Investing in real estate in a high interest rate environment




Sequoia Asset Management Investment Manager Winston Sammut discusses property opportunities and pitfalls in the current economic climate.

Paul Sanger: We are talking today with Mr Winston Sammut, an investment manager at Sequoia Asset Management. Winston has over 40 years' investment experience, including 20 years in the listed property industry. Winston was previously the Head of Listed Securities with the ASX-listed property fund manager Charter Hall Group (ASX:CHC). Winston, welcome back to the network.

Winston Sammut: Thank you.

Paul Sanger: So, let's get into some questions now, Winston, within your sector. Is there specific property exposure that stands out as an opportunity or possibly even a safe haven in the current environment?

Winston Sammut: There are a number of REITs at the moment that are yielding 6 and 7 per cent, which is quite attractive. And they're not in the traditional property sectors that are, I suppose, in areas that do have question marks over them. And by that I mean commercial office space and retail as well. Now, these areas are supported by government funding. So, I'm talking about childcare. I'm talking about retirement and seniors living, not aged care, but retirement and seniors living, and, to some extent, rural assets, given that Australia is the food bowl of Asia.

Paul Sanger: Okay. Moving on, Winston. Do you see a situation at present where valuations have decoupled materially from the outlook? And how would you approach such a scenario?

Winston Sammut: Well, what markets don't like is uncertainty, and there's certainly a lot of uncertainty about valuations. In the property area, we have two different types of valuations that are being looked at, and that is valuations of unlisted investments or direct property funds, and valuations in the listed market, where people can trade daily, buy and sell as they wish, whereas in the unlisted there's windows of redemptions and so on.

Now, all properties are generally valued once, fully valued once every three years. More recently, they're being valued much more frequently. So, what an entity does generally is they'll get a proper valuation, a full valuation, on a third of the portfolio one year, then another third the next year, and then a third on the third year. So that over a three-year period, all the properties are actually valued.

Now, the unlisted market has been fairly slow to adjust their valuations to reflect the fact that interest rates have gone up quite a bit. Whereas in the listed market, a lot of the stocks that are trading are trading at 25 to 35 per cent discounts to their net asset value. So, they're very, very big discounts.

Now, what is likely going to happen over time, ASIC has said that they are looking at valuations in the unlisted area, so there's probably a bit of pressure for them to adjust accordingly, but they seem to be coming down via the stairs as opposed to via the lift in the listed area. So, I expect more pressure on valuations, particularly if we do see some more rate rises in the next couple of months.

Paul Sanger: Winston, regarding listed property exposures, are currently equity prices reflective of the changes in the property sector, and do you anticipate more downside, particularly in the office space?

Winston Sammut: That is a good question. Look, as I mentioned before, in the listed market, it's probably been overdone on the downside. So, the valuations are probably about where they should be. The most recent valuations in the listed area that have come out have shown prices or values down by 5 to 10 per cent, in some cases a little bit more, whereas in the unlisted market, it's only about 4 per cent or 5 per cent. So we do expect, as I said, some pressure.

And in terms of office, the issue with office is that not only is it being hit by increased costs to fund the loans, but there's this work-from-home situation which is reducing the number of peoples that actually turn up into an office, and therefore it's putting pressure on and demand for office space, and pressure on the basis that, for the office REITs to do well, they need to get increased revenue from increased rentals, and that's not happening.

Paul Sanger: Winston, continuing on that theme, the ongoing debate in real estate revolves around whether the vacant office buildings in many cities will ever be filled again. Can I get some more thoughts on this?

Winston Sammut: Well, if Australia's going to follow the situation that's in the US, vacancies are very, very large over there. We are probably not quite as bad at this stage. Post covid, occupancy, as opposed to vacancies, occupancy was probably around 20-25 per cent. That has increased across the board over time. We're probably around 50-60 per cent, maybe in some cases 70 per cent, but we are not back at the 100 per cent, and we are unlikely to be back at the 100 per cent. People do now have a choice, even though some businesses are mandating two to three days in the office, in some cases, four. I know the CBA came out with an edict at the beginning of the year that staff should be in three days a week. That's not being met by the staff, and there's a lot of opposition to that.

So, there are issues in terms of occupancy as opposed to vacancy levels because, in terms of vacancies, a lot of the properties are actually leased and people are paying rent. Businesses are paying rent. But they're just not filling them with people. And that's going to be an issue going forward when they go to renegotiate their lease requirements, their space requirements, and how much they're going to pay for that.

Paul Sanger: Winston, the impact on the office property is evident, but to what extent has the recent inflationary interest rate environment affected the broader property sector?

Winston Sammut: Well, it has affected the broader property sector simply because increased debt costs, borrowing costs do put pressure on the bottom line, and unless you can grow rents at the same pace, you've got a problem because your outlays are more than they were and you can't compensate for that. And that is happening across the board in terms of all the property stocks, because generally they gear their exposures by around 30 per cent, which is the acceptable level. We are not back to the GFC days, where gearing was 40-50 per cent, but 30 per cent is an acceptable level. But even so, when you see rates going from 0.1 to 4.1 in a short period of time, it does impact on your borrowing costs.

Paul Sanger: Okay. Let's wrap things up for our investors. How about give us a few ideas about the stocks you currently favour, those you're closely watching, and just as importantly, the ones you're avoiding?

Winston Sammut: Well, let's attack the avoiding ones. At this stage, we're avoiding over exposure to office, commercial office space. To some extent, we are looking at reducing exposure to the retail sector. But retail, there are different pockets of retail. Discretionary spending has been under pressure and will likely continue to be under pressure given cost-of-living issues. So, people will be spending more on things they don't actually need, as opposed to non-discretionary, which is food, for example. So, in terms of retail, our exposure is on those areas where people have to buy goods, and that's supermarkets, petrol stations -- you've got to fill the car up if you want to travel -- and away from discretionary spending.

Also, I mentioned the issue with childcare, which is government-supported. So, not from the point of view of being invested in the childcare operators, but rather the owners of the bricks and mortars. So, stocks like Arena, Charter Hall Social Infrastructure, that own the properties with long leases. They're triple net leases. So by that, it means that all the outgoings are a function of the tenant, not the landlord. So, it's a better sort of investment. And aged or seniors living. Not aged care, but seniors living and retirement living, given the growing population. And again, that's supported by the government in terms of rental assistance. There are areas where you can see that there is demand and there is growth. If we are going to have more people go to work, the female workforce is going to be on demand, as it were, to go out and get work. That puts pressure on them to have children looked after.

Paul Sanger: Winston Sammut, thank you very much for your time today.

Winston Sammut: It's a pleasure. Thank you.



Name Paul Sanger