Adam is the co-founder of Forza Capital, a property funds management business that specialises in value added and opportunistic investments on behalf of high net worth investors. Over the 11 years of operation, Forza Capital has built an enviable reputation through delivering investor IRR’s (net of fees) on concluded transactions of over 23%.
Adam heads up the investment side of the business. Adam has a strong interest in governance, sustainability and philanthropy – he was the former Vice President of the Property Funds Association of Australia (PFA), founded its Sustainability Committee and is currently involved as a Committee Member of Gruppetto, a philanthropic sub-fund of the Australian Communities Foundation.
Thematics’ have been a key driver of property investment decisions of late. Whilst they can be important indicators of market direction, they can be often overemphasised and should be considered secondary to core investment fundamentals.
When markets become dysfunctional, there is often a ‘flight-to-quality’ effect where investors rotate to perceived safer asset classes. In comparison to equities which have seen unprecedented levels of volatility in the wake of COVID-19, it’s not difficult to see why real estate is attractive given the ‘bond-like’ steady income streams that are often secured by strong covenants and long-term leases.
Increasingly investors and fund managers have invested heavily in ‘thematics’ in search of these long term income streams. Some of these thematics include healthcare, certain industrial and logistics property as well as childcare, non-discretionary retail, service stations and hardware (Bunnings).
Broadly speaking the interest in these sectors is justified – the tenants themselves are specialised and have been buoyed by structural changes and demographic or economic tailwinds which have resulted in increased revenue and stronger balance sheets. In many cases however, properties that have exposure to these thematics are being bought at very full prices where buyers are paying a premium for the tenants rather than the underlying assets.
Importantly, this can create significant downside risk for three key reasons:
Even if the tenants are specialised, often the properties themselves and the spaces they lease are not. One example of this is medical practices, which typically require fairly basic fit outs. Whilst the tenant fits the keenly sought after healthcare dynamic, there may be little preventing them from relocating to another nearby site at the end of a lease term. If considering a thematic property investment, one must ask - if the tenant underpins the value of the property, what are the barriers to them leaving?
It is important not to overpay for thematic-backed property. Whilst strong tenant performance may mean they are less likely to default, the landlord does not share in the profitability of the tenant’s business. In most cases, the only guaranteed return for landlords is the contracted rent.
Often where thematic are involved, a premium is paid for exposure. If the dynamics change, the resulting impact on capital value can be devastating. In 2019, the Charter Hall Long WALE REIT held the Virgin Australia HQ office in Bowen Hills Brisbane at a value of $95.5 million – a price driven by an apparently blue chip lease covenant. When Virgin announced they were vacating despite having more than 6 years remaining on their lease, the property was revalued at $52.5 million – a staggering 45% write down, with the fall in value far greater than the 6 years of lost income under the lease.
The alternative to buying the tenant is to start by analysing the fundamental value drivers of an asset. Rates per square metre of land and building area are good places to start, and all considerations relating to the leases and tenants are secondary.
By focusing on these key attributes, it facilitates a defensive investment position whereby the property value is less dependent on specific tenants or lease covenants. This is what really constitutes ‘buying well’, which is how the best investment strategies begin. Buying well is also important in attracting and retaining tenants because it creates a competitive advantage by enabling lower rents (for the same investment return as the competition) while providing attractive leasing spaces via new fit outs, new EOT facilities or new amenities.
It is also preference that any investment has a multiplicity of uses. The first reason is that it is easier to attract tenants. Niche tenants can be harder to find and secure, and being able to appeal to a greater market of replacement tenants fundamentally reduces the risk of the investment position. Assets with a range of uses are more resilient to structural change and can also provide greater flexibility to pursue alternate or higher and better use outcomes, adaptive reuse options, or repurposing of unused space for value creation and alternate exit strategies.
Whilst interest rates appear to have bottomed out and are now trending sideways, yields in many sectors have tightened. In addition to cheap credit, the sheer weight of global capital willing to accept low returns for getting exposure to the Australian property market makes it increasingly difficult to generate compelling, risk-adjusted returns.
Furthermore, over the last few years, bullish investors, local and overseas alike, have been rewarded as marginal deals have turned into windfalls as property has traded at sharper and sharper yields. This has conditioned the market and further reinforced the notion that the only direction for property is up.
While the argument can be made that there may still be room for further cap rate compression, our view is that this should be the ‘blue sky’. It can be dangerous to use hope-based strategies that rely on assumptions outside ones control to generate returns.
Regardless, the aggregate of these trends is that, in many cases, properties are traded above their fundamental, or ‘sum of the parts’, valuations. This means it is increasingly difficult to buy well, and it is necessary to actively drive value creation and work to manufacture upside in order to reduce downside risk and generate investment outperformance.
It is often said that investing is simple but not easy, and this is as true in property as any sector. To focus on capital preservation, one must determine value and the pricing of risk, both which can be skewed by overemphasising thematics.
It’s not that thematics aren’t important - it’s simply a case of ensuring that a significant premium is not paid for exposure to such thematics.