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Stephen Hayes on how global real estate is changing

Stephen Hayes is the Global Head of Real Estate Securities at First Sentier Investors.

GH: A few years ago, you wrote an article called ‘The Evolution of Our Cities’. Has COVID changed what you expected then?

SH: There’s an extra theme arising out of the pandemic and still evolving around decentralisation. CBD-based tenants and many service-based tenants are adopting flexible work practices as standard HR policies and that's given employees much greater control over where they live. It values more of a lifestyle decision, whereas previously, the workplace location played heavily into where people chose to live.

There are many ramifications. From a commerce perspective, there's no overall change in total but it’s moved from centralised, densely-populated areas out to suburban locations. Over time, we expect to see more leisure and service activities appearing in town centres within each major suburb. From a real estate and infrastructure perspective, that means a lot. Land values have risen in suburban locations, not only across Australia but almost all major cities globally. The theme is the same and inflation has been rampant. It will take pressure off toll roads with less commuting, which is very inefficient, and there are lifestyle benefits as well. Employees can manage their time better.

GH: If a business moves to a hybrid work environment, do they still need the same amount of office space? And it looks like coffee shops and restaurants in the city are still quieter.

SH: It’s part of this decentralisation theme, and yes, retail in the CBD is disrupted. On the office tenancy question, it's yet to be properly tested because in Australia, the average larger corporate lease is around seven years so there are gradual maturities coming up. Accommodation requirements are assessed towards lease expiry so any changes will be progressive. But yes, absolutely, they will require less office space.

There are a couple of themes within the office market. One, there is a flight to quality, especially towards carbon-efficient and energy-efficient buildings. Things like touchless entry and a wide range of new technologies with that go with new buildings, but they're expensive as well, so tenants have to be able to pay for them. I don’t think that theme will be strong enough to prevent the overall disruption of CBD office space for an extended period of time. It’s not the death of the office building but there will be less natural demand. Vacancy rates will rise, rents will fall over time, including the retail services at the bottom of the towers as well. The building’s use may change, for example, towards education instead of corporate.

GH: You manage global portfolios, do you see any global trends which are not yet playing out fully in Australia?

SH: In many other countries, younger generations are adopting rental over home ownership. Historically, we have valued the Great Australian Dream, young people with a pattern of settling down in employment and entering into an extraordinarily large loan for up to 30 years. We are generally indebted to an institution for that time and at the end of a working life, the home is the largest asset.

Younger generations don’t trust banks, they're quite financially savvy and it doesn't make sense to have all their wealth tied up in a single asset like that. And now, the build-to-rent product from institutionally-owned and managed apartment buildings built purely for rent is absolutely compelling. That’s not only from an affordability perspective, but for lifestyle, a typical house or rented apartment cannot compete with these buildings.

GH: Why’s that? What makes them different?

SH: You enter the building using your phone, you enter your apartment using your phone, you arrange the lease on your phone, you pay your rent on your phone, if you want to. You contact maintenance to fix your leaky tap on your phone, if you want to move apartments, you use your phone, if you want to book the yoga room, or some office space, or the media room, or a car from the carpool or a bike … you get the picture. Younger people are growing up with these conveniences and technologies and it's an easy decision for them to enter this sort of product offering.

And here’s what Australians don’t yet appreciate. Firstly, it is in the interest of the institutional owner to maintain the occupancy. A renter leaving is very bad because then there’s downtime that hits the operating margin. So they offer a holistic product that encourages renters to stay, and that includes affordability. There is a symbiotic relationship between the owner and the customer. The other thing is – and this applies in Australia such as the Mirvac development of 215 apartments at Homebush called Indigo – the tenants can enter a lease for as long as they like. Indigo is let to 98% occupancy and most have adopted a 12-month lease, but tenants always have the option to stay. It gives the certainty and security, like home ownership, without the big upfront payment and an enormous loan for a long time. Australia has been really slow to adopt this.

GH: Other than the Great Australian Dream, any other reasons for that?

SH: State land taxes don’t favour it. If you think about an SMSF that owns an apartment – and that product will be heavily disrupted – if there are 100 apartments in the building, one apartment might incur 1/100th of the land tax liability. But each owner has access to the land tax threshold (currently $822,000 in NSW) so probably pays no land tax. Whereas if you own the whole building, you incur 100% of the land tax. The states are onboard in building more of this product with a 50% land tax exemption until 2040.

GH: Australia is part of the global ecommerce and industrial warehouse boom, which has benefitted the likes of Goodman and Charter Hall. Has this still got room to grow?

SH: This is early days. The first iPhone was launched in 2007 and we’re only 15 years into it. This will run for decades and decades. Cities are messy, disheveled places, they're not well organised, they were never expected to have such large populations with all the conveniences we have today. It will take decades to modernise supply chains. Procurement centres or logistical warehousing are nothing like they were 20 or 30 years ago, when they were glorified tin sheds. Now, these buildings are modern and full of technology. Some of the fitouts cost upwards of $500 million and they are integral to the future of society and cities.

Whenever we click on our phones, a lot happens behind the scenes, and much of it is inefficient. The tenant demand for modern logistical warehousing is the highest I've seen in my entire career. If companies don’t want to compete only on price, they must get it out of the door the fastest.

GH: You divide your portfolios into categories such as retail, office, industrial and specialised. How has the mix changed and what do you expect over the next three years?

SH: There’s a misconception that real estate portfolios contain a lot of ‘old world’ traditional-type assets such as tall office buildings and shopping malls. From a global perspective, those assets make up only a fraction of the real estate types by market capitalisation. The majority of real estate is in the new world, the modern economy where capital is going to not from. Residential is a large component, especially the apartment side. We have the widespread adoption of technology, logistical warehouses, technology hubs, data centres are an integral part of the whole internet usage and streaming services, self storage. Health care is massive with everything from acute care private hospitals to outpatient facilities, specialised rehabilitation facilities, seniors housing, skilled nursing facilities. The amount of capital going in is immense. Science and research and demand for laboratory space is off the charts, driven by the pandemic. There are a lot of opportunities.

GH: You recently launched a new fund with a carbon reduction focus, how will that work?

SH: Responsible investing has been fully ingrained into our investment process for a decade, so this isn't new for us. We've been able to collect data properly now to benchmark the real estate sector, including the carbon associated with developments. It's around 40% of man-made greenhouse gases, so it is a massive emitter. We're invested in some of the largest landlords in the world and they're sophisticated and we've been engaging with them on the carbon side. The reporting coming out of the publicly-traded markets for real estate only tells part of the picture on carbon. We want a full picture so every stock within our portfolio includes a complete carbon analysis. We take it to the landlords and say this is where you're behind.

GH: We know about solar and recycling, but do you have a couple of quick examples of how buildings are reducing the use of carbon?

SH: One that doesn't get a lot of air time and can't really be retrofitted is geothermal, using the earth's core temperature to maintain the ambient temperature. In most building, temperature control is a major use of carbon, the heating, ventilation and air conditioning (HVAC) systems.

GH: How does that work, do they drill hundreds of metres into the earth’s core?

SH: Not that far down. It’s a range of tiny pipes sitting underground pumping air from the building into the core and it either warms or heats and takes workload off the HVAC systems. We have a mixed-use (office and retail) investment in Toronto where they are excavating deep into the ground and building massive wells that will contain water from the lake to circulate through the building to maintain the ambient temperature. It’s so large they will be able to cater to a range of nearby city blocks.

GH: Do you own something now that you expect you still own 10 years from now?

SH: Most of our portfolio. The only component we probably won’t own is around 5% of the portfolio in hotels and resorts. They are more cyclical and starting to return to normal so we're looking for valuations that appeal. Everything else we invest in as a long-term owner based on strong fundamentals and thematics.

GH: You have global opportunities, but do you like any Australian stocks in particular?

SH: We spoke about logistics and the Goodman group is a global leader in the development of modern warehousing for long-term ownership. They also have a partnership model where they joint venture and a lot of superannuation funds and sovereign wealth funds invest with them. The high quality of their portfolio with targeted cities, high barriers to entry, land is scarce, they are experts at building. In Hong Kong, they have multi-level warehousing, five or six levels, and they’re in Japan, London, Paris, California, New Jersey. And their portfolio is 98% occupied, dividends have grown 6% compound over the last 10 years, earnings growth that we're forecasting for 2022 is over 20%, with earnings up since the start of a pandemic by over 40%.

GH: How do you manage a global portfolio from Australia and gain the local knowledge of conditions in other countries?

SH: Yes, real estate's very localised in nature, they are fixed assets, you can’t pick them up and put them in another market. Each asset is different based on local fundamentals. So we've got a team of 10 located in Sydney, London and New York, in the different time zones. We’ve been together a long time and our track record speaks for itself.

GH: I must finish by asking you about sensitivity of real estate to inflation and rising rates.

SH: Central banks have been very accommodating with ultra-loose monetary policy, and as we all know, that's changing. But even with some rate rises, from an historical perspective, rates are still very low. There is a long way to go before money supply is constrained but central banks must act to control inflation. So in real estate and financial markets generally, the required returns will rise over time. If you're invested where the real return is not high enough, you will get impacted. But if you’re in the new economy, a beneficiary of these societal change, with low unemployment rates and healthy household finances, many will benefit and that's where we believe we’re invested.

 

Graham Hand is Editor-At-Large of Firstlinks. Stephen Hayes is Head of Real Estate Securities at First Sentier Investors (Australia), previously Colonial First State Global Asset Management and a sponsor of Firstlinks. This material contains general information only. It is not intended to provide you with financial product advice and does not take into account your objectives, financial situation or needs

For more articles and papers from First Sentier Investors, please click here.

 

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