Charter Hall's Steve Bennett on supply shortages, rental growth, and why they stepped into the Life Sciences sector

Hello and welcome to the Investment Markets podcast, where we aim to discuss investment matters that impact self-directed investors. I'm your host, Darren Connolly, CEO at Investment Markets. And with me today is Steve Bennett, Direct CEO at Charter Hall. Today, our focus is commercial property with a dive into one of the most sought after sectors of the market. However, as always, before we get into it, I need to remind you that this is all general advice and general information only and nothing in this podcast should be construed as an investment recommendation. You will need to decide what is right for you. And I'm delighted to welcome you back, Steve. You are our first returning guest.

Thank you Darren, I feel privileged and glad to be here.

Excellent. Now, it's been six months since you were here, Steve, and it feels like a long, long, long time ago. Yeah, a lot's happened. We've had a lot's happened. We've had Iran, we've had a budget, we've had tax changes. We even squeezed in the World Cup.

Yes.

Can you give the audience a bit of a feel for the commercial property market and the state of play and what's changed in particular over that last six months?

Yeah, look, so I guess what's changed, the big swinger is the federal budget came out, which included a whole bunch of tax changes, which... Unsuspecting. Unsuspecting and didn't necessarily take to the election and largely caught the market unawares. From a commercial property point of view, what I would say is, and this isn't an endorsement for what the government did by the way, but they are a net benefit for income producing assets and commercial real estate generates strong levels of income. And when you look at it, if you're an investor who previously had money in residential, and there's a lot of talk, call it $3 trillion, negatively geared, CGT changes. There will be money that moves into income producing assets, whether it's private credit, commercial property. So that's a key change. The volatility, as you mentioned, the Middle East war, look, it hasn't had too much of an impact. There was some minor changes to input costs in terms of construction materials and that, that's largely worked its way through. Six months ago, I think we had our first interest rate increase, Darren, when we sat here. We had a couple more since. And now, like we've seen for the last few years, no one really knows what's going to happen. So is there going to be another one coming up? I don't think so. The next meeting, could there be ones after? Possibly. What we do think will happen though is that As we move through this cycle, you're going to see different parts of the market respond differently. So you can't just say all residential or commercial will do good, bad or indifferent. You really need to dig into the specifics and what's changed.

Isn't all property local, Steve, ultimately?

property is local and um they have their own drivers as well that's the other thing i would say so look we're not in residential in any major way yes we'll do it where it's a repositioning on something which we already own or there's a higher and better use but What we do like, and we've spoken to a lot of investors over this period, is they are looking at commercial property in a serious way. So if you only have 10% of that resi stock, that's $300 billion. That's a lot of money. That's a lot of money. The MSCI commercial benchmark is only $101 billion. So you could have a huge amount of capital, I'm not saying tomorrow, but over the near and medium term, that looks to get into high quality commercial properties. So that's something we do think has materially changed, particularly since May.

and the 1 July 2027 is going to be a major line in the sand for investors pre and post.

Yeah absolutely and if I look at one of the big drivers trying to keep this macro still at the moment here, everyone knows the supply challenges in residential. I can tell you there's parts of the commercial property sector like convenience retail that it's even worse and so getting new stock out of the ground is very challenging So the groups that own institutional quality property in tightly held areas, we think they're going to benefit from really strong rental growth.

So the challenges are pretty universal then across all of Australia and all sectors in terms of getting that stock out of the ground?

That is, and like Australia, we've put out a Why Australia paper relatively recently, and it talks to all the positive things that you can lose sight of when you live in Australia.

It was a very upbeat paper.

Yeah. And it was drawing on the facts. I know in Australia we can sometimes feels like we want to talk ourselves into a recession or a downturn. But if you look at our credit rating, we've got a AAA credit rating tick. From a commercial property point of view, we've had very strong population growth historically the last 10 years, and it's set to continue going up. We've had good economic growth. Our government debt is still low if you look at the G12 as a percentage of GDP. We're a country rich in natural resources. Around half the money that we manage on behalf of institutional clients is offshore pension funds, sovereign wealth funds, some of the biggest investors in the world. And one of the things that they constantly say to us about Australia is it's transparent, good rule of law, investment returns, compare favorably. And these are investors that can take their money and put it anywhere.

So Australia stands out as a a good investment destination for all of these capital providers?

It does. And look, it doesn't mean the government's got everything right either. There's certain states where we'd argue that the property taxes are punitive, particularly for foreign investors. But By and large, Australia, those investors tell us screens very favourably. So it's a white paper we put out. It's got a lot of data in there. It's a good read for those that want to understand Australia's place in the world. Obviously, we've approached it from a commercial property perspective. We've benchmarked it against other parts of the market, like globally, and our risk-adjusted returns look very good. And particularly where we're at in the cycle, we're coming out of the third downturn in the real estate marketing commercial since the 1990s. It's a very favourable, in our view, time to deploy capital into the sector.

I think it was a very, having been through the report, it was a very positive report that I guess sometimes when you're reading those headlines in the media, particularly around residential, you can get caught up in some of that negativity.

Bad news, bad news, bad news headlines. I'm guilty, it's a big shocking headline, everyone clicks through and it's interesting. if it said commercial real estate outlooks positive, like, yeah, it's not much of a story residential property set to crash 10%. You know what that grabs headlines, it grabs the clicks.

It certainly does. And in terms of that positive story, then where do you see those opportunities emerging? Because to your point that you made a little bit early, it's not, it's not all the same, right? You can't have that broad brush that says all commercial property is going to be great, or all commercial property is going to be bad. It very much differs depending on what you're looking at.

Yeah, look, I'd argue I've been doing real estate for 26 years that what you just said has been the case always. I think what has changed is that parts of the market are more bifurcated than ever before. So thinking you can just take a sample of the market and get good returns, I think they'll be disappointed. If you look at certain sectors, prime office shocks people. We're seeing real rental growth at good levels, particularly Sydney and Brisbane. Industrial logistics, vacancy rates have normalised. They were artificially low for a long time. They're now still globally some of the lowest vacancy rates in the world. Is this the stock issue?

The stock, yeah. The stock out of the ground coming through? It's demand and supply.

So the supply challenges are real in all real estate classes, including Resi. The input costs are high. Skilled labour is still tough. Up in Brisbane, you've got the Olympics 2032, which is going to hoover up a whole bunch of skilled workers.

Hasn't started yet.

hasn't started yet. So it's interesting. We've tried to get ahead of the curve and we've picked up some great industrial properties for our $3.2 billion DIF4 for our industrial logistics fund. And we've bought in those Brisbane markets and we're seeing assets, most assets are valued below their replacement costs. and from a long-term owner's point of view like we do at Charter Hall that's a great thing. It means to get new stock out of the ground you've got to have much higher rents to justify the feasibility or you have a supply contraction and we're seeing a little bit of both. So I think those owners that own that high quality stock regardless of the sector will do well but there's definitely going to be pockets and regions to be a little bit more wary of or which will be a bit slower to emerge into the growth cycle.

So there's a little bit of rental upside in those in those scenarios constraints on the supply side so they're both favorable for for those owners.

Yeah look we we think The next few years, valuation growth is primarily going to be driven by real rental growth.

Which is good. Which is good. So to give you some numbers. Maybe not for the tenants.

Look, it's all very fair. The way leases are structured in Australia, it's set down. The tenants, the landlords know how it works. In office, you tend to get around 3.7% annual increases. Industrial, a little bit lower. Certain other leases are linked to CPI. So they give you that good inflation hedge. And we do think there will be cap rate compression. And just remember, commercial property works like bonds. So as cap rates or bond yields go down, valuations move the other way. But we do think in the near term, that valuation growth is primarily going to be driven by increases in rental growth and cash flow. And once again, which is great for Charter Hall, purchases and investors are placing a premium on high quality cash flows. So long term leases to very strong tenants that can go through different cycles.

So the fundamentals are starting to swing or have been swinging in favour of commercial properties. Is that a fair statement?

It's a fair statement. And look, it has been a pretty big downturn. Most of the markets peaked June 2022. What we've now seen, and I've got to be careful I don't say any Charter Hall group results Friday the 21st, but what we have seen now is four quarters of valuation stabilizations or some small increases. That's great. So that's given our investors, our financial advisors, parts of the market that confidence to see that you have hit that trough pricing. And to be clear here, some of the valuation reset was bigger than the GFC. That shocks people in some markets. That's surprising. Yeah. So what that means is we're seeing low double digit returns forecast for the next five years from core, some of the most defensive real estate in the country. Typically that would be, and I've always said through my career, eight to 9%. And If I come back in 12, 18 months, I suspect it will be saying that. That 12 to 13% total returns is simply because of the point in the cycle that we are. As we come out of that trough pricing, we'll see the market move by rental growth. And then as we progress further through, as rates, we expect rates will come off sometime next year, you will see cap rates come in and you really will get that valuation kick. And it dovetails very much in with the supply contractions which we're forecasting over that next five years.

So those supply issues are going to keep on going for quite a reasonable period of time, I believe?

Yeah, look, I'm not saying no supply is coming out of the ground, because that's clearly not true. What I'm saying is that the supply that does come out needs to generally attract very high rents and it needs to make sense. If you look at office Sydney where we're filming this right now, there's only two assets coming out of the ground between now and 2030. I think the next one after that's 2032. Like, that's not much supply for a very big market where tenants are chasing prime assets that are well located in the Sydney CBD. And then industrial logistics, we estimate the replacement costs are 25 to 30 percent above what our valuations are. So it doesn't make sense to speculatively develop. Even though you do have a big tailwind of that e-commerce penetration, the logistics are getting reorganized, there's greater levels of stock kept on hand. So it's not just the supply constraints, it's the level of demand which is meeting as well.

And have you seen, you touched on office and industrial logistics, have you seen that play out in retail as well?

So the part of the retail market that we're in is convenience retail. So think of everyday needs. So the things you buy regardless of what's happening in the cycle. So Woolworths, Coles, food, Bunnings, service stations, that sort of thing. If you have assets in good metropolitan locations, we think they're absolute gold. I just always encourage people, think about your local Woolworths or Coles. How easy would it be to put another one in near you? And in most cases, almost impossible.

Very, very, very difficult. Yeah. Particularly in inner city areas. Absolutely.

And so you've got a whole bunch of forces colliding here where... you've got the densification. So population growth is a thing. And what governments are trying to do is concentrate those populations around existing infrastructure. So road, public transport, parks, amenities. It means they don't need to spend as much money. And you can utilize what's already been built. Makes a lot of sense. If I look at where I live, eastern suburbs of Sydney, it's impossible to put anything new. For those owners who have those kind of assets, you're getting population going up, inflation, which tends to drive up the sales. And it means the tenants are getting more productive sales and higher levels of sales out of those sites. So over the next five years, we think that convenience retail will have some of the lowest supply we've seen in decades. So watch this space. I always find it quite interesting. Everyone's across what's happening in resi and the supply side. it's happening in other parts of the real estate market as well.

Well, if you think of some of those trends, they would apply to all assets. They do.

They do. Skilled labour, land shortages, funding costs, quality builders, they all go into what makes a development feasible. And only where it makes financial sense will a developer construct it, which as you'd expect.

Well, why would you build something you're going to lose money on?

Yeah.

You wouldn't be around for very long if that was your sort of business model. Now we've seen, so those three core sectors, I guess, are always at the forefront of people's minds in the commercial property sector. But we've seen a lot of interest in a lot of other specialist centres, or sorry, I should say specialist sectors, including the likes of data centres and healthcare. Why do you think these specialist sectors are now getting a lot of attention? And what makes them special?

Look, they're not all the same is the first thing I would say. We're not in the data centre business. They're obviously something that society needs and they are driving a lot of the economic growth at the moment. Where we have played the data centres side of things, it's typically rezone industrial land and sell it at a much higher and better use to a data centre provider rather than us developing it. We've been a bit wary of healthcare, like hospitals and that. We've all seen some of the challenges with the big tenants in that space, Healthscope, some of the public fights between the insurers, health insurers, government, private hospitals. It's kind of the perfect storm there.

Yeah. You don't want to be in the middle of that.

No. And look, there's also a question mark over NDIS funding. At some point, everyone recognizes that rate of growth will need to slow. So we've been very targeted. We've actually very recently picked up a very high quality life sciences asset. Call it just a bit under half a billion dollars. We've made a piece of that available to high net wealth investors, and we're partnering up with some of Charter Hall's institutional investors. And that shouldn't be confused with a hospital. It's largely run off Medicare. The lease is a 20-year triple net lease. And a lot of people don't know what a triple net lease means. Well, let's go there. I love it. I love talking acronyms in property. It's basically the opposite of what you get in a residential property. In a residential property, you're up for electricity, outgoings, council rates, repairs and maintenance, capex. This lease, all those costs are borne by the tenant. And you may say, why would the tenant agree to that? Well, this property is so important to their business that they want to control everything. And so that suits me perfectly. It means our cash flows are de-risked. They've signed a 20-year lease, 100% occupied, and the tenant in this case is Sonic Healthcare, almost a $10 billion market cap entity. And it's a kind of perfect investment that we've been looking to get into. So not all of these other asset classes or alternate asset classes in property are created equal.

So it's been quite selective in the sector, the tenant and the asset? Yeah. I think probably fair to say. Absolutely. So what in particular makes this asset special?

Yeah, look, the first thing I would say is they don't come along very often. So when this opportunity came up, we were able to throw the resources of Charter Hall, our big, highly skilled transaction team, legal, treasury, and we could meet the timeframes that the vendor wanted in terms of getting certainty. It meant that we're in a very good position and we're able to acquire that property 8% below independent valuation. That's a great starting point. But we're managing this vehicle for the high net wealth sleeve anyway for five years. So I'm always looking at the exit as well.

But it's a 20 year lease.

20 year lease, yes. So five years time. I can sell it. I can bring new investors in. We'll come up with the right approach to maximise value for those investors. And for incoming investors, it needs to make sense. And they're looking at it and go, well, I've still got 15 years. The tenant has 30 years worth of options. This site trades 24-7, has almost $200 million of capital improvements that the tenants put into the property. So they're probably not going to disappear anytime soon? No, they're not. And it's very important with long-term leases that you do the work on the financial covenant. And Sonic Healthcare are an amazing business. This site actually does all their pathology for Queensland, Northern Territory and Northern New South Wales. Sonic have over 45,000 staff and more than 450 collection centres get fed into this. And the reason they've built it there in Bowen Hills, about a K and a half out of Brisbane CBD. Close to the transport.

Transport, absolutely. I know because I don't live too far away, but it's close to the hospital as well. It is. It's in that healthcare precinct.

So you've got highly skilled labor to draw on. You can bring staff in on the public transport easily. Great connection to roads and airport. This is a core part of their infrastructure for the business. In many ways, it has infrastructure-like characteristics, but in this case, we've obviously put it in that commercial property bucket.

And is this the start of a foray into life sciences or is this, because I would have thought these types of assets are quite, as you've sort of outlined, they're quite tailored to the operator or the tenant. Is this the first of many or is this a one-off?

Look, we've done these kind of deals before, not of this scale. Assets of this quality with the tenant covenant, the lease structure, simply don't come along that often. Is it a unicorn? Uh, it's not a unicorn because there will be more, but it's not something that I expect will happen next month, for example. And always be wary. This isn't a local doctor's pharmacy or dentist dressed up as some big institutional, highly sophisticated centre. Like this is, and I see, I've seen a lot of those types of assets where, um, the fundamentals don't necessarily match up to the pitch. So there will be other opportunities that come across. One of the strengths of the Charter Hall Group, we've done more than $11 billion of sale and leaseback transactions, and this deal was a sale and leaseback. And the reason why we've been successful, as I alluded to, our speed, we give sellers confidence once we say we'll do something, as long as nothing comes up in DD, 99 times out of 100 we'll complete. And we're also a great long-term partner. If you have a long-term lease, you want to make sure that it's with an institutional manager that's sophisticated, that will maintain the assets, even in circumstances where, in this case, we're not required to do that. Plenty of the other $11 billion of sale and leaseback, we are, it's more of a traditional lease structures.

Yep. So Steve, to conclude, we've sort of established that there are some favorable tailwinds behind the commercial property market. Charter Hall and the report seems to be quite upbeat and positive about what's coming next. But every investor should always be watching the environment, understanding what's happening, looking at particular metrics. So what in your position on a day to day basis, what are you looking at? over the next 12 months. What do you think is a potential further upside trigger or maybe a downside trigger? What's on your radar?

I would say in terms of the things to look out for on the positive side, rental growth is going to drive valuations in the near term. We do believe there will be cap rate compression, but that will come along as rates change direction and path over the next few years. Watch the supply or try to watch it. There's just not much coming through. And when you look at the demands that we're already seeing in all the real estate sectors and the positive rental growth, structurally, that's as good as it gets in commercial property. Things to watch out for. I'm always very upfront. Unlisted property or commercial property is illiquid. I would say be wary of structures that pretend that an illiquid asset class could be turned into a liquid investment with regular amounts of withdrawals. Will it work? Some or most of the time, sure. But the liquidity tends to run into problems at the time when people most need it. So whether it's a GFC, whether it's COVID. And I am familiar, there's a lot of these structures that have come out of the ground. We saw what happened in the US with private credit. where they gated and they limited liquidity. And trust me, private credit is a lot more liquid, a lot shorter term in most cases than what you get in in commercial real estate. So I would just say that's just something to watch. And the level of income that you can get from most parts of the commercial property sector is very attractive. And I would argue that the recent federal budget changes have made commercial property much, much more favourable than prior to that change. And particularly when you compare it to the forecast returns coming out of residential property investing.

So tailwinds, tailwinds driven by market dynamics government changes, taxation changes are positive the last six months then maybe for charter hall if we if we look back?

We are forecasting some strong growth over the near term in terms of the assets that we manage. It's not going to be uniform across every part of the commercial property landscape. If you have leases and tenants default, well, you're going to have some big valuation hits. We've structured our portfolio across more than 70 billion of real estate to focus on those institutional grade assets. with institutional grade tenants that generate strong levels of rental growth. And we haven't deviated. We didn't get pulled into the private credit area, the data centers, residential development. And I'm not saying there's anything wrong with those sectors. It's just we've stuck to our core business and we think our investors will be rewarded as we move into that real growth part of the cycle.

I think there's always a positivity that's sticking to your knitting, Steve. Yeah, and where you really add value. Yeah, and not getting distracted into other things. Absolutely. Well, Steve, thank you for your time today and the insights into the commercial property market and life sciences in particular. It was illuminating as always.

Thanks, Darren, and hopefully see you in another six months, I guess.

Look forward to it. Thanks, Steve. Cheers. Thank you to everyone for listening and watching. I encourage you to always follow or share on your channel of choice as it makes a huge difference in helping people find us. And for more insights from experts like Steve and to search, find and compare hundreds of investment products all in the one place for free, including Charter Hall, go to investmentmarkets.com.au.