Outlook

The RBA meeting on 6 August is the key event of the September quarter. The decision to hike or hold rates will be dependent on June quarter inflation (released 31 July) and June labour data (released 18 July). While there is a case for monetary policy to be more restrictive, the RBA has adopted the position that preserving employment gains is a key priority and so the threshold for a hike is high.
If rates are held steady, the labour market continues to soften, and disinflation resumes its downwards trend, we should see further improvement in capital market liquidity and property transaction activity. While there are risks to the outlook such as shipping disruptions, volatile election outcomes, and conflict escalation, the Australian economy appears to still be on the narrow path towards a soft landing.

How did the Cromwell Funds Management fare this quarter?

In April, approximately 25% of the Cromwell Direct Property Fund (DPF) portfolio was revalued, with another 17% in May and 52% in June. Eight of the fund’s nine assets have now been independently revalued. Overall, from December last year, capitalisation rates have softened by 30bps to a weighted average of 7.18%, equating to a 3% fall across the portfolio, which is now valued at $607 million.

The Brisbane office market, where just under 55% of DPF’s portfolio is held, is experiencing strong fundamentals. This is evidenced by positive net absorption, a decrease in headline vacancy and positive net effective rental growth of 3.4% for the quarter, and 14% over the past 12 months. As noted in the market update above, Brisbane is leading the country for rental growth and is currently one of the strongest-performing leasing markets in the APAC region.

High construction costs and upward pressure on labour, helped along by Queensland’s significant infrastructure pipeline over the next 3-4 years, will see supply constrained for some time, which bodes well for leasing demand and future rental growth on existing assets. Additionally, the anticipated rapid increase in immigration is likely to further drive demand for commercial office space, as well as in the medical, retail, and industrial sectors.

While Cromwell is optimistic that valuations have experienced the worst of the cycle and will now stabilise, it is pertinent to note that recent CPI prints and the Reserve Bank of Australia’s neutral stance on rates may delay this stabilisation. In the interim, Cromwell’s key focus remains on maximizing portfolio performance to help ensure the delivery of regular distributions.

Portfolio updates for the quarter
Cromwell is continuously exploring ways to enhance the tenant experience and improve the amenities offered within its buildings. The implementation of a tenant portal, Cromwell Connect, is currently underway across several of our assets. This portal will enable tenants to access various forms of data, make bookings for communal training or meeting rooms and interact with retailers for services such as ordering coffees, booking dry cleaning, and reserving Pilates classes.

Cromwell Property Trust 12’s (C12) Dandenong asset recently underwent balcony refurbishment works, including the replacement of artificial turf with tiling. Additionally, 100 Creek Street in the Brisbane CBD is undergoing a comprehensive lift modernisation, which includes the upgrade of lift motors, with a heating upgrade project scheduled for later this financial year.

The solar works at Dandenong, Mascot, and Townsville assets have now been completed and energized, resulting in seven of the nine DPF assets benefiting from solar power.

The portfolio experienced strong leasing performance for the quarter, with six deals signed at 100 Creek Street, four of which were completed using existing spec fitouts. The other two were renewals on just under 1,300 sqm. Furthermore, one of the largest tenants at Queen Street exercised a 2-year option over almost 1,500 sqm, and at Mascot, a 5-year renewal with a tenant secured in 2023 was recently completed, occupying just under 1,300 sqm. Cromwell is also receiving good levels of enquiry over a couple of full-floor vacancies in Brisbane and Adelaide.

The portfolio currently maintains a 95.5% occupancy rate, with a weighted average lease expiry of 4 years.

Cromwell’s asset management and projects teams remain hard at work to maximise occupancy across the portfolio, whether by renewing current tenants or relocating them within the buildings using existing fitouts. This approach allows the cost of incentives to be spread across the lease term rather than funded upfront. Moreover, Cromwell is dedicated to maximising energy efficiency and maintaining and improving NABERS ratings through carefully planned lifecycle programmes aligned with decarbonisation plans and ESG initiatives. In April, 545 Queen Street was awarded a 6.0-star NABERS Energy rating for the first time, an improvement from its 5.5 stars. This achievement was the result of years of sustainability planning, energy-saving initiatives, and ongoing consultation with Australian energy solutions provider, Conservia.

Cromwell is pleased to be progressing on its net zero pathway, having already achieved a 73% reduction in emissions across the DPF portfolio³.

Read more about the Cromwell Direct Property Fund: www.cromwell.com.au/dpf.

Past performance is not a reliable indicator of future performance.

Cromwell Funds Management Limited ACN 114 782 777 is the responsible entity of and issuer of units in the Cromwell Direct Property Fund ARSN 165 011 905.

Before making an investment decision in relation to the Fund it is important that you read and consider the Product Disclosure Statement and Target Market Determination available from www.cromwell.com.au/dpf, by calling 1300 268 078 or emailing invest@cromwell.com.au.

Except for the Tasmanian Budget which has been delayed from May to September.
Consumer Sentiment (Westpac-Melbourne Institute, May-24)
This excludes Queen Street in Brisbane which is undertaking a decarbonisation audit in FY25

May 1, 2024

Actively managing our assets: 95 Grenfell Street, Adelaide

Chesser House at 95 Grenfell Street, Adelaide, was acquired by Cromwell Funds Management in April 2022 for $81.35 million, on behalf of Cromwell Direct Property Fund (DPF) unitholders. The 11-storey building has a total net lettable area of 11,155 sqm, with rental income underpinned by blue-chip building users, as well as federal and state government tenants.

In-building amenity

As part of Cromwell’s approach to asset management, the performance of each property is continually appraised – relative to market demand; possible future uses; socio-demographic profiles; and growth corridors. Understanding the property cycle, future capital works, and the demand for continuing occupation underpins every asset management and refurbishment strategy across our business.

The most recent tranche of building works at Chesser House was completed in September 2023. These works involved installation of a full-floor LED lighting, ceiling finishes, floor finishes, and services upgrades; a lift lobby refurbishment on Level 9; and a brand-new end-of-trip facility with a dedicated bike storeroom . Consequently, these works resulted in two new leases being signed.

In addition, a 93KW solar panel system was installed, which generates 17% of the total base building power. The property has maintained its NABERS Energy Rating at 5.0 Stars, with Green Power at 22.5%. The NABERS Water Rating is currently 4.5 Stars.

Across our business, Cromwell’s Asset Management team continues to take shifting tenant requirements into consideration, such as those post COVID-19, when designing these spaces. The recent focus has been on designing breakout areas and collaboration zones in addition to providing quiet rooms to those wishing to concentrate on tasks or avoid distraction.

End-of-trip facilities

The end-of-trip design utilised a neutral colour palette accentuated by premium finishes that complement the recently completed building lobby. An indigenous artwork called “Waves of Hope” by Samantha Webster was also commissioned via Wall Trade.

A considerable number of bike racks were installed by market-leading bike room creators, Five at Heart – included to meet the increasing demand of people cycling to work.

95 Grenfell Street tenants awarded Cromwell an overall satisfaction level 4% higher than the Tenant Survey Index

Property profile

The property is located in the heart of the South Australian capital and provides direct linkages to major transport routes, as well as connectivity to Adelaide’s premier retail precinct, Rundle Mall, and the grassy Hindmarsh Square. The parallel Pirie Street has also emerged as a leading entertainment, food and beverage destination for locals and visitors to the City of Churches.

The property façade was last upgraded in 2017 and features a steel structured lightbox fitted with contemporary LED lighting coupled with translucent panels. The lighting can be programmed remotely to adjust the colour, luminosity, and function of the lightbox, providing a striking visual appearance.

Inside the building, a double-height entrance lobby gives way to a working lounge and café, as well as a 7-metre feature green wall, fitted with engineered grow lights and an irrigation system. The foyer space provides quiet, sophisticated meeting spaces for tenants to use.

May 1, 2024

An introduction to property valuations

Cromwell’s Investment Manager, Lachlan Stewart, is an experienced commercial real estate professional, who has spent more than 20 years working for highly respected organisations, including Colliers International and GE Capital Real Estate. He specialises in property valuations and financial modelling.

The importance of valuations

Section 601FC(1)(j) of the Corporations Act imposes an express obligation on a commercial property owner to ensure that the scheme property, which includes any real estate, is valued at regular intervals appropriate to the nature of the property. A company can decide to internally value or externally value a property.

As such, a commercial property valuation is the most reliable way of determining the market value of an income-producing property – it serves as an important, professionally backed tool for owners, investors, banks, regulators, and other interested parties.

Unlike residential property, commercial properties can be complex in the way that they are valued, given that every commercial opportunity is driven by a different set of needs and unique contributing factors. These factors will be explored in greater detail below.

How properties are valuated

There are two main methods of valuation that are routinely applied to the asset valuations in Australia – the income capitalisation approach and the discounted cash flow approach. It should be noted that there are other methods of valuation, but, for the purposes of this article, we will examine these two most common methods.

Income capitalisation approach

The income capitalisation approach to property valuation examines the net income a property would achieve in an open market – regardless of whether it is leased or vacant – divided by the appropriate capitalisation rate, to give the core value of the asset.

The capitalisation rate (cap rate) (yield) is the component that moves with market forces, such as interest rate changes, economic growth, vacancy rates, inflation, and lease covenants. The capitalisation rate is similar to the price-earnings multiple, often used when valuing shares. Valuers will also look at the capitalisation rates of comparable sales over the previous 12 months when calculating the market value of an asset.

In example 1 consider a property, which produces income of $100,000, is capitalised at 6.0% – the market value would be $1,666,666.

If, due to market forces, the capitalisation rate tightened to 5.0%, and the income remained the same, the market value of the property would increase as per example 2.

Example 3 demonstrates if the capitalisation rate rose to 7.0%, and the income remained the same, the capitalised value would decrease.

As you can see, market value moves inversely from capitalisation rates.

Once an asset value is determined, valuers can adjust for certain variables.

For instance, the valuers would make an adjustment for how much the current tenants are paying, compared to what the market rent of that property should be. Likewise, there would be adjustments made for any discount or tenant incentives that a building owner is applying to that space for the duration of those tenants’ leases.

As part of this approach, valuers also look forward over the immediate horizon – which might be anywhere between 12 and 36 months – to consider any near-term lease expiry and will make an adjustment to reflect the costs associated with that downtime and re-leasing. They will examine whether there is any vacant space, as well as the costs associated with leasing that space out.

Valuers also look at any capital expenditure (capex) considerations that there might be. For example, if there’s a broken lift, and it’s estimated that $5 million will be required for a replacement, adjustments will be made to the core value, to end up with the market value. That value is applied to a point in time – “as at” the day of valuation.

Discounted cash flow approach (DCF)

More assumptions are involved in a DCF when compared to the income capitalisation approach – including the target return or discount rate, rental growth, lease expiry allowances, renewal probability, capital expenditure, and a hypothetical sale profit– but it has the potential to provide a more accurate picture of the cash flow horizon over a longer period.

Using this method, valuers typically forecast a 10-year cash flow, with a hypothetical sale profit at the end of year 10. All the income over 10 years is discounted back to a present-day value at an appropriate discount rate. An exit terminal value at year 10 (for the hypothetical sale, using an appropriate terminal yield) is also discounted to a present-day value. To derive the net present value of the property, it becomes the sum of the discounted property cash flows and the discounted terminal value.

Determining an appropriate discount rate

To determine an appropriate discount rate, a comparison is made with returns from alternative investments, the most common comparison being the 10-year government bond rate, as it is considered ‘risk-free’ and matches the investment horizon. A premium is then applied to reflect the risk of a property investment when compared to the ‘risk-free’ rate.

Adjustments

Adjustments are made within the 10-year cashflow. For example, consider a multi-tenanted building. Realistically, not all tenants are going be there for the entirety of that 10-year horizon – so, these lease expiries are factored into existing lease cash flows.

The valuer considers what happens when each tenant’s lease expires, applying a renewal probability of that tenant remaining (or leaving) and applying associated costs for potential downtime, capex to refurbish the space and the costs associated with re-leasing (leasing fees, incentives, etc.).
If an expiry is in six years, for example, the valuer has an informed opinion of what the market rental should be as at today, and then they’ll apply a growth rate to get to the market rent at that point in time. They’ll also apply a tenant incentive and will have a hypothetical lease term at that point in time.

So, the valuer is making a lot more assumptions here than what they would do in a capitalisation approach – but they’re also getting a longer horizon of cashflows to look at.

In summary

In the face of fluctuating markets, a commercial property valuation is the most reliable way of determining the representative value of Cromwell’s income-producing assets. As a business, we adhere very closely to the methods outlined above to provide investors with clear and accurate information on each of our assets. Cromwell will continue to provide transparency about the valuation process – and how our properties are valued, as the information is generated.

January 23, 2024

December 2023 direct property market update

Peta Tilse, Head of Retail Funds Management

Economy

Over the December quarter, interest rates were reasonably volatile both in terms of short and longer-term rates. The RBA increased interest rates by 25 basis points (bps) in November, taking the cash rate to 4.35%; its highest level since the end of 2011. The justification for the move was to bring inflation to target within a reasonable timeframe (i.e. by end-2025), rather than risk a prolonged overshoot and upwards shift to inflation expectations.

Subsequently, softer than expected inflation offshore and in Australia, together with dovish comments from central banks, helped take some of the heat out of bond yields through to December. Australian government 10-year bond yields decreased by 52bps over the quarter to 4.0%.

More recent data has shown Australia’s annual inflation pace slowing quite materially from 4.9% in October to 4.3% in November¹. While there could be an uptick in Q1 2024 due to base effects and government subsidies rolling off, there was little in the latest data which would give the RBA cause for concern. Goods inflation continued to slow, and services inflation appears to have peaked. While dwelling and rental costs and insurance premiums rose further, dining out and household services eased. Overall, inflation is on track to undershoot the RBA’s forecast for the quarter, decreasing the likelihood of a hike in February.

cpi_forecast

While expectations of further cash rate hikes have diminished, 10-year bond yields remain approximately 40bps higher than a year ago², putting pressure on debt costs and access to capital. The macro impact of interest rates continues to be the main challenge facing commercial property, despite bottom-up demand drivers remaining relatively resilient. This is being reflected in higher capitalisation rates (effectively the earnings multiple for property), and in turn putting downward pressure on asset valuations.

In further economic data, the labour market remains tight, however there are signs of softer conditions emerging. Unemployment increased to 3.9% in November (latest available data), the highest it has been since May 2022 and slightly above consensus expectations (3.8%)³. Hours worked was flat over the month leading to a higher underemployment rate, job ads declined, and there were more applicants per job – all signs of slowing. Positively, the increase in the unemployment rate has been orderly and driven by strong population growth (i.e. supply), rather than job destruction. In fact, annual jobs growth increased to 3.2%, with 104,000 jobs created over the quarter-to-date (65% being full-time), a positive for office space demand.

Outlook

The global economy is slowing but at a relatively measured pace, engendering optimism that a “soft landing” can be achieved. Australia’s economy is in a similar position, with inflation slowing but employment conditions softening but remaining resilient. Similarly, household consumption has slowed without falling precipitously. Markets are becoming more confident that the rate hiking cycle is at or near its end, which should help ease uncertainty and improve liquidity for property over the coming months.

These factors put the Australian commercial property market in relatively good stead from a demand perspective. While a slowdown is expected over 2024 and early 2025, a more significant contraction (i.e. recession) is looking less likely. Businesses will continue to review their space requirements as they adjust to hybrid working, though the balance between in-office versus remote is expected to shift towards the office over 2024. Location continues to be an important driver of occupier preferences, combined with amenity and building quality (at a given price point).

Capital continues to view Australia as a favourable investment destination given its attractive demographic profile, growth prospects, and relative social and political stability. As uncertainty abates and liquidity improves, transaction activity should increase. The best opportunities will present where sentiment has become dislocated from market fundamentals.

How did the Cromwell Direct Property Fund fare this quarter?

On 27 October 2023, Cromwell announced the termination of the proposed merger between the Cromwell Direct Property Fund (the Fund) and Australian Unity Diversified Property Fund, as a result of deteriorating market conditions.

Given market dynamics for Australian real estate markets, and in particular potential movement in office asset valuations, the Board decided it appropriate to externally revalue the Fund’s assets to identify if any values may have moved materially owing to the nature of the assets and market circumstances. The Fund’s gross asset value experienced an 8.9% decrease. While partially offset by rental growth, this decline is mainly attributed to elevated interest rates and a softer capital market in the second half of 2023, which led to a 72bps expansion of the Fund’s weighted average capitalisation rate, which now stands at 6.87%.

Despite the valuation decline, the Fund’s asset portfolio continues to experience positive leasing activities, particularly in Brisbane. The Fund has improved occupancy (on a look-through basis) to 96.4% as of December 31, 2023.

Effective 14 November 2023, the Fund temporarily suspended new applications and ceased to offer the Distribution Reinvestment Plan (DRP). These measures will be in effect until the valuation process concludes and the audited financials for the half-year ending 31 December 2023, are released. It is anticipated that applications and DRP will be reinstated in early 2024 as this process completes.

During the quarter, the Fund implemented new hedging which lifted the hedge ratio to 51.7% against drawn balance, and produced a weighted average hedge term of 1.85 years as at 31 December 2023.

Cromwell remains committed to unlocking property value through proactive asset management, aiming to navigate the cyclical downturns in the commercial property market.

Read more about the Cromwell Direct Property Fund: www.cromwell.com/dpf.

Past performance is not a reliable indicator of future performance.

Cromwell Funds Management Limited ACN 114 782 777 is the responsible entity of and issuer of units in the Cromwell Direct Property Fund ARSN 165 011 905.

Before making an investment decision in relation to the Fund it is important that you read and consider the Product Disclosure Statement and Target Market Determination available from www.cromwell.com/dpf, by calling 1300 268 078 or emailing invest@cromwell.com.au.

Monthly Consumer Price Index Indicator, November 2023 (ABS, Jan-24)
Capital Market Yields – Government Bonds (RBA, Jan-24)
Labour Force, Australia, November 2023 (ABS, Dec-23)
Real Capital Analytics, Jan-24
Retail Trade, Australia, November 2023 (ABS, Jan-24)
Australia’s Industrial and Logistics Vacancy Second Half 2023 (2H23), CBRE (Dec-23)

January 9, 2024

December 2023 quarter ASX A-REIT market update

Stuart Cartledge, Managing Director, Phoenix Portfolios

Market Commentary

The S&P/ASX 300 A-REIT Accumulation Index moved substantially higher in the final quarter of 2023, gaining 16.5%. Property stocks meaningfully outperformed broader equities in the quarter, with the S&P/ASX 300 Accumulation Index adding a lessor 8.4%. This outperformance was driven by a large move in bond yields. After hitting a peak of approximately 5.0% during the quarter, the 10 Year Australian Government Bond yield dropped materially, finishing below 4.0%.

Property fund managers earnings are particularly leveraged to movements in bond yields. Given this it is unsurprising that they were major outperformers during the quarter. Charter Hall Group (CHC) had previously materially underperformed as bond rates rose, however recovered strongly, gaining 29.2% over the quarter. Centuria Capital Group (CNI) followed a similar path, rising 32.7% for the quarter. Goodman Group (GMG) as only a marginal outperformer for the period, lifting 18.6%, however had performed stronger earlier in 2023, finishing with a total return of 47.5% for the calendar year. In contrast, despite having a productive period from a business development perspective, property debt fund manager Qualitas Limited (QAL) only added 3.1% as its investment products will not directly benefit from a reduction in interest rates.

Those with exposure to residential property, particularly smaller capitalisation securities, were major underperformers across the December quarter. AV Jennings (AVJ) lost 9.1%, propelled lower by a heavily discounted, and somewhat surprising equity raise. Aspen Group (APZ) underperformed the index, only up 1.9%, with Peet Limited (PPC) similarly gaining only 4.5%. Performance was more robust for large capitalisation residential property developer Stockland (SGP), up 15.6%, just below the index’s strong result.

Office property owners had very mixed results during the period. Leading the way higher was GPT Group (GPT) which rose 22.2% for the quarter. Centuria Office REIT (COF) was also an outperformer, recovering some of its recent underperformance, adding 20.2%. On the other side of the ledger, Australian Unity Office Fund (AOF) lost ground in an absolute sense falling 16.2%, whilst Dexus (DXS) gained only 8.9% after announcing current Chief Investment Officer, Ross Du Vernet will take over from Darren Steinberg as Chief Executive Officer of the company in 2024.

Retail landlords were very strong performers to finish off the year. The major outperformer was Unibail-Rodamco-Westfield (URW), who’s share price shot 47.5% higher. As one of the more financially leveraged stocks in the sector, it is a relative beneficiary of lower global interest rates. Scentre Group (SCG) and Vicinity Centres (VCX) were also outperformers, up 21.5% and 20.4% respectively. Both are beneficiaries of more resilient consumer spending than anticipated, with initial indications of spending across the key Christmas period appearing robust.

In general, smaller capitalisation, non-benchmark property owners were substantial underperformers during the quarter. Each of Desane Group Holdings (DGH), 360 Capital REIT (TOT), Newmark Property REIT (NPR) and Gowings Brothers Limited (GOW) had negative absolute returns despite the movement in the Index and bond yields. In many cases this may be more representative of shorter term supply and demand dynamics for shares rather than underlying business underperformance.

January 9, 2024

Build to Rent – an emerging asset class in Australia

Stuart Cartledge, Managing Director, Phoenix Portfolios

SC_mirvac

In October 2023, Phoenix participated in an Investor Day, hosted by listed REIT, Mirvac Group, that focussed on “Living Sectors”. Aside from the joy of wearing a high-vis jacket, those with an eye for detail will notice the badge, clearly indicating that the occupant of the jacket is a “Young Worker”.

In this article we share with you some of the lessons learned by that young worker from the day.

Australia has a housing crisis. We may have had an inkling of this one before the tour, but with an estimated 1,000,000 new immigrants expected to arrive in Australia over the next 3 years, requiring approximately 400,000 dwellings, we’re going to have to get cracking with the government’s new housing targets.

The chart below puts these figures into the context of what has been delivered in the past. The key takeaway for us, is that the Australian Government may well be having another Utopia moment.

With demand likely to remain robust, and rental markets as tight as a drum, the opportunity for an entity such as Mirvac Group to deliver product into this environment is compelling.

Built-to-rent

Financial metrics are interesting

Financial modelling for BTR is made a little tricky by some big movements in construction costs over the last few years, which ordinarily would lower returns, combined with some offsetting and also significant market rental increases in the residential sector. For MGR, the end result is a stabilised yield on cost of 4.5% – 5.0%. Along with rental growth, maintenance costs and ancillary income, the investment return (Internal Rate of Return) is estimated to be around 7% – 7.5%.

MGR’s investment in the sector is structured in a joint venture as shown in the diagram below.

External investors sit alongside MGR, and enjoy investment returns that benefit from MGR’s active management and can take comfort that MGR’s interests are very much aligned with theirs.

In addition to the returns on capital invested in the joint venture, MGR also earns funds management, development management and asset management fees across the platform. This fee stream is more volatile but adds to the returns that MGR shareholders enjoy.

Mirvac-summary_btr

Phoenix assumes that MGR is able to build out its current pipeline of BTR opportunities and will be able to identify future projects to reach its medium term target of 5,000 apartments on the platform. Importantly, we also assume that the company will be able to continue to partner with external investors to deliver a solid outcome for all stakeholders.

We expect the BTR market to get more competitive, but with penetration rates so low and the demand for housing so high, we forecast a solid runway for the foreseeable future. The only sad thing about the day, was the discovery that BTR is typically targeting the affluent renters, aged between 25 and 39. The “young worker” on this tour is more likely a target for the over 55 land lease portfolio, which we will write about in subsequent articles.

October 20, 2023

September 2023 quarter ASX A-REIT market update

Stuart Cartledge, Managing Director, Phoenix Portfolios

Market Commentary

The S&P/ASX 300 A-REIT Accumulation Index moved lower in the September quarter, losing 3.0%. Property stocks underperformed broader equities in the quarter, with the S&P/ASX 300 Accumulation Index giving up a lessor 0.8%. This underperformance is unsurprising considering the 10 Year Australian Government Bond yield increased meaningfully over the quarter, finishing at approximately 4.5%.

Despite the property index underperforming over the period, the headline result masks the weak performance of most property stocks. Only 8 out of 32 index constituents outperformed the index. This result was mostly driven by the outperformance of the index’s largest stock, Goodman Group (GMG), which rose 6.9%, despite the weakness seen elsewhere. Many investors became excited about the opportunity in data centre investment that GMG referenced in their result. For more on GMG, see the performance commentary section of this report.

During the quarter, most property stocks reported their full year financial results to 30 June 2023. A key feature of results was increased interest costs and the impact they are having to short term profitability and distributions. Phoenix normalises for mid-cycle interest rates when considering the valuation of a stock, so the impact was minimal to our valuations, however, was seen as very significant by those focussed on short term distribution outcomes.

Stocks with exposure to office property were particularly weak during the quarter. Incentives to secure office tenants remain elevated and vacancy is beginning to creep into office portfolios as existing long-term leases come to their end. Growthpoint Properties Australia (GOZ) lost 20.8%, whilst Cromwell Property Group (CMW) gave up 29.3% and Centuria Office REIT (COF) dropped by 14.6%. Large capitalisation office owner Dexus (DXS) also lost ground, off 6.4%. Charter Hall Group (CHC), whilst a diversified manager of property funds, has a meaningful exposure to office property and was also weak, giving up 11.4%.

Owners of large regional shopping centres broadly reported solid results in August’s reporting season. Specialty sales were strong, supported by elevated inflation and resilient consumer spending. All-important specialty re-leasing spreads were positive for both Scentre Group (SCG) and Vicinity Centres (VCX). There is some concern that cyclical factors such as weakened consumer sentiment will weigh on future results despite the recent strong performance. SCG and VCX marginally underperformed the index, losing 4.1% and 4.7% respectively. Owners of smaller neighbourhood shopping centres were weaker during the period as their rental outcomes are not as directly tied to inflation, but their costs are rising sharply. Region Group (RGN) gave up 11.0% and Charter Hall Retail REIT (CQR) finished the quarter 13.0% lower.

Developers of residential property showed resilience during the period as the undersupply of housing in Australia came into focus. All else equal, a sharp increase in interest rates should have a cooling effect on residential house prices and sales, however the impact of interest rates is offset by an acute shortage of both rental and stock for sale. Peet Limited (PPC) outperformed, up 1.2%, AV Jennings Limited lost only 1.9% and large capitalisation developer Stockland (SGP) dropped 2.7%.

October 20, 2023

Australia’s housing battle: Interest rates versus supply and demand

Stuart Cartledge, Managing Director, Phoenix Portfolios

Residential property occupies much of Australia’s news coverage and much of the brain space of Australians in general. Everyone seems to have an opinion on house prices and housing policy and not all of it seems to be based on fact. This article will try to provide an analysis of the current factors inﬂuencing residential property and in dealing with those facts, provide some examples of how Phoenix is making investments that are supported by the current environment.

Interest rates

It seems all of us have heard comments like “house prices always go up”. Anyone with a basic understanding of maths and economics have told those people they cannot be correct. With that, let’s look at the median house price in Sydney since 2002:

Looking at the chart above it almost does seem like house prices always go up. But wait: what happens when interest rates go up, surely house prices will crash? Let’s zoom into the chart above and look at the eﬀect of recent interest rate rises on the value of homes in Sydney:

Despite interest rates on new home loans more than doubling oﬀ their lows, it is clear that house prices have been stunningly resilient, growing once more after marginally decreasing when rates began to increase.

Those concerned about the sustainability of current house prices will correctly point to just how much it costs to own a home. Approximately 75% of home purchases are supported by the use of a mortgage. Obviously, those making the purchase can only do so if they can service the payment on that mortgage. To show this, the chart below looks at the monthly cost of servicing a new mortgage (Loan to Value = 90%) on the median home in Sydney and how it has changed over the same period.

The cost of servicing a mortgage has clearly risen dramatically. A mortgage obtained on the median home in Sydney now costs more than $7,400 per month to service. This has increased by more than 50% since December 2021, less than two years ago. Common sense suggests that this must have a limit. Surely at some point people can’t aﬀord to service their mortgage anymore and surely even the ~25% of people who buy a home with cash won’t have enough cash to buy the home they want. That all has to be true, but house prices prove that at this stage we have not reached that breaking point.

Housing demand

In the most basic sense, the quantum of dwellings needed in Australia is related to the amount of people in each dwelling and the population of the country. The Australian Bureau of Statistics (ABS) and Reserve Bank of Australia (RBA) have compiled the nation’s historic average household size and recent trends as shown below:

While perhaps a controversial ﬁgure, former RBA Governor Phillip Lowe summed up recent changes astutely, saying:

“During the pandemic, the average number of people living in each household declined. People wanted more space. They were working from home. Rents actually declined for a while. People said, ‘Rather than have a ﬂatmate I will just have an oﬃce at home,’ so the average number of people living in each dwelling declined and that increased the demand as a result for the total number of dwellings”.

So, we have less people living in each dwelling and the other component of household requirements, populaion, is also increasing strongly. Again, the RBA and ABS help by showing both the impact of population growth (in light blue) and change in household size (dark blue) over time in the chart below:

Again, Phillip Lowe sums up the situation:

“The other thing that is now happening is a big increase in population. The population is increasing by two per cent this year. Are there two per cent more houses? No. The rate of addition to the housing stock is very low. We have a lot of people coming into the country.”

This comment touches on the other key element to home prices in Australia. Namely, the supply of new property.

The other thing that is now happening is a big increase in population. The population is increasing by two per cent this year. Are there two per cent more houses? No. The rate of addition to the housing stock is very low. We have a lot of people coming into the country.

Phillip Lowe

What are we doing about it?

Amending the long-held planning practices, incentives of government and ﬁxing global supply chains is above our pay grade. What we can do is observe and acknowledge the situation and make investments that beneﬁt from the realities of housing undersupply. This can be done by investing in companies that either have development approved housing projects, or a history of working with planning authorities to obtain approval, despite all the complexities inherent in residential development.

One such investment in the portfolio is Mirvac Group (MGR). Most of MGR’s development takes place in urban inﬁll locations. These projects often increase density and at times have included iconic projects across Australia. MGR is currently developing the old Channel 9 headquarters in Willoughby in Sydney’s North, which will deliver 417 lots, with a total development value of $800 million. Existing iconic projects completed by MGR include The Melbournian, and The Eastbourne in Melbourne. MGR has also been a pioneer in the embryonic “build to rent” property sector. This involves building large apartment buildings, with all lots held for rent on an ongoing basis as opposed to being sold on completion. Those in Melbourne can inspect LIV Munro, adjacent to Queen Victoria Markets, which was recently completed and has 490 apartments available for rent. In the midst of record low rental vacancy, this business both addresses a need and provides low risk returns to investors.

Another investment in the portfolio is Peet Limited (PPC), which specialises in master planned communities across the country. These tend to be extremely large plots of land on the urban fringe of major cities and will eﬀectively be new suburbs and in some cases almost new cities. PPC’s largest project is Flagstone, located between Brisbane and the Gold Coast in Southeast Queensland. It will take a generation to complete, however once built will house 120,000 people and become Australia’s 20th largest city, a similar scale to Cairns. It will include a 100-hectare town centre, with a regional shopping centre similar in size to Chatswood Chase and will have a bigger town centre than the Brisbane CBD. This project has all relevant approvals. It is projects such as this that will go a small way to addressing Australia’s housing undersupply.

October 19, 2023

September 2023 direct property market update

Peta Tilse, Head of Retail Funds Management

Economy

pf_quarterly_oct2023_cpi The quarter started off on positive footing, with inflation across advanced economies edging down to 4.4% YoY in July¹. Central Banks’ continued focus on inflation outcomes saw data moderate, helping to ease pressure on rates. However toward the quarter’s end, it was rising energy prices (in part driven by a supply halt by OPEC+) which posed some risk to the inflation outlook and therefore increasing interest rate expectations once again

In Australia, the pace of annual inflation slowed in July from 5.4% to 4.9%, before picking up in August to 5.2%². While services inflation does remain sticky, the August increase is unlikely to be seen as cause for concern by the RBA, namely because it was driven by volatile items such as automotive fuel (up from -7.6% to 13.9%) and holiday travel (5.3% to 6.6%).

Australian bond yields were dragged higher over the quarter by the US, as markets grappled with comments from the Federal Reserve’s Chairman Powell suggesting the Fed’s job is not done, and higher-than-expected Treasury debt issuance.

While the cash rate in Australia did not change over the quarter, market pricing in early October suggested a 34%³chance of a hike. The October meeting of the RBA Board saw a new Governor (Michele Bullock) in charge. The Board elected to leave interest rates on hold (at 4.1%) which was welcomed by the market. Market pricing (as at 9^th October) has all but removed the prospect of another move, only ascribing a 5% chance of another 25bps, and signalling that the central bank is almost at the end of the cycle.

While expectations of further cash rate hikes have diminished, longer term interest rates (proxied by 10-year bond yields) remain ~40bps higher than a year ago⁴. This is continuing to put pressure on debt costs and is the main macro driver challenging property valuations, despite resilience across demand drivers.

The labour market remains tight, with unemployment staying unchanged at 3.7% in August⁵ and the number of employed people increasing by 50k over the first two months of the quarter (September data still to come). However, the “quality” of jobs growth was poor, with the number of full-time jobs decreasing by -15.9k over the same period. Leading indicators such as job vacancies and applicants per job advertisement point to slowing jobs growth ahead. Population growth is running at a far stronger pace which should cause unemployment to move beyond 4% before the end of the year, providing support to the view that the RBA hiking cycle may be complete.

On the consumer front, the impact of higher mortgage rates continues to be the primary concern. The RBA recently released its biannual Financial Stability Review which provides an updated assessment of household resilience and loan serviceability. The fixed-rate “cliff” is generally being managed well, with 45% of fixed loans originated during the pandemic having already rolled off onto higher rates and 90 days arrears rates remaining below historical averages. While risks are clearly most elevated for borrowers with high loan-to-value ratios (>80%), around two-thirds of fixed-rate mortgage holders have liquid savings equivalent to at least 12 months of scheduled mortgage payments⁶.

Outlook

The Australian economy remains in a solid position despite global headwinds. Inflation is slowing, employment is solid and population growth will provide support to demand over the course of the year. The rate hiking cycle appears to be nearing its end, financial stability has been maintained, and distress remains contained.

These factors put the Australian commercial property market in good stead from a demand perspective. Businesses continue to adjust size requirements for occupancy as they live with hybrid working, although in certain markets this is now largely known. Experiential workplaces with clever refurbishments and amenity continue to attract and retain quality tenants; something we continue to see within our assets. Location has emerged as the biggest driver of occupier demand and asset performance.

Powerful megatrends such as the need for more sustainable, energy efficient real estate, demographic shifts, and rising demand for segments serving the modern economy such as urban logistics, healthcare and highly amenitised offices will create income growth opportunities.

With the Israel-Hamas conflict adding further uncertainty to geopolitical risks and a soft Australian dollar, capital continues to view Australia as a favourable investment destination. This is because of its attractive demographic profile, growth prospects, and relative social and political stability. However, elevated interest rates, wide bid/offer spreads, and limited transactional evidence have all put pressure on valuations.

How did Cromwell Funds Management fare this quarter?

Reflecting the good leasing activity in Brisbane, it was a busy quarter for 100 Creek Street, Brisbane with the leasing of speculative suites helping to fit the asset’s occupancy to 88.4%. The Fund’s current WALE (on a look-through basis) is 4.3 years, and occupancy sits at 94.4%.

There were no valuations updates in the quarter for the Fund given the entire portfolio was independently revalued last quarter. With higher interest rates and softer valuations weighing on the Fund, and understanding regular income is important to all unitholders, the Cromwell Funds Management Board made some financially prudent changes in September. These included ceasing to offer redemptions for a period of 6 months, and reducing distributions to 5.75cpu p.a; bringing it in line with expected profit from operations. Other important changes included the addition of a 5% discount to the Distribution Reinvestment Plan. Further details are listed here.

Performance (%) p.a as at 30 September 2023

Year	Cash (AU)	Bonds (AU)	Shares (AU)	Cromwell Direct Property Fund
1	3.56%	1.61%	10.9%	-11.0%
3	1.36%	-3.92%	8.55%	2.31%
5	1.28%	0.34%	5.08%	3.48%

_{Past performance is not a reliable indicator of future performance.}_{Source: Lonsec and Cromwell Funds Management}

_{1. The Forward View – Global, NAB (Sep-23)

2. Monthly Consumer Price Index Indicator, ABS (Sep-23)

3. RBA Rate Tracker, ASX (Oct-23)

4. Capital Market Yields – Government Bonds, RBA (Oct-23)

5. Labour Force, ABS (Sep-23)

6. Financial Stability Review, RBA (Oct-23)

7. Australia Industrial and Logistics Figures Q3 2023, CBRE (Oct-23)}

Property	Management Team	Building services	Overall score
95 Grenfell Street	90	80	85
Tenant Satisfaction Index	84	79	81

Property Avg Equivalent Yield	Prime CBD Office	Outer Central West Sydney Industrial	NSW Regional Shopping Centres	NSW N’hood Shopping Centres	10y Gov Bond Yield
Mar-22 (%)	4.44	3.26	5.13	5.13	2.50
Dec-23 (%)	5.69	5.25	6.00	6.25	4.19
Change (bps)	125	200	87	113	169
Spread to Gov Bond (bps)	150	106	181	206	na
Historical (25y) Avg Spread (bps)	184	310	200	340	na

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June 2024 quarter ASX A-REIT market update

Market Commentary

Market outlook

Performance commentary

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June 2024 direct property market update

Economy

Office

Retail

Industrial

If rates are held steady, the labour market continues to soften, and disinflation resumes its downwards trend, we should see further improvement in capital market liquidity and property transaction activity.

Outlook

How did the Cromwell Funds Management fare this quarter?

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Actively managing our assets: 95 Grenfell Street, Adelaide

Leasing Activity

A total of four new leases have been signed for Chesser House in the last nine months (to 1 April 2024), including a significant state government tenant.

95 Grenfell Street tenants awarded Cromwell an overall satisfaction level 4% higher than the Tenant Survey Index

Key statistics:

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An introduction to property valuations

The importance of valuations

Types of valuations

Commercial property valuation is the most reliable way of determining the market value of an income-producing property – it serves as an important, professionally backed tool for owners, investors, banks, regulators, and other interested parties.

How properties are valuated

Capital markets can also influence cap rates. If a particular asset class or sector becomes more desired, the price investors are willing to pay per unit of income will increase and vice versa.

Contributors to a property’s value

In summary

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December 2023 direct property market update

Economy

Office

Retail

Industrial

Outlook

How did the Cromwell Direct Property Fund fare this quarter?

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December 2023 quarter ASX A-REIT market update

Market Commentary

Market outlook

About Stuart Cartledge

Performance commentary

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Build to Rent – an emerging asset class in Australia

What is “Build to Rent”?

Mirvac is pioneering BTR in Australia

Financial metrics are interesting

About Stuart Cartledge

Performance commentary

Learn

September 2023 quarter ASX A-REIT market update

Market Commentary

Market outlook

About Stuart Cartledge

Performance commentary

Learn

Australia’s housing battle: Interest rates versus supply and demand

Interest rates

How can we aﬀord this?

Housing demand

Housing supply

The real issue

What are we doing about it?

A closing note

Learn

September 2023 direct property market update

Economy

Office

Retail

Industrial

Outlook

How did Cromwell Funds Management fare this quarter?