In this episode, we chat with Justin Pica, Regional Portfolio Manager at CBRE Investment Management, to discuss the future of the office sector, the advent of online shopping, the rise of inflation, and active management. We also explore upcoming challenges and opportunities in the sector and how investors can gain a potential source of income and growth from AREITs.

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Transcript

Paul O'Connor:

Welcome to the Netwealth Portfolio Construction podcast series. My name is Paul O'Connor and I'm the head of investment management and research. Today, we welcome Justin Pica from CBRE Investment Management, who is the leader of the listed Asia Pacific real estate research team and is responsible for the oversight of the firm's Sydney office.

CBRE are the appointed manager of the UBS Property Securities Fund and Justin is a portfolio manager. CBRE is one of the world's largest real asset investment managers. With US $124 billion in assets under management as of 31 March 2021.

CBRE Investment Management is 100% owned by the CBRE Group, a Fortune 150 company listed on the New York Stock Exchange. CBRE is a global, fully integrated commercial real estate services organization with over 100,000 employees in more than 100 countries.

The business is headquartered in Pennsylvania USA, and the firm employs over 60 professionals, including an investment team of 29 located in five offices around the world. CBRE is listed Real Assets Investment Management Business, and its predecessors have been managing investments on behalf of retail and institutional clients since 1994.

UBS Asset Management Australia Ltd is the responsible entity for the fund and is a subsidiary of UBS AG and is the parent company of the UBS Group, whose other main businesses include wealth management and investment banking. UBS is an active manager with varied range of capabilities across equities and fixed income.

And as of 30 June 2020, UBS Asset Management Australia managed 47 billion in assets under management. Justin Pica joined CBRE, his predecessor firm, in 2010, and prior to that Justin worked in a various research and analyst positions at ING Investment Management and the Commonwealth Bank of Australia.

He has over 24 years of real estate industry experience and earned a Master of Applied Finance from the University of Melbourne and a Bachelor of Business from Swinburne University. Justin is a member of the Chartered Accountants Australia and New Zealand and serves as a member of the Asia Regional Advisory Committee for the FTSE NAREIT Global Real Estate Index.

UBS has long established presence in the Australian funds management market and have six funds on the Netwealth super and IDPS investment menus across fixed income, equities, property, and infrastructure. The Australian listed property market is one of the oldest freight markets globally dating back to 1971 and is considered mature when compared to other offshore listed rate markets. But Australian retail and institutional investors have historically allocated to AREITs as an asset class due to the ability to gain exposure to high quality investment grade property and the liquidity also offered by the sector.

The asset class provides exposure to a wide range of properties, including industrial, office, retail, diversified and other properties such as health care, aged care, and hotels. The outbreak of COVID in March 2020 resulted in a significant sell off in the right market, along with the broader equities market sell off. But the AREIT sector bounce back, providing strong returns in April and May last year and ended the 2020 calendar year with only slightly negative returns in the current financial year. The AREIT index has returned more than 10%.

It has surprised many sceptics due to the impact COVID continues to have on the global economy. Whilst the returns have been sound, there are many issues for property investors to consider, including challenges like the office sector is facing, given the structural change to staff working from home and what that means for the broader office sector, notably, there's been significant variation in performance between the sectors, with the retail sector remaining subdued, which indicates there's good opportunities still for active management to add value.

However, strong growth opportunities remain for other subsectors of the AREIT market, such as industrial property that is continuing to benefit from the changing consumer behaviours, including online shopping and limited land supply, and the growing need for aged care and health facilities.

So, I'll certainly be interested in Justin's views on both the headwinds and the tailwinds across the whole of the AREIT sector, also, with the recent rise in inflation and debate as to whether this recent rise is the transitory or structural, I'll be interested in as views on the level of gearing across the asset class.

Perhaps to start with Justin, can you provide the audience with some background how you ended up specializing in listed property?

 

Justin Pica:

Thanks, Paul. I started my professional career outside of property. I grew up in Melbourne and after secondary school I undertook a degree majoring in accounting. I like numbers and felt accounting was a logical path to pursue. Early in my career, I was lucky enough to land an accounting role with National Mutual's property development subsidiary at the time. From there, a few things clicked or me, first, I realized I didn't enjoy accounting as much as I would have hoped, and secondly, I realized property was an interesting asset class and I began to build a passion for while working in the accounting role. I've been fortunate enough to have some great mentors in my career, and one of those mentors tapped me on the shoulder one day and suggested I should try my hand at property rather than accounting.

In 1999, while at National Mutual, I transferred into a property analyst role. This is how I segued from accounting to property. Following that, in 2001, I moved into a listed property analyst role, joining Commonwealth Bank and later ING Investment Management.

This really began my journey specializing in listed property. I'd found my passion and listed property and haven't really looked back since.

 

POC:

I'm glad to hear that Justin. I guess that that is the aim for all of us in a career there to find a passion that we really enjoy getting up and going to work for daily, so it's good to hear.

Moving into the questions for today's podcast, the volatility and listed equities markets post the outbreak of COVID was significant. So, can you provide some insights into how the property subsectors performed and namely industrial, office, retail and the other sectors?

 

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Justin:

The AREIT sector was down 35% in the month of March 2020 as COVID fears sending equity markets into freefall. It was one of the worst single months of performances for AREITs since the inception of the index.

On a relative basis, AREITs even battle versus other listed asset classes, AREITs underperformed local equity markets by over 14% in the month. They also underperformed global rates markets by over 17% in the month of March as well, looking at how the various rate subsectors fared, on a relative basis, the more resilient sectors fared better, as you'd expect, whilst the more economically sensitive sectors that were exposed to potential significant demand destruction from the COVID shock. The more majority of AREITs dropped guidance during the period, citing uncertainties around the economic impact of COVID.

The retail and office REITs were the major underperformer with groups like Centre Group and Vicinity Centres down more than 50% in the month, while Centuria office was down as much as 46%. Defensive stable bond like REITs with quality covenants and steady rent roles such as Bunnings, Waypoint and even Charter Hall REIT where down less than 20%.

Industrial logistics REITs such as Goodman and Centuria Industrial also fared better than most that were down between 20 to 30% in the month. Given their solid balance sheets and significant exposure to the growth in e-commerce and online sales, which was a clear winner before COVID and has only strengthened during COVID.

 

POC:

So, I guess the biggest focus has been on the office market due to the empty CBD office buildings in both Melbourne and Sydney that we've seen. So, what has been the impact on vacancy rates and rental yields? And did the market oversell the sector, which is sort of, I guess, usually the case during periods of significant market sells offs?

 

Justin:

Yeah, it's definitely the case this time as well. And just looking at direct market CBD office market vacancies have risen significantly with the onset of COVID, and sublease vacancies have hit new record highs for a period and rents have declined.

These market conditions have pushed tenant incentives to levels that have not been seen for many, many years and in some markets, and landlords have acted to mitigate the weakening demand supply backdrop. Rising vacancies, softer achievable rents, and adjusted occupier sentiment.

Vacancy rates in Melbourne and Sydney CBD have risen from 2 to 3% levels immediately pre-COVID to above 9% today. This is also above the long-term average vacancy levels, which are closer to six to 7%. Looking forward, we expect vacancy to remain elevated above historical averages for at least the next few years.

We're experiencing softer, effective rental conditions in 2021. This is on the back of weaker tenant demand. Net effective rents in Melbourne and Sydney CBD cities are down around about 12% in the past twelve months and nearly 20% from pre-COVID rental levels.

Many, many tenants continue to contemplate reducing their office footprints based on CBRE recent occupier survey. More than 50% of respondents have suggested they will consider reducing office space over the next three years.

Looking at rental yields before incentives, these yields continue to track in the mid 4% range and are holding relatively steady at pre-COVID levels across both Melbourne and Sydney CBD, albeit incentives can continue to rise in most markets, particularly in Melbourne, where they are now close to 40% versus 27% immediately prior to COVID.

We believe higher incentives will be sustained, least for the near term, given the combination of higher supply in some markets, increasing flexible working and elevated sublease vacancy versus pre-COVID levels across Australia capital values have been surprisingly resilient, they really only fall in around about 1% in the last twelve months.

And frankly, most of that fall has been in the secondary asset class of offices, which are down also around about 1% . From a listed market standpoint, unsurprisingly, office rates underperformed in 2020, and some were down greater than 15% and, as you suggested, rebounded in 2021.

The listed market has taken the view that offices are reopening, trade and economic growth is ultimately improving, and with COVID eventually behind us, this will be positive for office demand also office transit evidence has been better than expected through the pandemic. Office stocks continue to trade at five to 10% discounts to direct markets, our proprietary NAVs are high today and direct transaction evidence suggests assets are trading at book value or better. This is being driven by ultra-low interest rates, the continued search for yield and lower return expectations.

 

POC:

Justin, what do you believe is the future of the office sector and what's the AREIT market telling us? And what sort of insights can you shape from CBRE fundamental analysis of the sector?

 

Justin:

We believe offices will continue to be an important asset to the future that prospects the businesses taking ten to 15% less space in future is a real possibility. We expect a permanent increase in working from home result in a cumulative net decline in office demand, which is negatively impacting fundamentals and lowering expectations for rental growth.

People and businesses have a strong desire to be together, to collaborate, to build culture and support team productivity, learning and development. In future, the office will be considered more than just physical space, but rather a platform for professional business and personal development.

A recent Australian Sabra Future of Office survey suggested that over 70% of senior business leaders have a desire to bring employees back to the office, but at the same time they're willing to offer a greater degree of flexibility and choice.

Over 50% of respondents plan to implement policies allowing office-based working with the option of working from home. The adoption of this hybrid working arrangements will require companies to enhance their workplaces late to deliver the types of seamless and engaging experiences that remote working cannot.

Given the demands of Office of the Future, we expect to see a clear polarization of demand from occupiers and investments, less quantity and more quality believe there will be continued bifurcation between the winners modern, flexible, and environmentally friendly office buildings versus older vintage commodity style office buildings.

 

POC:

So, if you're correct, they just and the businesses are typically taking ten to 15% less space. What does that mean for current valuations of the office sector? Are they cheap? Are they expensive?

 

Justin:

Valuations are relatively cheap at the moment versus direct market values at the moment, Paul, the listed sector is trading at about a five to 10% discount to direct real estate asset values. And from a direct office real estate perspective, values that surprised us on the upside with that strong capital demands continuing in the space

 

POC:

Yeah, interesting, interesting, so striking me is potentially some investment opportunity there. Justin, what are you? AREIT sectors have been the biggest beneficiaries of the changing economy over the last twelve months and what trends have been accelerated that were already in place beforehand?

 

Justin:

I would point out funds, management platforms, residential, industrial, logistics, emerging and alternative asset classes, which are becoming more mainstream and parts of retail, namely large format retail and non-discretionary retail as a major beneficiary of a changing economy over the past twelve months.

The industrial logistics sector has been a clear beneficiary, I should say, of the growth in e-commerce and online sales. Well, this is a clear structural tailwind product. It is only accelerated because of.

The e-commerce market in Australia is increased 105% from 2015 to 2020 now accounts for over 13% of total retail trade. COVID has been a clear catalyst for the acceleration of this trend of online sales. With the online penetration rate jumping from 9 to 13% over the course of 2020 alone, Australia still lags other major countries and behind global averages of 22% for online sales.

Therefore, there is still great scope of expansion in this sector. CBRE forecasts the penetration rate of online sales to reach, if not exceed, 20% by 2025. REITs with sought after industrial logistics properties are benefiting from strong fundamentals with a step change in occupier demand and low supply in some key markets, resulting in capital and rental value uplifts the REITs. Capital values have been particularly strong, with most of the industrial REIT portfolios recording strong cap rate compression of greater than 50 basis points and valuing places at close to 20% over the past twelve months.

 

POC:

So, investing in beds and sheds has been a positive thematic and a focus for many real estate investors, including CBRE. What's the AREIT market telling us about logistics and residential?

 

James:

Currently, the industrial logistic names have outperformed both Goodman and Centuria Industrial are both up over 20% year to date. We're also seeing the market show a preparedness to pay higher multiples for groups that can add value to assets through either development or repositioning themselves or third parties.

We believe the running industrial logistics can continue in public markets over the medium term. Physical occupied demand is high, land is scarce, supply is generally in check and the earnings growth is healthy. This is supporting higher values , our NAVs are higher, typically mid to high single digit year to date.

Turning to the AREITS related rates, these various business segments have performed very well over the past twelve months. These stocks are showing better sales activity, driven by ultra-low interest rates, heightened savings rates, improving employment conditions and good demand supply conditions.

 

POC:

I've noticed just in that many retail centres have been transforming in recent years by, I guess, broadening beyond the traditional retail shops by including, I guess, you know, things such as dining and entertainment and health care. So, who have been the winners and losers in this sector?

 

Justin:

Retail sector outlook has improved for the most part in 2021 versus 2020, driven by the reopening of economies. Better consumer confidence and deeply discounted listed property valuations in the investor demand is also improved, particularly in the large format retail and non-discretionary retail areas.

And this is where we're focusing our funds retail REIT exposures. While retail stocks overall have underperformed the AREIT index in 2021, some retail markets and some sectors performed better than others. Discretionary retail is continuing to suffer from COVID disruption to business activity.

They also continue to face structural headwinds. The growth in ecommerce is causing elevated down times and pressures on remixing particularly too much fashion, high maintenance, capex and over renting. In a nutshell, the long-term structural challenges posed by e-commerce have combined with the cyclical shock caused by the pandemic and so falling capital values over the past two years and deteriorating effective rents are widespread across the market. Turning to non-discretionary retail fundamentals have held up better the asset classes demonstrating income resilience during COVID and has benefited from increased sales and less structural risks. Given many of the tenants’ services, daily needs and essential services based.

 

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POC:

You mentioned earlier, Justin, that the alternatives are becoming more mainstream. Where are you finding the opportunities in the alternative real estate asset class? And what lessons have you learned from being part of the global CBRE team that actively managed portfolios across the world?

And I guess can provide you with some insights about trends and themes going on in other markets as a result?

 

Justin:

Yeah, emerging, and alternative sectors. Which are typically uncorrelated to other asset classes are becoming more mainstream. Particularly with the headwinds facing many of their traditional commercial real estate, asset classes, office, and discretionary retail, for example, and pricing in industrial is becoming very rich.

These alternative sectors include childcare, health care, landless communities, built to rent, storage service stations and even the agricultural sector. Certainly, these sectors have traded at why'd you bring traditional real estate but COVID has illustrated the resilience of these asset classes through times of economic uncertainty.

Public markets globally benefit from significant exposure to alternative sectors, particularly the US REIT market, which has over 50% waiting to alternative sectors. The Australian REIT market has been slower to move into alternative real estate relative to the US, with close to 10% and growing weighting today.

There are listed opportunities in Australia to get exposure to most of these niche sectors. But a percentage of the AREIT index is relatively small, so it requires an active manager to be able to allocate more to these things.

We think that the agricultural sector is a great inflation hedge with rising demand for commodities, specialist managers are showing an ability to improve the productivity of farmland for many different uses, including cattle, cropping and plantations, for example. When done well, this can create significant value for shareholders.

The childcare sector benefits from increased demand function of greater urban density and population growth. Government community recognizes the importance of day-care, additional education and support native primary school and the positive impact it has on increased workforce participation, particularly from females.

Sector also enjoys strong government support in the form of subsidies, as seen through a COVID, when it was considered to be an essential service against landless community sector. It has been a beneficiary of positive demographic trends and the need for affordable over 55s retirement accommodation.

The strength and liquidity of the residential market is also providing an additional tailwind as retirees can sell their homes faster, facilitating the move to landless communities, income from owners in this asset class is underpinned by government pensions.

It's very high quality and low risk income, and we've seen no defaults during COVID.

 

POC:

So, we are in times of rapid change. And what are the key themes and ideas you're thinking about and focused on in your Australian portfolio? What about your CBRE colleagues in the US? What are the key themes and ideas they're considering in the US context, and how does that help your thinking and inform your views?

 

Justin:

In Australia, we prefer many of the things we've already discussed, including non-discretionary retail, residential, funds management platforms and alternative sectors such as land, communities, childcare, and agriculture. Non-discretionary retail is showing strong rental income resilience. It's enjoying high cash collection through COVIF and has low e-commerce impact and offers affordable rents to tenants. Investor appetite is strong and direct asset values are continuing to rise in this sector.

Emerging and alternative asset classes, including land lease communities, childcare, and agriculture, are benefiting from positive long term structural demand things. They have sort of the government and institutional that income streams are attracting ongoing international and domestic capital to these asset classes.

Fund management platforms are benefiting from continued search for yield and relatively attractive narratives of Australian real estate, we expect that trend to continue.

Turning to the US, some of the things that are resonating with our team includes industrial, logistics, retail malls, shopping centres and storage, to name a few. Retail shopping centres in the US are benefiting from resilient non-discretionary spending at the type you'd see U.S. supermarkets and pharmacies. We also like a quality mall REITs, superior balance sheets where valuations are attractive, and growth is actually accelerating from 2020 lows. The appealing alternative asset class sector, our team like, is office storage, offering resilient and attractive long term growth attributes supported by accelerating demand and rising rental rates.

At CBRy, we benefit from being part of a global real assets investment specialist. For example, our US team's fundamental knowledge and investment experiences in the land lease community sector, which is a far more mature institutional asset class in the US versus Australia, has helped us locally better appreciate the attractive investment attributes of the sector.

This is only just emerging in Australia, with groups like Ingenia lifestyle communities and Stockland entering the land lease community sector.

 

POC:

Given the ongoing debate about the rise in inflation, is real estate and actual inflation hedge given, I guess many rental agreements, including inflation or CPI in annual rent increases. So, it strikes me that it is and it can provide some inflation protection.

 

Justin:

It is. Unlike bonds, income streams grow, many lease structures have built in CPI pumps, while other sectors have short duration leases, that reprice in the short term, depending on market conditions.

Over the past 20 years, AREITs have generated over 4% outperformance relative to broader Australian equities during periods of above average inflation expectations, albeit it's fair to say in the short term, the sector can underperform when inflation rises quickly, and bonds sell off sharply.

 

POC:

So, with interest rates at historic lows, I guess prudent gearing to me makes sense. So, can you provide the listeners with some insights into the level of gearing across the AREIT sector?

 

Justin:

Today, gearing is 24% across the sector. This was 27% a year ago. In the context, prior to GFC, gearing set around 40%. Unlike during the GFC in the COVID recession, real estate companies balance sheets performed very, very well and are in good shape.

Speculative activity appears in check. Today, the sector has much longer dated debt and more diversified debt sources. In the GFC, it was mostly bank debt, with short dated or lumpy expiries. Importantly, during the COVID recession, public companies maintain continuous access to both debt and equity markets.

 

POC:

And maybe finally then Justin, to the last question, many investors allocate to AREITs in their diversified portfolios to provide a reliable source of income and for the potential for some capital growth, and hence need to consider whether they going to employ an active or passive strategy to provide this exposure in their portfolios. As 2020 was a highly volatile year for equity markets it is a good opportunity, I think, to assess active managers performance and test the merits of active management. So how did your fund perform over recent years and including 2020? And what do you think CBRE's keen point of difference is?

 

Justin:

Our fund delivered almost 14% per annum on a rolling three year basis, and that's off the fess and has added more than 4% of 400 basis points of annualized performance over the benchmark in that period. In the 2020 calendar year, the fund was broadly flat and outperformed the benchmark by around about 4%.

Importantly, in 2020, the fund outperformed through the volatility in both strong up and strong down markets. Active management meant you weren't a total passenger through the market's ups and downs of 2020. There were substantial opportunities for active AREIT managers to add value over a passive index fund due to potential for significant alpha generation in the AREIT sector.

Wide stock and sector dispersions, as we saw in 2020, increase the opportunity to drive alpha through active management. Expectations for increased M&A, for example, allow an active manager to overweight opportunities, whereas passive strategies are at best, a market weight. The AREIT index is typically had high weighting of over 50% of additional real estate, such as retail and office asset classes, providing active managers and ability to over allocate, I should say to preferred things, such as highly sought after alternative and emerging sectors. Our funds’ performance has benefited immensely from active exposure to long dated positive structural trends, while avoiding those areas with structural headwinds, merging asset classes like land lease communities, childcare, health, and agriculture, for example, many of these things are underrepresented in AREIT index. As a manager, we believe the fundamentals we observe in the direct real estate market ultimately drives performance of public real estate stocks over the medium to long term.

Our key point of difference, and one of the reasons why you would choose CBRE is our information advantage. Our connection to the CBRE group resources, systematic and repeatable investment process. We are uniquely positioned investment manager within CBRE Group specializing in listed real assets.

Our information advantage, is our ability to leverage CBRE extensive direct real estate network of brokers, researchers,  property managers, praises consultants and lenders to draw unique and timely insights. Ultimately, harnessing the extensive data and market insights to drive better stock and portfolio decisions, resulting in better investment outcomes.

We believe our proprietary information advantage and extensive data resources ultimately supports our systematic process and provides us an ability to consistently deliver excess returns to our clients.

 

POC:

Justin, it's been an interesting discussion and particularly hearing your insights into the AREIT property market and some of the challenges, I guess, and the volatility we've experienced over the last 18 months, but also i guess some of the resilience of the sector in the subsectors, some of the growth opportunities that you've highlighted in talking through, I guess you views on industrial and office and retail and diversified and I guess the alternative properties asset class, including like healthcare and aged care. So, I'd just like to thank you very much for joining us this morning on the on the Portfolio Construction podcast series. So, thank you, Justin, for your time and your insights.

 

Justin:

Thank you, Paul and Netwealth for the opportunity to speak with you today. It's been very much appreciated.

 

POC:

No it's been an enjoyable discussion, hearing your insights there, as I've mentioned there and I guess the broader views of the CBRE Investment Management business there and to the listeners, thank you for joining us again this morning on the podcast series.

I do hope you're having an enjoyable week given springs now. Honestly, the weather's certainly providing a more positive outlook for us all as we get up in the morning. But wishing you all the best and I look forward to the next instalment of the Portfolio Construction Podcast series.