Is commercial property investing dead?

Our next speaker is Ed Krushenk, Fund Manager at Newmar Capital.

Ed has 15 years of experience in real estate funds management and was previously a director at PwC's Real Estate Advisory.

His topic today is one that's bound to stir some debate.

It's commercial property investing debt.

Let's welcome Ed.

Thank you, Angelina.

It's a pleasure to join you today to discuss the topic of great significance to investors and property enthusiasts alike.

And that is the commercial property sector.

And the topic of today's presentation, as you've touched on, is commercial property investing debt, is obviously intended to grab investors attention.

And as the commercial real estate sector continues to respond to an ever evolving and complex backdrop, we examine the fundamentals of real estate investment and why investors should keep a close eye on investment opportunities today.

Since the RBA commenced its rate hike cycle in May of 2022, the commercial property market has experienced one of the most significant corrections or resets in recent history.

And this reset is the result of a higher interest rate environment and market acknowledgement that we are in a higher for longer interest rate setting, which has resulted in investors adjusting their risks and return requirements or the associated cost of capital of investing in real estate.

And for property investors who invest in both commercial and residential, I think it's important to distinguish the key drivers and the fundamental distinction between the commercial and residential property sectors.

And whilst residential property values are primarily driven by factors like location, size, amenities, and interest rates, commercial property values are influenced by a different set of criteria.

Specifically, commercial property values are a function of rental income, forecast cash flows, and cap rates or yields, which measures the return on property investment.

And as interest rates rise, the cost of borrowing increases, impacting the overall return on commercial properties, which in simple terms, when the risk-free rate of return represented by interest rates go up, investors require a higher return for commercial properties to justify their investment.

This need for a higher return leads to a decrease in commercial property values.

Detailed on the chart on the page is the RBA target cash rate over the last 10 years, in addition to the 10-year government bond over this same period, which in property investment is used as an indicator on the market's risk-free rate of return.

And looking back to early 2022, we've experienced 13 rate hikes by the RBA, with the rate climbing from a historic low of 0.1% to a current rate of 4.35%.

which is a cash rate we haven't seen since November 2011, and we got to these levels in a very short amount of time in just over a 12-month period.

This significant change in the interest rate environment in such a protracted period has had a significant impact on real estate investment in Australia and globally more broadly.

I think it's also important to note that even before COVID-19 and the stimulus to the economy that resulted in these historically low interest rates, the cash rate was pretty steady between one to 2% over the preceding five-year period, providing a very consistent and reliable base for real estate investment in Australia.

And to understand the relationship between interest rates and commercial property values, let's consider a graph that illustrates this connection.

And detailed in the chart on the page is the 10-year government bond

compared to the listed A rate index and all funds capital returns.

And as you can see, the 10 year bond rate has gone from less than 1% in early 2021 to 4% in a three year period.

This has resulted in the real estate returns, whether that is the listed A rate index or unlisted funds being negatively impacted.

In more recent months,

As the 10-year bond rate has tightened, we have seen an improvement in both the broader equity markets and listed A rates, which is an encouraging sign for real estate assets.

More broadly, as it reflects investor confidence, it tends to be a leading indicator for unlisted real estate values.

What does this mean for us now?

Market forecasts suggest that a reduction in distress is on the horizon, and this shift will likely lead to positive adjustment in commercial property values.

Recent reporting sees results from the listed A rates show that the softening in cap rates has likely reached its peak.

Now broadly speaking, commercial property is divided into three main types, office, industrial, retail and health.

Each of these sectors has been affected by rising interest rates as yields have recalibrated.

And to illustrate this point, detail on the page is a summary of the MSCI wholesale fund returns by each subsector over the last 18 months.

As you can see, all funds have been negatively impacted, with the office and health sectors being hardest hit, whilst retail and industrial have fared substantially better.

And the reason for this relative outperformance is driven by traditional supply and demand fundamentals.

And whilst retail property was particularly hit hard during COVID-19 pandemic, as traditional shopping centres experienced significant disruptions,

But as this pandemic subsided, retail property began to recover.

And despite recent interest rate hikes, retail properties have weathered these changes better than other subsectors.

Now, why is this the case?

There are a number of reasons, but inflation has played a crucial role.

In times of high inflation, annual sales levels of shopping centres tend to rise.

Retail properties often have feature anchor tenants who pay turnover rent, meaning that their rent increases with their sales volumes.

And this arrangement has helped to offset some of the negative impacts of rising capitalisation rates.

And consequently, retail property returns have remained relatively robust compared to other commercial sectors.

In summary, we are approaching a pivotal moment as the potential decreased interest rates combined with the resilience of tenor rents in retail properties suggests that commercial property values are likely to rise.

And given the RBA's current stance and the trends we're observing, we seem to be at or near the bottom of the property cycle.

And this suggests that commercial property market is poised for recovery, making now an opportune time to consider investment in this sector.

Thank you for your presentation, Ed.

It's now a good time to invest in commercial property.

Yes, quickly, this is Angelina.

Although we do anticipate continued volatility in bond yields as sentiment does recover, investors should be optimistic.

Real estate investment has been important in intergenerational wealth creation for many years, and this is driven by its fundamental utility in the economy as a real asset and has gone through many a cycle as it is right now, but has continued to outperform over many years for investors.

As interest rates decrease, we expect to see a positive impact on property values, and from a broader investment thematic

perspective.

Real estate returns will be underpinned by durable trends, these being continued population growth and Australia has one of the highest net migration forecasts globally, rising income and wealth as a result of a relatively healthy economy that continues to add jobs

and a lack of new supply of commercial property as a result of constraints associated with high construction costs and broader barriers to entry, which has impacted investor return requirements.

And we believe these factors will drive sustainable rental growth and cash yields going forwards.

If we look at one of the, I guess, a case study from this point of view and the key thematics that underpin Newmark's acquisition of Warrnambool Gateway Shopping Centre in mid-2023, the property is located in the heart of a strong, diversified local economy with Warrnambool being a true regional city.

In Warrnambool, there are significant barriers to entry for competing retail and given current cost of construction and lack of available prime retail land.

The centre is underpinned by strong performing anchor tenants.

Ben Cole's Aldi came up with a significant track record at the centre and 95% of the tenants at the centre are national retailers and are predominantly non-discretionary and essential retail focused.

And since acquisition, we have identified a number of opportunities to grow income and add value, which in markets like this demonstrates the importance of active asset management.

And if we stick with Warrnambool for a moment, we look at MAT sales growth.

We have seen really strong growth since acquisition underpinned by its major tenants being Coles, Aldi and Kaymer.

And this is driving durable income growth at the centre.

And the trust is performing strongly, distributing 8% per annum.

And we see some really good opportunities to add further value and income growth for the centre.

What are the biggest challenges facing commercial property investing right now?

There's a number of P1s at the moment, Angelina, but investor confidence and sentiment is going to continue to impact the real estate investment market at the moment during this initial phase of the recovery as investors remain cautious about future investment activity.

And this is really around the result of continued uncertainty around forecast interest rates and the timing and quantum of RBA's interest rate easing policy.

In addition to cost of living issues and the high inflation market we have been enduring at the moment will have an impact on the sector as a result of the impact on consumer spending in discretion in goods that will impact some retailers more than others.

Thanks, Ad.

Thank you, Angeline.

I really appreciate it.