‘Thematics’ have been a key driver of property investment decisions of late. Our view is that these are often overemphasised and should be considered secondary to more important investment fundamentals.
When markets become dysfunctional, there is often a ‘flight-to-quality’ effect where investors rotate to perceived safer asset classes which are anticipated to perform well. In comparison to equities which have seen unprecedented levels of volatility in the wake of COVID-19, it’s not difficult to see why real estate is attractive given the ‘bond-like’ steady income streams that are often secured by strong covenants and long-term leases.
Increasingly we’ve noticed investors and fund managers investing heavily in ‘thematics’ in search of these long term income streams. Some of these thematics include life sciences, certain industrial and logistics property as well as property assets with defensive attributes in essential services, social infrastructure, and non-discretionary retail.
Broadly speaking the interest in these sectors is justified – the tenants themselves are specialised and have been buoyed by structural changes and demographic or economic tailwinds which have resulted in increased revenue and stronger balance sheets.
In many cases however, properties that have exposure to these thematics are being bought at very full prices where buyers are paying a premium for the tenants rather than the underlying assets. In our view, this creates significant downside risk for three key reasons.
Firstly, even if the tenants are specialised, often the properties themselves and the spaces they lease are not. One example of this is medical practices, which typically require fairly basic fitouts featuring partitioning, joinery and additional sinks, along with a high parking ratio depending on the number of practitioners.
It is often argued that there is a high probability of cash flow renewal and ‘tenant stickiness’ associated with such specialised tenants, however this is not necessarily the case. The tailwinds that support tenants with exposure to aforementioned thematics do not always lead to a higher likelihood of lease renewal, and certainly do not prevent tenants from leaving.
On the example of a medical clinic, there may be little preventing the tenant from relocating to another nearby site at the end of a lease term. In fact, because High Street retail is struggling to retain tenants, properties traditionally leased to retailers are actively seeking healthcare tenants.
If considering a specialised property investment, we would ask ourselves – if the tenant underpins the value of the property, what are the barriers to them leaving?
The second reason we believe that it is important not to overpay for thematic-backed property is that, whilst strong tenant performance may mean they are less likely to default, the landlord does not share in the profitability of the tenant’s business. In most cases, the only guaranteed return for landlords is the contracted rent.
The third and arguably the greatest risk applies to any property investment where a premium is paid for a tenant. If the tenant leaves, the resulting impact on capital value can be devastating.
This is best illustrated by a recent example. In 2019, the Charter Hall Long WALE REIT was carrying the Virgin Australia HQ office in Bowen Hills Brisbane at a value of $95.5 million – a price driven not by the underlying metrics of the property but long term and an apparently blue chip lease covenant.
When Virgin announced they were departing despite having more than 6 years remaining on their lease, the property was revalued at $52.5 million – a staggering 45% write down, and the property may yet sell for less. The fall in value of the property is greater than the sum of future net cashflows under the lease, reflecting the valuation premium for the Virgin lease.
There’s no doubt that the events leading up to Virgin’s issues were unforeseen, but no lease covenant is without some risk and this needs to be factored into each and every acquisition.
Assessing value without the tenant
The alternative to buying the tenant is to start by analysing the fundamental value drivers of an asset. Rates per square metre of land and building area are where we begin, and all considerations relating to the leases and tenants are secondary.
By focusing on these key attributes, it facilitates a defensive investment position whereby the property value is less dependent on specific tenants or lease covenants. In our view, this is what really constitutes ‘buying well’, which is how the best investment strategies begin.
Buying well is also important in attracting and retaining tenants because it creates a competitive advantage by enabling lower rents (for the same investment return as the competition) while providing attractive leasing spaces via new fitouts, new EOT facilities or new amenities.
We believe the holy grail is when the investment outcome isn’t reliant on any tenant.
We also have a strong preference for assets that have a multiplicity of uses. The first reason is that it is easier to attract tenants. Niche tenants can be harder to find and secure, and we prefer to appeal to a greater market of replacement tenants as this fundamentally reduces the risk of the investment position. Assets with a range of uses are more resilient to structural change.
Non-specialised assets can also provide greater flexibility to pursue alternate or higher and better use outcomes, adaptive reuse options, or repurposing of unused space for value creation and alternate exit strategies.
Investing based on fundamental value drivers is lower risk, but it’s not easy.
With the recent RBA announcement that the cash rate would remain low for years to come, yields in many sectors have tightened. In addition to cheap credit, the sheer weight of global capital willing to accept low returns for getting exposure to the Australian property market makes it increasingly difficult to generate compelling, risk-adjusted returns.
Furthermore, over the last few years, bullish investors, local and overseas alike, have been rewarded as marginal deals have turned into windfalls as property has traded at sharper and sharper yields. This has conditioned the market and further reinforced the notion that the only direction for property is up.
While the argument can be made that there may still be room for further cap rate compression to maintain historical spreads with falling bank interest rates, our view is that this should be the ‘blue sky’. We are not inclined to use hope-based strategies that rely on assumptions outside our control to generate returns.
Regardless, the aggregate of these trends is that, in many cases, properties are traded above their fundamental, or ‘sum of the parts’, valuations. This means it is increasingly difficult to buy well, and it is necessary to actively drive value creation and work to manufacture upside in order to reduce downside risk and generate investment outperformance.
It is often said that investing is simple but not easy, and this is as true in property as any sector.
Forza’s investment thesis has always been focused on capital preservation. Key to this is the assessment of value and the pricing of risk, both which can be skewed by overemphasising thematics and tenant covenants. It’s not that tenants aren’t valued – in fact, they are ‘king’ – it’s simply a case of ensuring that a significant premium is not paid for any lease covenant.
We believe to be successful in property investment it is critical to be able to readily assess the underlying value of an asset. Often it is not obvious, and therefore backing ‘thematics’ can seem like a much easier alternative at times.
We are not suggesting that thematic investing is risky, rather we seek to avoid overpaying for any thematic exposure.
Whilst we foresee thematic investing and cheap debt continuing to drive the market for some time, we are confident that there will be pockets of value. We will continue to search for property at metrics that make sense and with a long-term approach, to reap the rewards of patience and discipline.