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Wentworth and Federal Election; The wood for the trees

Snapshot / Markets

Australia

Oct 22 2018

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Whilst the final results of the weekends Wentworth by-election remain unclear with Independent Keren Phelps and Liberals David Sharma looking close to hung, headlines continue to focus on climate change, the banking and superannuation royal commission, and the declining residential property market.

Residential 

House prices have fallen 2.6 percent nationally and 4.9 percent in Sydney, according to the 2018 September CoreLogic figures.

In a comment to the AFR this week, group chief economist for NAB Alan Oster said I'd say the housing market is still pretty healthy. Sydney is still up 26 percent, and Melbourne is up 33 percent [from four years ago]. "I see this as a mild mid-cycle adjustment."

McGrath reported a loss in Ebit of $1.9 million for the quarter to September, as indicated in an update to the ASX on Tuesday. Whilst spring selling season has started as early as August for the last five years, auction results show a decline in seasonal transactions.

Chinese-owned private developer Aqualand has a $5b residential development pipeline in Sydney and took a strategic stake in McGrath earlier this year demonstrating long-term confidence in the Australian residential market despite the credit restrictions. Managing Director of the family-owned company, Jin Lin reiterated the group's confidence and long-term vision for Sydney specifically.  Read more here.  

Official data shows that approvals for new residential dwellings have dropped to their lowest levels in two years in August this year with apartment approvals falling the most significantly. In addition, the AFR reports last weekend's auction clearance results falling to close to 30% in Sydney.

UBS economist George Tharenou suggests that the worse than expected approval figures provide evidence that new housing investment is slowing in response to falling dwelling prices and a slower consumer uptake across Australia’s eastern seaboard.   

JP Morgan economist Tom Kennedy suggests in a recent report that weaker residential construction is likely to hit the wider economy, indicating that the moderation in approvals in the last few months is consistent with JP Morgan’s forecasts, that the impulse from residential investment to GDP will turn negative by early 2019.  

Whilst approvals slow, apartment construction declined its most in six years, according to Ai Australia and the Housing Industry Association. The latest Performance of Construction Index shed 3.9 Points to 32.8 in August, the lowest since October 2012, which was 27.6. A reading above 50 is indicative of growth and below 50 is indicative of contraction. The further from the median, the more pronounced the rate of contraction or expansion.

Whilst there are assurances of Australia’s economic growth and buoyancy, with key indicators still showing growth, the hang over from the cooling of the residential market via credit restrictions and knock-ons are yet to be seen and fully understood.   

Record levels of immigration as the stimulus to get through the global financial crisis since 2008 have buoyed our local economy and offered us resilience through the period. The growing population has created a continued demand for housing and residential accommodation. 

The lever which initiated the APRA and the subsequent Royal Commission into banking and resulting credit and lending restrictions was the threat of the S & P Australian rating downgrade, a threat which has now been removed as the rating agency has improved its outlook on Australia and its AAA rating.

As in my note last week, the credit restrictions whilst slowing the growth of the residential market are doing nothing to address affordability. Even though pricing has come down, it’s difficult for the consumer to obtain a mortgage.  Additionally, the softening of the market is compounding the lack of supply, which doesn’t accommodate the required population growth and will ultimately lead to continued pricing growth in the medium to long-term.

Our economy appears to rely very much on inflows of skilled migrants to replace and provide support for the diminishing tax-payer base as a result of the top-heavy aging population, and crude supply-demand fundamentals.

Trade wars between China and USA send shock waves through the domestic and international equities markets. Whilst macro geopolitical head and tailwinds may effect movement in interest rates over time, its the domestic real estate credit restrictions impacting speed of growth of the real estate market, creating transactional restrictions to the consumer rather than highlighting any systemic weakness in the market itself.

Regardless of the Wentworth or Australian Federal election outcome, or knock-ons of potential removal of negative gearing benefits, what is fundamentally clear is that Australia is reliant on immigration and in-flows of skilled- tax paying migrants for economic stability, growth, and buoyancy, driving ongoing demand via a growing population.

With 10m residential dwellings to accommodate a population of 25m, growing at c. 350,000 people per annum MP Funds Management is confident in the sustained growth of the sector.

Notably, groups like ASX-listed Mirvac are entering the built-to-rent sector as a result of issues around ongoing demand, difficulty with new supply and affordability. Funded 30% by the Clean Energy Finance Corporation, their first project of many, Indigo at Sydney Olympic Park is scheduled for completion in 2021. Mirvac has suggested forecast annualised investment returns at c. 4.5% to its institutional investment partners for their build-to-rent activities. Additionally, with UBS Asset Management as custodian, a private middle eastern investment group have entered the Australian build-to-rent sector in Queensland, with a $550m, 1251-apartment village known as "Smith Collective". The development will offer 1- and 2-bedroom apartments together with 3-bedroom townhouses for rent.

Research released by Knight Frank mid-2018 shows nearly half of Australians are choosing to rent by choice and more than half will still be renting in three years' time, making the build-to-rent sector more viable than in the past. Known as multifamily in the US, the build-to-rent sector refers to large investors holding whole buildings of professionally managed apartments for rent not for individual sale.

Today’s CLSA note reports Mirvac’s residential business remains on track to settle over 2,500 lots in FY19, with 560 settlements in 1Q19 (22% of its target) with c. 2% defaults and 69% of FY19 residential Ebit secured. 

During the quarter, Mirvac released 428 lots, with strong demand at Woodlea, VIC, where 81% of lots released were pre-sold, with 57% at Olivine, VIC and Crest, NSW pre-sold. Pre-sales remain high at $2.1bn with margins of 25% expected to be achieved and over 50% of its future lots with embedded margins over 25% given Mirvac acquired over 18k lots during FY11-15 in Sydney and Melbourne at attractive prices on capital efficient terms. 

CLSA views current market conditions will allow Mirvac to opportunistically restock from mid-2019 - softening consumer residential markets is creating downward pressure on development site values.

Read more here.

 

Retail. 

Retail property is getting an equally bad wrap with sentiment reflective of the shift away from traditional retail and poorer retail performance as a result. MP Funds Management continues to see opportunity in well located, mis-priced assets which have the ability to capitalise on population growth and shifting consumer behaviors.

Whilst the key drivers evolve and listed groups like Vicinity sell off assets at a discount to book value, the market continues to evolve in ways that create pricing opportunity for well-located assets that have the ability to be repositioned to capitalise on the emerging new dynamics.

Vicinity has announced the sale of 11 non-core assets with low specialty productivity of $7,611/sqm for $631m, ie a 5.1% discount to book and implied transaction cap rate of 6.94% (35bp of cap rate expansion).

Other players such as listed Frasers property group, Simon Property Group, Ashe Morgan and Panthera property group have committed to re-invigorating the retail space with an appreciation for creating vibrant entertainment- focused precincts, with food and beverage offerings that cater to both convenience and a ‘destinational’ day out.    

Todays CLSA note reports Mirvac’s retail portfolio delivered retail sales growth of +3.2% and +3.1% for specialties vs 3.1% and +3.7% at FY18. Occupancy remained high at 99.2% with positive leasing spreads across 112 leasing deals with speciality productivity of upwards of $10k/sqm and occupancy costs of 15.2% vs 15.3% at FY18.

Read more here.

Commercial.

Sydney CBD commercial office assets continue to be tightly held and trade at c. $20,000 per sqm plus – and-climbing premiums. Rents are at above $1000 per sqm and vacancy hovers at around 4-5%. Ongoing major infrastructure continues to improve accessibility, amenity and as a result, also creates upward pressure on pricing growth. Whilst 2023-24 will see the completion of major office towers, a significant amount of that new space is already pre-committed. Capitalisation rates continue to sharpen, with recent transactions reflecting cap rates of c.5%, and the competitive domestic landscape is compounded by the global equity groups and their hunt for yield.

According to the latest Dexus Q4 Australian Real Estate Review, Sydney CBD rents continue to grow at 10% on an annualised basis, Parramatta continues to outperform with net effective rental growth reflecting rates of 17-22%. According to the report, Melbourne commercial has had the strongest quarterly net absorption in over 10 years.  

The recent bidding war between global giant Blackstone and Canadian pension fund, Oxford Properties Group, for the $4.4 billion Investa office portfolio platform which has office assets across Australia exemplifies this.  

CLSA's morning note reports Mirvac’s office portfolio has capitalised on strong office markets with +11.3% re-leasing spreads over 11,000 sqm with low incentives of 17.9% and high occupancy of 97.2% (vs 97.5% at FY18). 

Mirvac’s $5.8bn office portfolio and $3.1bn office development pipeline (83% pre-leased) remains one of its primary growth drivers providing over $95m of new NOI and over $200m in development profits (P&L) and NTA uplifts (c.5-6¢) by FY22. 

CLSA suggest Mirvac’s national office cap rate of 5.69% is conservative and should compress at least 35bp, growing NTA by c.10¢ or c.4-5%.

Read more here.

Real estate credit markets.

Whilst non-bank lenders actively pursue residential development loan opportunities, our view is that this is only viable in the event that the base case takes into consideration holding the asset for the medium term should the pre-sale buyers’ default on settlements as a result of the ongoing credit restrictions.     

Given the residential institutions are entering this build-to-rent sector as a result of the ingoing issues surrounding supply and affordability, MP Funds Management sees holding high quality, income producing rental product as a sound base case in pockets where the property fundamentals are strong and support growth. 

Whilst there is non-bank capital available to finance construction, albeit more expensive than bank money, the ongoing APRA and Royal Commission mortgage lending constrictions (implemented as a result of the S&P rating concern in 2016 & now resolved) is what is ultimately creating the dampener most profoundly in the consumer market, across both the new construction and residential supply space, as well as auction clearance rates. 

Australia is heavily reliant on the revenue from this space and it’s likely that the sector may begin to shift after the federal election. 

Investment loans for income-producing assets in the commercial property space continue to be favorable to the banks. 

With banking restricting the SMSF lending space for real estate exposure, the $700b aggregate value of Australian SMSF capital has only a 19% exposure to Australian property. With SMSFs no longer able to obtain loans for real estate this ratio of investment exposure is likely to decline and its likely that this sector will evolve significantly in the short to medium term. Australia’s residential sector having a value of c. 7 trillion, the commercial sector, .980 trillion and equities a c. $1.9 trillion value (Core Logic June 2018), it makes sense that investors would want high-quality real estate exposure in their portfolios.

MP Funds Management is a specialist real estate investment manager and has invested in real estate assets with a gross value of c. $1.1b over c. 21 transactions, producing an investment return of c.21%.

Visit MP Funds Management here.

Read about our investment platform, Golen Goose Capital here.

 

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