Episode 6 – What’s in store for real estate in 2024?

Disclaimer: The information contained in this podcast is general information only and opinions of participants are their own and not the views of their organisations. Any advice is general advice only. Past performance should not be relied on as indicative of future performance. Intro: Welcome to The REAL Deal, a monthly podcast about what’s happening across the real estate and infrastructure sectors.

Episode grab (Andrew): I learned a phrase very early in my career, Darren, that said no one pays a premium for uncertainty, and what we saw over the last 12 to 18 months is a period of uncertainty around where that risk free rate is going to sit. Now, I feel that investors are starting to narrow that variance around expected probabilities, and that in itself forms a level of confidence and gives you more certainty and confidence in how you price-risk assets.

Intro (cont.): That was Andrew Ballantyne from JLL, who joins Darren Steinberg to discuss what’s ahead for Australian commercial real estate sectors in 2024.

Darren: Welcome everyone to The REAL Deal podcast and Happy New Year. It's great to be back in the studio for the first episode for the year, and today we are joined by Andrew Ballantyne, Jones Lang LaSalle’s Managing Director for New South Wales. We'll be discussing the outlook for the year ahead, based on the trends across the key real estate sectors. Welcome Andrew, thanks for joining us today. Now before we kick off Andrew, why don't you give us a quick rundown of your background?

Andrew: No problem, Darren. I should probably start with the accent because that goes all the way back to the west coast of Scotland, which I left in 2001, did a short spell in London, and then was very fortunate to turn up in this great country in 2006. I joined JLL in 2007 down in Melbourne, moved to Sydney with JLL in 2012 and have been there ever since, doing a number of roles across research, client engagement and also managing director of the local office here.

Darren: Andrew, you've had a lot of global experience, so it's quite relevant that we start with what's happening in global markets. There's a lot going on. As we spoke about in the last podcast for last year, inflation does seem to be stabilising and recent data has shown it to be coming off a little bit, particularly here in Australia. What does that mean for the real estate sector? 

Andrew: Sure Darren, we've been watching inflation pretty closely and I noticed in your last podcast you talked about signs of stabilisation. What we've seen locally through the monthly indicator is that inflation actually came in below expectations. And if you look at the relationship between inflation and bond yields, not unsurprisingly there's a correlation of 0.7. So, what we've seen is that bond yields have started to ease back from high 4s towards that low 4% territory. So, ultimately while people view real estate as a hedge for inflation, I'm actually a subscriber to the view that real estate performs better in a more stable inflation environment. So as we start to move back towards that 2% to 3% range here in Australia, as the US moves back towards that 2% range, I think we're all looking to see a more stable inflation environment, that leads to a more stable interest rate environment, and we'll have much greater confidence in how we price-risk assets like real estate.

Darren: So inflation is coming off. Obviously when you look at real estate valuations, no matter what asset class we're talking, Andrew, the ten-year bond rate, particularly how people tend to price real estate ... so our view is that the ten-year bond will settle between 3.5 and 4%. That should mean that that good quality real estate will be somewhere between 6.5% and 7.5% total return. Do you share that view, or do you have a different view on that?

Andrew: Yeah, and I broadly agree with what you've said there, Darren. So ultimately as a real estate investor, taking a through-the-cycle view and ultimately looking at what the terminal risk free rate is rather than a spot figure, and how I build that up mathematically in my mind is historically there's been a 60 basis point spread between the cash rate and the ten-year bond yield. Ultimately, we know the cash rate will be positive in real terms, so it will be above 2.5%. More realistically, it's going to be in that sort of low to mid 3% territory, and then you add on that 60 basis point spread and that gets you into a similar sort of territory. Then you start to look at what the real estate risk premium is. So for those better quality assets sitting at around that 300 basis points, up to 350, would get us roughly in the same sort of territory. So yes, I agree with your view there.

Darren: Let's hope, after last year where I think we had a record low amount of transactions for the Australian market, that we start to with this more stabilised environment, we start to see the transactions pick up, which obviously then makes it easier for valuations and the whole system starts to move again.

Andrew: I learned a phrase very early in my career, Darren, that said, no one pays a premium for uncertainty, and what we saw over the last 12 to 18 months is a period of uncertainty around where that risk free rate is going to sit. Now, I feel that investors are starting to narrow that variance around expected probabilities, and that in itself forms a level of confidence and gives you more certainty and confidence in how you price-risk assets. So I think through the first half of this year, we will still see volumes at reasonably low levels and then the second half of the year we'll see a significant improvement in liquidity.

Darren: I agree with that comment. I made a bold prediction last year that that things would start to move again post June, July this year, so fingers crossed that turns out to be the case. Why don't we turn our attention now to the actual asset classes? Let’s start with office. Lots of talk about back to the office and every second day there seems to be an article about are people coming back to the office and what does that mean for office valuations? What's your view on the office sector for the year ahead, Andrew?

Andrew: I tend to take a step back and say, what is the purpose of office space and what is the purpose of cities? And ultimately when you look at most organisations, they're thinking about innovation and productivity and what they found over the last two to three years is that we've been working in a suboptimal manner. So while we know there will be a degree of hybrid working moving forward, the model that we've experienced over the last few years has been suboptimal, and that's coming through a number of the announcements we're seeing being made by C-suites in terms of what they believe drives collaboration and innovation within their own organisation. So I think we'll see a continuation of that overall journey. Then you come back to the role of cities. And I'm a big believer, and the New York Times had a great article talking about cities create serendipitous interaction. What a great word to use in an article! And to me that's economies of agglomeration and clustering and ultimately the benefits we have through that bump factor. So I think as we start to see more of that, confidence towards the office sector is only going to firm as we go through 2024. Nevertheless, we are going to be in an environment where economic growth is below trend, that will have an impact on overall headcount growth. So I don't expect to see a Lazarus like recovery in our net absorption figures in Sydney and Melbourne, but I do expect to see stabilisation. If you look outside of the two larger geographies, Brisbane, Perth and Adelaide are actually performing very strongly at the moment. So I think you will continue to see some strong tailwinds in those geographies. The other point that we've talked about over the years, Darren, is even being an analyst by trade, headline statistics can be very misleading. If you look at the office sector at the moment across just the CBDs, two thirds of the vacancy is held in 17% of buildings, so a lot of other assets have got very high occupancy. So it's ultimately those assets that are tiptoeing towards that structural vacancy and obsolescence factor. And they're going to hold a larger part of the vacancy. And if they're not willing to invest significant capex into those assets, those assets are really going to struggle and those phrases we hear, like stranded assets are going to become more relevant. The other way that you can look at office market vacancy is look at a market like Brisbane. If you take assets with floorplates of 1,500 square metres or higher, the vacancy rate is 3%, so significantly lower than the overall double digit. So even though Prime's come into single dexus.com 4 digit, if you're looking for contiguous space in an asset of 1,500 square meter floorplates, you don't have very many options. So I think it's really a story around peeling behind the headlines for the numbers over the next 12 months.

Darren: Yeah, I totally agree, asset selection is going to be super important. And we see that here within our portfolio, whether it be the successful leasing that is underway at Waterfront up in Brisbane, in the CBD there. It is one of the best sites but the floor plates are exactly as you say, they're larger floor plates, they've been in very high demand. Our project doesn't open till 2028, we're already over 50% leased in that market. Down here in Sydney, Gateway is 100% occupied. One Farrer, even though it's an older building, we spent the money on the sustainability elements and the lifts, air-conditioning, that's 98.4% occupied with a queue to get in there. So not only is it the right type of asset, but it's also the location that we've seen, and very much the core parts of the CBDs right across the country are in high demand from the tenant base. It will be fascinating, though, as you say, there's a lot of geopolitical risk floating around, and what that does for the employment prospects, particularly from international companies, whether they just keep a lid on it for the first half, as we see how things play out in the Middle East, in the Ukraine, and also up in the South Pacific.

Andrew: Yep. And I think also, Darren, 12 months is obviously a very short time period in office markets, so if you take a through-the-cycle view, it's really interesting when you compare Sydney, Melbourne and Brisbane to other cities. Ultimately, the relationship between population growth and employment growth, not unsurprisingly, is quite strong. So you compare those three cities over the next 5 to 10 years. Their office sector employment growth is amongst the strongest in the world. So even if you have a nervousness around the impact of hybrid (working) and what that means in terms of underlying demand, you're more confident around those cities that have employment growth. And our three cities, and Auckland as well, score very favourably on that longer-term analysis.

Darren: Look we'll come back to population growth later in the discussion, but yes, it's certainly something that needs to be taken into account by real estate investors. Let’s turn our attention to industrial I mean supply is tight in the key markets of Sydney and Melbourne, obviously the planning rules and the delays that have that are inherent in the planning system are still there. And in fact, with all the talk about the shortage of residential, a lot of resources are now being allocated to fast tracking residential, which is going to make it even trickier for the industrial sector. Can you give us your view on where industrial is heading this year?

Andrew: Sure. Industrial has very much been the poster child of commercial real estate over the last few years.

Darren: Who would have thought, Andrew, who would have thought?

Andrew: I remember when you would buy industrial on double-digit returns, and now you've seen that come in significantly [higher].

Darren: If we were all as good as we think we are, we would have bought industrial a few years ago and we’d be retired today.

Andrew: Yes I mean, obviously it’s had a phenomenally strong demand story over the last few years and an even stronger rental growth story. And that’s largely been led by a market which essentially has anywhere between 0% and 3% vacancy depending on the geography and the submarket. So as the economy slows, yes, clearly we will see leasing activity come off these very, very strong levels. But given that supply side of the equation, there's no major ease in the pressure valve that we see over the next 12 to 18 months. I did an exercise of looking at every project we were tracking over the next three years, and these are in various stages of under construction, through planning to basically a thought bubble, and we came up with over 9 million square metres, [and] less than one third of that's under construction. And you can really see that disconnect between what could potentially happen versus what's actually happening on the ground. The other story that I've been thinking a lot about, and you touched on some of the geopolitical risk factors, is those geopolitical risk factors ultimately shape organisation thinking and changes in behaviour. So what we saw through the pandemic was ultimately organisations holding higher inventory levels because they wanted to meet customer expectations. We started to see some of those organisations ease back on what they were holding, not back to where we were in 2019, but ultimately viewing that holding inventory is a cost on your balance sheet. Now you start to see some of that geopolitical uncertainty, you see discussions around, you know, disruptions in the Suez Canal, you look at the Malacca Strait, which is where about a quarter of the world's trade goes through, and suddenly organisations feel a little nervous again. So that means ultimately they want to meet that customer expectation and they start to think about what that means around inventory levels that they're holding. So I think that's going to be a good indicator to watch over the next 12 months.

Darren: It is. Our leasing team has a phrase. It was “just in time” with this quick to the customer approach, to “just in case”, as you say, hold the inventories there just in case we have delays with shipping et cetera. We did see a lot more subleasing space available in the last quarter of last year, but I think even now that trend is starting to reverse.

Andrew: But even with some of the sublease, Darren, a number of the options that were offered were groups that basically said, the only facility available to us is 30,000 [square metres], but we only need 14, but we need the space. And then they've ultimately said no, we can now sublease the other 15 or 16,000 of it. And a number of those subleases that are happening are happening at profit rents as well, given the very strong rental growth that dexus.com 6 we've seen. So while we certainly don't believe that we're going to see a continuation of the 25% to 30% per annum that we've experienced in Sydney and Melbourne, just looking at our growth rates for 2024, we're still in 5% and 6% territory, which is still a growth rate significantly above that more recently lowly printed inflation figure. So that's a sector that's given real growth in the cash flow at 5% and 6% rental growth.

Darren: Super healthy, and I suppose the one thing we forgot about when we were talking about office, and it's the same for industrial, is just the cost to build some of these new facilities. So when you bring the economic rent that's required to get them built, that will also help hold up valuations, but also makes acquisition of mature assets quite attractive rather than taking the build risk.

Andrew: It's simple. I studied economics, I think like yourself, a very long time ago, and I think of ultimately the cost of production. And ultimately what we're talking about here is the input costs have gone up, so the overall cost of the finished product has gone up. It's a form of cost push inflation. At the same time as financing costs have gone out and obviously cap rates that you can apply on new development feasibilities. So if you look at pre-lease rents in the industrial sector since the start of COVID, they're up about 75%. That's very much a cost push inflation. If you look at the office sector, we estimate that economic rents are anywhere from 20% to 25% higher than where we were in June 2022.

Darren: And we we're seeing that through the portfolio, despite the fact incentives are up as well, but the face rents have definitely kept growing.

Andrew: It's interesting you touch on rental growth, Darren. And I think it's great that we can jump around because I think the stories are intertwined in a number of ways. And if you look at Sydney as an illustration, we recorded 6.5% face rental growth last year, and we've had a lot of people phoning us up and going, where did you see that come through? Because the reality is the market is probably discriminating more than it's ever done. And you touched on the occupancy rates on some of your flagship assets, and we've seen really strong rental growth in that part of the market. There's been other assets which have been very, very soft. And they're ultimately facing that structural vacancy story that we see. And that's something that's been replicated in gateway markets elsewhere. So if you take New York as an illustration, last year they talked about the number of deals done above a high benchmark being an all-time record high, even with vacancy rates significantly higher than what we're experiencing here. So this demand for the best quality assets is strong, not just in our own cities, but in cities around the world and ultimately, organisations if they want to be in that type of space, that's what they have to pay to be in it. And it fits their ESG mandates that you touched on. But also they're looking at that space and saying, we can use it in a more efficient manner than what we can in an older building. So they think more about that cost per employee rather than a rate per square metre.

Darren: Yeah, that's I mean, this is the thing the stats are starting to skew funny numbers because as you mentioned earlier, you've got a whole lot of B/C grade buildings that are virtually unleasable today that are sitting there 99% empty. So when you look at these headline statistics, it doesn't tell the full story and can scare some individuals that don't know enough about the depth of the data and can’t analyse the data properly.

Andrew: And I think you're originally from Perth, we actually did the exercise on Perth and people talk about structural vacancy. But you say they go, well what does that actually mean? Is that just a phrase you've come up with? So what we did a number of years ago, Darren, was we actually quantified it and said if a building hasn't seen capex spent on it and it's had vacancy for over two years with fairly limited inspections, is ultimately that space cannot be leased at any price point. And we used Perth as the market as the first example, because Perth had much higher vacancy, and we estimated that one third of Perth's vacancy was structural. And that's what we're now seeing being replicated in the other geographies, especially Sydney and Melbourne.

Darren: Yeah, it's a fascinating story because there are still owners that are non-institutional that just do not upgrade the assets to the right level, and they're just not up to speed with things like the new accounting standards for reporting on ESG, for example, which make tenancies uninhabitable if they haven't had the money spent on them, by listed companies anyway. Why don't we turn our attention to retail for a minute, which is the third of the major sort of asset classes. Retail sales have held up very, very well last year. The sales are starting to come off a little bit now. But obviously you've got things like Black Friday where the sales have been brought forward. Inflation is obviously helping the sales come through as well, particularly in the supermarkets. Have you got a view? What's Jones Lang [LaSalle]’s view on where retail is heading over the next 12 months?

Andrew: It's a really interesting one because I think in the short term with some of that demand that you were talking about, consumer sentiment, the most recent print that we had on that showed that it’s 20% below long-term averages. So clearly consumers are very nervous. At the same time, we're pretty much still close to full employment, and we've still seen house price growth and we've seen equity prices grow. So it's a real interesting mix in terms of that wealth effect versus how people are feeling. So ultimately, as we do go through 2024, clearly cost of living pressures will have an influence on household P&Ls and household balance sheets and how they allocate that discretionary and non-discretionary spend moving forward, . But what I think is interesting about retail, is we have seen a little bit of a tip down in our vacancy rates across most categories, with the exception of CBD retail, which is still at a fairly elevated level. And the way that I've been looking at this journey for a period of time is, in my simple mind, online is a form of floor space, so if online spending is about 15%, we suddenly added 15% to the market in a short period of time, and the market was oversupplied. And ultimately coming back to being an economist, markets try and find their equilibrium, and the way that retail has found its equilibrium is through less new development activity. Outside of some neighbourhood shopping centres and some LFRs, we haven't seen larger shopping centres being built in Australia for a number of years, so we believe that we're now actually getting back towards that equilibrium. Yes, we've still got the short time headwinds that are coming through the sector that we touched on, but now we're back at an equilibrium. It's a different discussion for retail moving forward than the one that we've had probably over the last decade.

Darren: Now we've had six years of very low supply being put into the market where previously, you know, it was a way for shopping centres to really revamp the whole asset was to do a development. It was very high returning, but obviously with everything that's happened, the valuation movement, because if you think about it, retail was the first asset class that really did have that valuation movement down, now everything's sort of equalising. Industrial is the latest to do it and office obviously has been hit over the last couple of years as well, but the sales have continued to be very, very stable, as you say, on the back of house prices and high employment. It will be fascinating to see how it plays off this year. But one of the key drivers of all asset classes, particularly retail, is population growth. And we were talking last week, we spoke about the high migration numbers, and then over and above the migration numbers, you've got this this student population that has come back in. I think there were half a million migrants, but there's been another half a million students that have come in on various visas. So there's a million new people into Australia, which of course will not only underpin retail sales but tends to underpin all real estate markets, especially residential, but you need office and more industrial as well.

Andrew: Yes, population growth is the key multiplier. If there's ever one statistic you look at through the cycle, that's the one. And if you look at industrial and logistics, every additional head of population is 4.5 square metres of floor space. We’ve seen that ratio jump over a number of years because the market has gone through a structural shift as we start to buy more online and it's meant greater demand for distribution facilities, but the shock absorber has been retail which has obviously had less. So it's been a displacement that logistics has benefited from that overall story, but it's very much a population growth story. What I think is going to be interesting is we look at Australia and say, our long-time population growth is anywhere between 1% to 1.3%, depending on how optimistic you are, but that's not across every city, that's not across every LGA, and when I look at the migration numbers, we're seeing a higher proportion come from India. And I think that's interesting as well for the multiplier effect, because without generalising, we tend to find Indian migrants have larger families. So there's a multiplier effect that comes through there. So demand for childcare in the early stage of life, real estate that we see come through there, but also the clustering that happens with migrants within certain LGAs. So you will see certain LGAs have very strong population growth. So the trade area of the shopping centre, that is the dominant centre within that LGA, is going to grow much more than 1.2% or 1.3% per annum. So I think retail, and it always has been very much around asset selection, is going to become even more as a result of that population story. And your point on students is fascinating. I remember doing some modelling during the pandemic and saying, how many years will it take for student enrolments to get back to where we were in 2019? They're pretty much back. Go and look at the Department of Education, we’re within a couple of thousand of the enrolment figure that we had in 2019. So that's a phenomenally sharp return that we've seen. And that's been interesting even around some of the tourism numbers that we've seen as well coming through. Yes, we're still way below where we were in 2019, but they're coming back very quickly as well. And that tourism spend is obviously important for the Australian economy as well.

Darren: It's been fascinating watching those numbers grow. I mean, certainly for the most of my career over the last 30 years, it's the population growth that's underpinned the real estate markets here in this country, and with numbers like that coming through, we've seen it in our student accommodation portfolio as well, but you can certainly feel the confidence in the residential, when I talk to the residential developers about these numbers coming in.

Andrew: Yeah, that PBSA market, it’s been fascinating to watch the evolution of that. And if you look at Australia, depending on what measure we use, we're consistently in the top five in terms of the international education market. So we always punch way above our weight. But I always like doing those comparisons with Canada as an illustration. And if you look at Australia, being British I still think the Times has the most credible university rankings in the world. We have ten in the top 200, in Canada has seven. So even just as a simple measure of the why. So it's not just the English language, it's not just that longer term pathway towards citizenship, it's actually the quality of our institutions. So there's a real melting point pot of ingredients that say why, that's going to be successful here in terms of that international education piece.

Darren: Long may it last. Long may it last. I think we should just touch on alternatives. That wasn't the focus for today, but the alternative sectors of student accommodation, as we discussed, build to rent, obviously they got a lot of momentum at the back end of last year and a lot of capital was looking at them purely because they weren't office and they weren't retail, and logistics was looking heavily invested. What's Jones Lang [LaSalle]'s view on alternatives in the coming year?

Andrew: Yeah, sure, there’s a whole range of alternatives that we have to touch on. If you look at living last year, living was the highest traded sector globally, and it's still only dominated by a few major jurisdictions. You know, the US to a lesser extent the UK, a little bit of Japan, a little bit of Canada. So we've already seen institutional investors increase their allocation to living, which is across BTR or multifamily, PBSA that we've touched on, even more discussions around co-living as a sector. So, as a house, we are certainly a subscriber to BTR. We do believe that it is a journey, it's not immediately, and we certainly don't believe it's a substitute for the housing crisis that we're seeing here in Australia, it will still be on the margin, but it has an important role to play in terms of our overall accommodation strategy for the country. But what's been really interesting to see, Darren, is those projects that have completed, virtually every one of them are reporting occupancy rates above what their initial underwrite was, and rental rates that are higher as well. So that first wave has certainly been successful. That should attract more capital into the sector, but coming back to our earlier point around how much it costs to create real estate, it's exactly the same story for BTR. And even when you look at the BTR landscape, we see more projects in Brisbane than Sydney. Now, intuitively, Sydney should be a larger BTR market just given our population growth, given that it's a true international city, but we see more projects in Parramatta than we do in the CBD because ultimately being able to make those projects stack up is very hard in the city.

Darren: Yes, construction costs. And the one thing I've struggled with on every feasibility is just the return metrics [of BTR] versus return metrics in office, industrial, retail and health for that matter. So the returns appear to be a lot lower in BTR, where I would expect them to be. Capital is finite and the capital will gravitate to where it can get the best return. And they're all very good asset classes underpinned by the great geopolitical situation that Australia is in and population growth. So there's fundamentals driving each of the sectors here. So for BTR to truly get more than its fair share of capital to help accelerate the development, there needs to be something done to stimulate it. And I see even last week the government was talking about some tax changes and measures to try and make it more attractive to attract more capital.

Andrew: It's interesting. It's a sector that's priced for maturity, even though it's a nascent asset class. And if you look at the US and look at the US REIT sectors, as we've both done over a number of years, the beta coefficient on the multifamily stocks is lower than what we see in office, retail and logistics. So mathematically, if you believe we're going to follow the same path as the US, then you should see a lower volatility profile or a lower risk profile, which then says the return should be lower. But we're dealing with a sector that's very much nascent. So it's not priced for maturity.

Darren: I want to see it a bit more maturity yet, Andrew, before I pay, but I totally understand the logic that there should be a first mover advantage. I just want to see those numbers now in a bit more detail because I do believe people are underestimating the ongoing capex. From the feasibilities that I've seen, because I look at the office capex on the lifts and the air-conditioning, and having been involved in serviced apartments in a in a past life many years ago, just the maintenance on kitchens and bathrooms and keeping everything refreshed, I haven't seen a lot of that in the feasibility. So that's what I'll be looking at.

Andrew: Yes, quite right. It's interesting you touched on health, Darren, that's a demographic tailwind, so that's not really a year by year story. So we know even though we've got a very good age distribution for a mature economy compared to other mature economies, we clearly do have a tail in terms of people are aging and living longer. And we've done some simple modelling over a longer period of time, and if you look at the number of private hospital beds in Australia, you do some ratio analysis on the proportion that's over 65 years old, you look at growth. But also private hospitals is not just a story around people being older, it's a broader story. We estimated by 2040 we could have 75% more private beds than we have today. So that's the demographics, it's a slow-moving glacial demographics, as you know, but ultimately, if you can invest in the right stage of that story, you can do very well out of it. So we tend to take that as a through-the-cycle view and being very positive on private hospitals in particular.

Darren: Well, Dexus has made a big move there over the last 5 to 6 years, and we're really growing a great portfolio in our health fund. Andrew, we've covered a lot today. Thanks so much for your time. I know we've hopped from sectors into a whole lot of different topics, but really appreciate your time. Thanks very much for joining us.

Andrew: Thanks Darren. My most favourite activity spending time with my family, but my second most favourite activity is talking about commercial real estate, so it's been great having a discussion. Thanks for having me on today.

Darren: Thanks for listening, everybody and as usual, if anyone has any questions, please send them to therealdeal@dexus.com. Thank you.

ENDS