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MP Funds Management Review and Outlook 2017/18.

Snapshot / Markets

Australia

Mar 03 2018

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Our view.

For 2018, our investment decisions will continue to be driven by opportunities presenting strong property fundamentals and outstanding risk-adjusted returns, with a focus on primary capital cities across the Eastern seaboard of Australia.  

Our investment views are predicated on our belief that based on Australia’s aging population, the government is going to need to stimulate immigration of taxpayer population to provide required financial, medical and other support for this older demographic. The continued growth in the Australian population, together with impending shift in the control of wealth from generation X or the Baby Boomers to Millennials, as well as the results of the Australian Prudential Authority (APRA) imposed cooling initiatives, restricting the overall primary bank debt markets are themes that will continue to shape and drive our investment preferences. 

With this in mind, we are of the view that commercial office in core markets, high-quality residential, and retail that has an experiential or "destinational-day-out" focus will continue to improve in value over the long term.

The APRA measures, which commenced at the end of 2015, have meant that debt is harder to get across the board, be it consumer mortgages for a home or off the plan apartment, or construction and development financing loans for both residential development, as well as the development of commercial assets.

At the moment, major banks are primarily mandated to seek debt- funding opportunities for stabilised assets and at LVR’s (Loan to Value Ratio) generally below 65%. Or, where banks will lend to developers, it has to be in a location which isn't blacklisted and to a developer that has a long-established, reliable, track record with the bank and even then it’s challenging.  

These lending rules are predicated on our high levels of household debt, which is currently at 120% of GDP. Also in 2015, global hedge funds started shorting Australian bank stocks because of their high exposure to Australian consumer home mortgages and residential development debt.  The global Managers perceived Australia as having a housing bubble. This perception, which has been exacerbated by the media, didn't take into account our massive levels of localised regulation. 

Additionally, the Australian housing market represents over $7 trillion in savings, the increase in asset value over the last ten years has been considerable across the major capital cities.  According to the Real Estate Institute of Australia statistics, the median unit price in Sydney has increased approximately 85% over the last decade and median house prices more than 110%.  This has made the average Australian wealthier than what they were ten years ago.

Most investors and homeowners are well "in the money” when it comes to their bank LVR covenant on their home loan. Moreover, strict Australian banking rules mean that borrowers are personally obliged to repay that loan rather than hand the keys back - USA GFC style. Nonetheless this requirement that the major banks make lending criteria more rigorous, and increase their NTA (Net Tangible Assets) has been implemented, and makes Australia safer than ever and more appealing for inflows of investment capital. 

Immediate knock-on effects.

All of this above has had a multi-faceted effect in Australia:

1.    Media has been covering the immediate resulting decline in both, residential prices (10-20%)  and auction clearance rates, which has fueled the unfounded view that we have a housing bubble

2.    Local would - be home buyers who actually can get bank funding or alternative funding from a non-bank lender have become exceptionally cautious because of this media coverage and the process to get a home loan is more invasive, arduous and protracted than ever before, even though the cash rate is at historic lows. The thing is that banks can’t put interest rates up quickly because our nation of consumers has leveraged at the old bank lending rules and standards, despite the increase in equity enabled in the last ten years of market growth.  We have high levels of household debt, and the APRA cooling measures are working at reducing this.

3.    The housing market has slowed significantly, as has the development of residential apartment product, both because of the difficulty in obtaining debt/ new mortgages. Development needs off the plan sales to get bank funding for construction, however, if the off-the-plan market has become significantly more conservative, less development will get off the ground because developers will not be able to reach their presales hurdles to get this construction funding from the bank, in turn restricting new supply. [Banks require 100% plus of debt coverage from unconditional presales commitments]. Non- bank lenders have stepped in to take the bank's positions however these funding groups also have a requirement for pre-sales.

4.    Australian banks, with their increased NTA requirements as mandated by APRA and more conservative lending guidelines, are robust and becoming more so. As pillars of the Aussie economy, this makes us safer and more attractive as a global investment destination.

China.

At this same time, China has imposed measures to restrict outflows of Chinese capital to a cap of $50,000 per annum. Free-flows of eye-watering Chinese money into the Australian property sector for the previous several years was perceived as a significant outward contributor of the upward pressure on house and other property sector asset prices. There has been recent coverage suggesting declines in Chinese investment into Australia of up to 60%, however where things become a bit opaque is where some Chinese – owned assets have been reported as changing hands, for example Wanag Jianlin and Dalian Wanda’s billion-dollar One Alfred development in Sydney’s Goldfields House, the asset has actually changed hands to Yuhu Group, a Chinese company that Wang Jianlin and the Chinese state may have a potential and significant interest in.

Also, where groups like China’s most prominent insurance company, Angbang went on a global $30billion buying spree in the USA, buying significant assets like the Waldorf Astoria, the Chinese government has now taken control of those assets on the premise of Angbang’s high levels of corporate debt. What isn’t clear though, is the Chinese Government’s interest or shareholding in Angbang. Regardless of the individual entities fronting the media coverage of the transactions and the economic reasoning behind the so-called transactions, the whole thing looks like a lot of corporate veiling of Chinese state-controlled and government-owned companies in an ongoing expansion of the Chinese footprint and asset control globally.   

From a geopolitical standpoint, China owns over one-fifth of the USA's $20.1 trillion Government debt. As at 2017 the USA's debt sat at about 104% of their $19 trillion GDP.  Given the vested interest these countries have in each other, it is going to be unlikely that anything other than media commentary and showmanship ensues between them.

China remains our primary trade- partner and continues to be the primary consumer of our property for the foreseeable future. Interestingly, China's notoriously low household debt has crept up recently, averaging 28.4% over 2006-17 and then at the end of 2017 hitting 46.8% of their gross domestic product (GDP).  

In further developments, term limits on China’s presidency may be removed as part of several constitutional amendments to be considered at the annual congressional meeting that starts this week on March 5. While somewhat controversial, the abolition of term limits is expected to be approved. This is expected to have negative implications for China’s economy and if this is the case, will likely create further motivation for wealthy and middle-class Chinese to send their children to Australia for education and to themselves immigrate.

Brexit has made Europe less attractive to global investors with sentiment at a significant low. America has a controversial Government, and so vanilla Australia looks pretty good, globally speaking.

MP Funds Management 2017 highlights.

During 2017 MP Funds Management had had 13 investments repay that produced a blended investor IRR of 22%.  Regarding new deals, we have been actively reviewing opportunities in the market and run due diligence on a large number of investments that we have chosen not to proceed with mostly, based on our assessment of risk vs. return and pricing.

Some highlights for us regarding our completed investment in 2017 were:

1. Our involvement with Ashe Morgan at Post Office Square in Brisbane, which was a mixed-use asset in the CBD of Brisbane, with over 40% of the rental income underpinned by a car park lease.

2. Our involvement with Centennial Property Group on 132 Arthur Street, a commercial office tower in North Sydney. 

3. Our involvement with Thakral Capital Australia in Tim Gurner's stage one $350m FV project, which was 651 apartments and 1700 sqm of ground floor retail, which has been occupied by Winnings Appliances.

In December 2017, we co-invested with Ashe Morgan in their acquisition of 9 Hunter Street, in the CBD of Sydney, an outstanding asset. Sold by Corval, who acquired the asset in 2012 and spent significant capex on it, it presents to a very high standard.

Ashe Morgan secured the asset from Corval in December for $202 million, with significant rental growth opportunity and further planning upside.

Asset highlights:

•    The asset provides income from day one and a running yield. It’s made up primarily of a 15,548sqm stratum office asset that was 98% occupied on acquisition with a mix of high-quality tenants enabling an average passing yield of 5.2% (on the purchase price).  he baseline IRR is in the low double digits, with no development risk. The value-add works projected to be carried out by the sponsor have the ability to bring the overall IRR into the high teens. 

•    Ashe Morgan, the principal, and the primary investment manager have co-invested themselves in the deal, so there is a high level of alignment.  

Where the upside exists:

•    The asset was acquired at $13,000 per sqm when most other assets within the proximity are trading for closer to $18,000 or $20,000 per sqm, also its under-rented at $780 gross rent per sqm, with market rents more in the vicinity of $900-$1200 gross per sqm.

•    The Brookfield development of Wynyard station, diagonal to 9 Hunter together with the closures of George Street to make way for the pedestrian mall area, light rail and gentrification of Circular Quay means that all properties in the immediate precinct will benefit.

•    There is also the ongoing theme of diminished office space supply in the Sydney CBD, driven mainly by the conversions of office space to residential and hotel uses and compulsory acquisitions by the government for the new Sydney Metro transport system.  This reduction in supply, with the limited short-medium replacement of stock, has driven rents up significantly, kept incentives low and provided for Sydney having the lowest vacancy rate of all Australia office markets at 6.4% currently.

Looking back and looking forward.

Most of the investments MP Funds Management was involved in during 2014-16 were debt deals for development, primarily the construction of residential apartment projects. Given the softening of the residential market in the short term, (mostly driven by APRA cooling measures), non- bank lenders have stepped in to provide stretch senior construction funding at rates between 10% - 15%. Although for a developer this may seem expensive, and for an investor providing a high-ranking security is attractive vs. our usual second-ranking position as mezzanine, the residual IRR doesn't meet our targets because of the multiple progressive drawdowns. There is too much cash-lag.

Sitting in the waterfall behind an expensive non-bank senior debt provider, as a mezzanine-type construction funding investment, especially with a slower market isn’t attractive.

We will continue to look at residential deals that meet our return targets, have proper sponsor alignment and that have a risk profile we are comfortable with. We are also interested in pursuing land banking opportunities.  As usual, we will co-invest with other groups, across multiple asset classes, where the property fundamentals are strong, and there is substantial track-record and proper alignment.

Our population growth story.

Our view is that our aging population is a significant factor that will drive and shape the Australian economy and fundamental dynamics which will have a knock on to all property sectors.  

The population growth story and the difficulty with planning mean that at some point soon residential pricing is going to become a real issue due to lack of supply. There is an ongoing and growing need for government to provide support around planning, affordability, and supply.   We have experienced over a decade of undersupply in housing, and so this current pullback in supply is considered a long way from being a structural surplus of housing.  Read more here.

In Australia, as in London and most established first world countries, we have an aging population. Our current Australian population is 24 million, and 14% above the age of 65 requires tax-payer financial support. In about 50 years’ time, based on current growth, that number goes to 52 million and 25% will be over 65. This means the tax-paying working population will need to support the 25% who require additional government – provided financial and medical support.

Wages growth has been fairly stagnant so the only option (aside from aging parents living with and being cared for by their kids) is to look to job creation and immigration of skilled, tax-paying working population.

As at September 2017, Australia’s budget deficit was $4.4 billion lower than expected and aside from increases in corporate taxes, the improvement was primarily due to cuts in social services payments. The $33.2 billion deficit represents 1.9 percent of GDP.

Separately Australia’s Government debt is $326 billion, which as a percentage of GDP, is 18.9%. Our interest bill is anticipated to be $16.4 billion this year, which according to some commentators, the International Monetary Fund (IMF) sees this as a reasonable level or a developed country like Australia. According to some economists, what is going to prevent interest rates getting up to 18% as they did in the 80’s, is that our Government debts are denominated in Australian Dollars. In the 80’s our debts were in US dollars and other currencies, so any depreciation in currency exchange rates made our debt look risky and so the interest rate on our Government debt was increased, which was passed to the consumer.

As mentioned before, our household debt is sitting at about 120% of GDP, which is also what has driven these APRA cooling measures, to reduce the overall reliance on external debt, which is a good thing.

As a result of this aging population, Government is currently putting in place measures to significantly stimulate immigration to grow the skilled, working/tax-paying population, by digitizing the immigration processing platform. This will mean more efficient processing times and enable larger volumes and inflows of skilled labour.

Our ongoing requirement for housing.

Again, bringing this back to housing, in NSW we have a housing deficit and new supply is very restricted due to tight local planning. The upshot of all of this is that despite any current regulator imposed cooling measures which have put recent downward pressure on house prices, our housing market is going to continue to get exponentially more expensive.

The current commentary is tending to focus on immediate short-term decline fear, but the macro supply-demand fundamentals help paint a more accurate long-term view.  

If our population is growing at a faster rate, via immigration, than our housing supply can accommodate, this will not only mean upward pressure on house and apartment prices but will also mean significant upward pressure on residential rents.

Groups like Mirvac Stockland and Lendlease are currently exploring the “build-to-rent” sector, however, more support from Government is required regarding rebates and tax incentives. The success of the established “multi-family” sector in the USA is what needs to happen in here Australia.   

The other thing that needs to be taken into consideration is that the property industry has doubled its contribution to Australian Gross Domestic Product over the last decade, and since 2014/2015 this contribution has outstripped mining and financial services.  Further to this contribution of GPD by the property sector as a whole, is the flow on effect from the industry creating not only demand for goods and services but also job creation. 

The role of the property and its associated industries in supporting economic buoyancy and growth is critical and needs to be supported by Government. Particularly in terms streamlining planning processes and continuing to focus on making housing more affordable for Australians.

From a futurist or evolutionary perspective, as an investment and asset class, property as bricks and mortar will always be required it can’t be outmoded or made irrelevant. Despite any improvements in property "green" or "smart" homes and offices technological advances in improved building methodologies, we will always need a roof over our heads or a place to go to work.

All of these themes point to growth in the property sector long term as a whole. We will continue to make refinements to our approach to take into consideration any short-term volatility with a key focus on high-quality assets in core markets.

More than ever we are focused on being dynamic enough to take advantage of any high quality mispriced opportunity that fits within our investment objectives and presents an outstanding risk-adjusted return.  

Mandi Prager, CEO, MP Funds Management

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