growth, and sectors where supply is constrained. And for our investees, what we have and are witnessing over the last 18 months since the rates started rising, is actually robust growth and for some sectors accelerating growth.
Jodie Saw:
And your view on those bank values, Justin?
Justin Blaess:
This is an interesting topic because it seems, particularly if we go back to three to four months ago, there was a lot of commentary in the press around the risk commercial real estate exposure was to particularly the small banks in the US. So, our thoughts on it are lending standards in this cycle have remained relatively conservative, especially compared to the pre-GFC period, with current LTVs – so loan to value ratios – of around 50%, versus if you compare it to the pre-GFC, it was 65 to 70%. There actually hasn't been a huge spike in commercial real estate lending. For the last eight to 10 years, it's consistently in the US been around 10, 11% of GDP.
Now while total commercial real estate lending in the US is large – estimated to be $3 trillion, and small banks a disproportionate amount of that at approximately $2 trillion – what needs to be remembered is almost half of that exposure is residential, and that is, like Australia, performing quite well. Similarly, so has industrial, so has alternate sectors like data centres, and even retail has been performing well. The really troubled sector in the US is office, which has been well reported, and that is actually a smaller part of that bank exposure, about 40%. So that would imply approximately $400 billion in loans.
What's more, in the office sector values have actually been falling for the last five years or so, it's not a new phenomenon, and therefore there hasn't been a speculative asset price bubble. Now we think what's happening at the moment is delinquency rates continue to remain at all-time lows, historic levels. If we look at the GFC, delinquency rates peaked at around 9%. If we go back to the recession before that, at the start of the ‘90s, the savings and loan crisis, peak delinquency rates were around 12%. So if we use this 12% as a proxy for maybe where delinquency could go on a worst case scenario, you're talking approximately $48 billion prima facie of losses. Now this, however, ignores that loan span, multiple years of maturities and all have different LTVs and different levels of amortised debt principles. But taking that number as a whole, the Federal Reserve actually estimates that small bank equity in the US is around 700 billion. So, what you can see there, $700 billion of equity against prima facie $48 billion of losses. Therefore, there is plenty of equity.
So, what do we conclude is that in isolation, we don't see commercial real estate exposure as being a systemic risk to the banks in the US. In fact, in Moody's most recent report on US small banks, they talked about liquidity mismatch mark to market losses on long-term fixed interest as a greater risk. And I guess it's important to remember that neither Silicon Valley Bank, Signature Bank or Credit Suisse failed because of commercial real estate exposure.
Now we want to think about the REITs in particular. REITs owned better grade office buildings. And what we're actually seeing in the US is a flight to quality. Tenants are upgrading space, therefore occupancy in better quality buildings are okay, and these buildings are still getting refinanced. Look, it's almost certain that there will be buildings handed back to their lenders for workouts, but we think it'll be largely outside the REIT space and we don't think it'll be wholesale either.
Jodie Saw:
We hear a lot about supply issues across many market sectors. Can you talk to us about the mismatch between the supply and demand in the real estate market?
Justin Blaess:
The biggest issue we say with supply is lack of. Excess supply is actually quite isolated. There's certain markets and certain sectors in the industrial, US office, a lot of speculative, pre-committed supply for tech companies that have now pulled back, certain US storage markets, life science, office, and certain US apartment markets, particularly in the Sunbelt, where supply is potentially a issue. And really, all of those sectors were big beneficiaries of COVID and generally in locations where land is plentiful as well.
Now, however, for many sectors, COVID was a big negative and supply stopped back in 2020 and hasn't been able to restart because of first supply chain blockages, then labour shortages and now high construction costs and interest expenses. And for almost all of these sectors, we have seen revenue bounce back, which is creating these incredibly positive operating environments. And these sectors are retail, senior housing, coastal apartments in the US, outside of the US sectors such as student accommodation in the UK.
Jodie Saw:
Justin, you recently toured North America and the UK and Europe, and you met with many management teams across many of the different sectors of the global real estate industry. Can you talk us through some of the opportunities and maybe some of the structural trends that you're seeing out there?
Justin Blaess:
That was quite an interesting trip, and overriding was a sense of a positive tone towards outlook. So I talked earlier – to date there has been no recession, unemployment remains low and economies are doing okay. Overlay this with the dearth of supply in certain sectors, and this positive outlook starts to make sense. And particularly if what is driving growth is secular, such as aging population or undersupplied housing or returning students to universities.
As an example of some sectors, retail for instance was facing very negative sentiment before COVID due to the combination of lacklustre economic growth and competition from internet retailing. There's actually been a decade of net negative supply in retail, but post COVID there's been a surge in bricks and mortar shopping. And in the best centres, which are generally owned by the REITs, there's been a stark turnaround in fortunes. What's more, there is now a really healthy buffer in rent to sales ratios. This is not just in the US, the same applies to Australia with our investing in Australia Centre Group reporting today, similar fundamentals supporting it as well.
I've mentioned senior housing, but just to talk about a little bit more detail. We're on the cusp of the first wave of baby boomers turning 80. This is the average age that residents move into assisted living, senior housing. So we're actually witnessing now a huge swell in demand. Supply is at decade lows and consequently rental growth rates are very, very strong and not just in the US. In the UK, student
accommodation. Students have returned to campus in numbers greater than before COVID. Supply collapsed during COVID and hasn't recovered, and there simply isn't enough student accommodation beds to satisfy demand by a multiple of two to three, hence rental growth rates being achieved at the moment around 7% or two times long-term averages.
Jodie Saw:
And with those observations in mind, how have you positioned the portfolio to capture some of these opportunities?
Justin Blaess:
Our portfolio is very much tilted towards stocks in sectors with long-term secular growth that are fundamentally under supply – in markets that are fundamentally undersupplied and/or have real barriers to supply – and importantly, with sensible and well-structured balance sheets at attractive valuations. These stocks are in sectors such as US and Canadian senior housing, best in class retail, European and UK storage, single family homes, manufactured homes, west coast of the United States apartments. And these are all sectors and stocks where we are excited about the near and long-term outlooks.
Jodie Saw:
It sounds as though the fundamentals of many REITs remain strong and that the recent underperformance has been more about sentiment rather than actual performance. So, should we be expecting further volatility or some additional repricing maybe? And is this an attractive entry point for REITs?
Justin Blaess:
While we are excited about the earnings outlook, it is difficult to predict short-term returns. For many of our investees, it seems sentiment is ruling the day. Further volatility seems likely, particularly as sentiment about the direction of interest rates waxes and wanes. However, it is earnings that will ultimately decide value and where share prices settle. For us, the most important thing is to continue investing in sectors and stocks where earnings will continue to grow. You know, this will ultimately ensure in the long term, we can deliver to our investors attractive returns.
Jodie Saw:
Thanks so much for your time today, and thank you to everybody for joining our podcast.
Justin Blaess:
Thank you, Jodie.
Conclusion:
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