Clean income and an attractive yield

In a time of slowing growth and elevated inflation, the ability to generate stable, growing income is an important driver of investment returns. Large Format’s yield nationally is 6.1%⁶, higher than many commercial and residential property sectors. We also consider the yield to be “cleaner” – what you see is what you get. Compared to major shopping centres for example, which are complex structures with substantial plant and equipment, often less capital expenditure is required to maintain a Large Format asset. This means the post-capex yield, or the money that actually ends up in your pocket, may be more attractive than a simple comparison of headline yields suggests.

The income underpinning the yield also grows over time, in contrast to the fixed nature of bonds. Like the broader retail sector, Large Format leases typically stipulate rent escalation each year of 3-5% or a CPI-linked amount, usually providing growth in excess of inflation. The income stream is dependable, with the majority of Large Format income derived from 5–10-year leases to ASX-listed or national retailers, such as Bunnings, The Good Guys and Freedom.

We believe the runway for rental growth in Large Format is sustainable, given the lower starting level and attractive economics for retailers. Mosaic Brands recently announced plans to open 40 “mega stores” through to Jun-24, as the larger format is 3x more profitable than their normal store size⁷. For some assets, further growth can be derived from intensification – development of unutilised land, car parks, or air rights into income-generating improvements.

Omnichannel-ready

Online’s share of Australian retail trade has increased from 5.1% five years ago to 10.7% today⁸. The rise of e-commerce has dampened demand for physical retail space relative to household consumption, particularly across discretionary shopping centres with large exposures to categories such as clothing and department stores. Cromwell forecasts online’s share of spending to increase to 20% by 2030, however there are several reasons why Large Format can view the shift as an opportunity, given its role in omnichannel retailing.

From consumers’ perspective, Large Format minimises much of the friction associated with a traditional shopping centre experience – friction which turns shoppers towards e-commerce. Convenience is the number one reason for purchasing online^9,10, as large multi-level shopping centres provide a frustrating car parking¹¹ and navigation experience. In contrast, Large Format assets are often a simple rectangular layout with large on grade or basement car parks. These assets can provide the benefits of a physical shopping experience, such as better customer service⁸ and the ability to touch and trial products¹², while minimising the painpoints. In-person shopping is particularly valued across Large Format’s typical retail categories such as homewares and home improvement.

For retailers, Large Format facilitates an improved omnichannel proposition in a number of ways. Rents are typically in the range of $300-600 per square metre, much lower than traditional shopping centres and closer to levels being seen across industrial assets today. Sites are generally large, flat, and designed to be accessible to the heavy vehicles delivering bulky goods to occupiers. Assets are also often well-located, with ample arterial and motorway connections servicing significant population catchments. These attributes make Large Format assets well suited to the full suite of omnichannel product “delivery” options, including buying in store, click and collect, and ship from store, while also offering reasonably cost-effective inventory storage – Nick Scali for example stores 55% of inventory in its showrooms¹³. In this respect, Large Format can offer investors a quasi-industrial exposure spanning warehousing and fulfilment, with the added fillip of revenue generation (making sales).

The physical store presence also aids in reducing last mile reverse logistics costs¹⁴ and processing times¹⁵, and provides retailers with an additional opportunity to engage with customers and generate a sale when products are being returned. By offering a seamless omnichannel experience, retailers can drive customer engagement and loyalty.

Customers’ preference for omnichannel is evidenced in trading outcomes, with “Bricks & Clicks” retailers winning online market share at the expense of “Digital Native” retailers¹⁶, and multichannel customers spending 2-3x more than single channel customers¹⁷. Omnichannel is important to customers and retailers alike, and Large Format’s characteristics can make it a preferred component in that proposition, particularly as e-commerce increases its share of sales and industrial rents reach higher levels.

Large Format Outlook

The outlook for demand is robust with retailers continuing to look for space – Super Retail Group for example is looking to open an additional 61 stores by Jun-26, while the likes of Baby Bunting, Bedshed, Nick Scali and Plush require a combined 125+ locations to reach their target store networks²⁰. The vacancy rate has tightened to 3.2%²¹, its lowest level since at least Jun-17, meaning limited space is currently available and future availability will be constrained by the muted supply pipeline. These dynamics are expected to create conditions conducive to rental growth, which CBRE forecasts will run at +3.0% p.a. nationally from 2023 to 2026²².

Stock selection is key, with Large Format performance closely linked to location, the strength of the surrounding catchment (i.e. income/population growth), and impacts from competition. Metropolitan sites in land-poor markets are preferred given the protection that scarcity (and lack of competition) provides to valuations over time – acquiring at attractive pricing is a key challenge for these types of assets. Dominant assets in fast-growing non-metropolitan markets can also be attractive if the risk of future competition can be adequately priced.

The Property Council of Australia/MSCI Australia Annual Property Index, MSCI (Jun-23)
Retail Trade August 2023, ABS (Sep-23)
Based on analysis by the Centre for Population, National population projections in the 2023-24 Budget; Cromwell (May-23)
National, state and territory population, ABS (Sep-23)
ABS 2021 Census; Cromwell
Australian Retail Figures Quarterly Market Report, 2Q 2023 (CBRE)
FY2023 Market Update, Mosaic Brands (Aug-23)
Rolling 12-month basis as at Jul-23. ABS Retail Trade (Aug-23)
IAB Australia and Pureprofile Australian Ecommerce Report 2023
Shopping Pulse, Klarna (Q2 2023)
Bricks & Clicks, UBS (2019)
Retail Monitor, Australian Consumer and Retail Studies, Monash Business School (Nov-22)
FY23 Results Presentation, Nick Scali (Aug-23)
Wallenburg, Einmahl, Lee & Rao (2021)
McKinsey (2021)
Inside Australian Online Shopping, Australia Post (2023)
Myer (Sep-23); Coles (Feb-21); Accent Group (Aug-18); Pallant et al (2020); KPMG (Dec-22)
SCCA (Sep-23)
Australian Industrial and Logistics Figures Q2 2023, CBRE (Jul-23)
Company reports; Cromwell (Sep-23)
JLL Research (Jun-23)
Large Format Retail Australia, CBRE (May-23); Cromwell. Rental growth refers to Prime net face rents (AUD/sqm).

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)}

October 11, 2023

Redefining the office flight to quality: A Sydney CBD case study

Colin Mackay, Research & Investment Strategy Manager, Cromwell Property Group

“Flight to quality” has been the real estate industry’s phrase of the year, particularly as it pertains to the office sector. While Cromwell agrees that a flight to quality is occurring and will continue to play out over the medium-term, our opinion of what that flight actually is – and indeed our definition of quality – is somewhat contrarian.

Quality has become synonymous with Premium – the top grade of office buildings. These buildings are modern developments with the largest floorplates, most internal amenity, and luxurious finishes and fitouts – and which naturally charge the highest rents. While this type of asset is an important part of the market, it’s worth assessing whether the popular narrative fits all the facts.

Are occupiers flocking to Premium assets at the expense of Secondary stock? Does the top-end of town hold all the cards?

Vacancy paints a different picture

Vacancy rates highlight a deterioration of demand relative to supply at the top end of the asset grade spectrum. In the Sydney CBD, Premium has the highest vacancy rate in absolute terms and when compared to its historical average.

B Grade has proven more resilient from an occupancy perspective, with vacancy actually decreasing over the last year.

Despite elevated vacancy, Premium’s net effective rental growth has outpaced A Grade and B Grade over recent quarters. There are a couple of potential explanations for this counterintuitive result.

Time lags: It takes time for changing conditions to be grasped by market participants, for negotiations to be had and leases signed. Premium had the lowest vacancy rate until mid-2022, with its main occupiers adopting a “wait-and-see” approach to space decisions through the pandemic. Now, Premium occupiers are handing back space and driving vacancy higher, but current rental outcomes are reflecting the tight conditions of prior quarters.

Affordability: The spread between Premium and A Grade rents narrowed over 2021-22 as Premium incentives increased. Industry feedback suggests occupiers have taken advantage of the relative affordability to upgrade, taking up less space but at a higher rate per sqm. This is positive for market rental growth but less so for income growth, given the occupancy effect. We expect Premium upgrading to run out of steam as affordability worsens, with the spread recently increasing to its widest level since 2014.

Incentives are financial ‘sweeteners’ offered by landlords to encourage tenants to lease space. Common incentives include contributions to tenant fitout costs, rent-free periods, and rental abatements where the amount payable is reduced for a period of time. The rent received by a landlord after incentives are accounted for is referred to as an “effective” amount.

In any case, for investors, there’s limited value in knowing today’s performance – what really matters is the future.

Price doesn’t always equal quality

Conflating luxury with quality ignores the needs of many office occupiers. While the largest companies attract the most attention, most office-using Australian businesses are small and medium-sized enterprises (SMEs)⁴. With cost being the top driver of real estate decisions⁵, these SMEs are in the market for a Toyota, not a Rolls-Royce with all the extras. They want the highest quality office, in the best location, but within their price bracket. So then, what is “high quality” office? Ultimately, it’s space which meets the needs and preferences of its target occupiers.

Some occupier preferences are timeless and will persist no matter how workstyles and space usage evolve, for example availability of natural light, convenient access to transport and plenty of nearby amenity (e.g. dining and gyms). These are hygiene factors valued by occupiers of any industry or size.

The pandemic has rendered some requirements less important. Floorplate size has historically been a measure of quality and is one of the criteria that determines whether a building is considered Premium or a lower grade. But with occupiers’ office usage shifting towards collaboration and social connectivity, a smaller floorplate can create more incidental interactions and a better ‘buzz’ in the office. While there is a minimum viable size in terms of efficiency and layout, we’re finding bigger isn’t always better in the eyes of occupiers.

Other requirements have increased in importance as occupiers shift to a new way of working. A greater level of embedded technology is expected, to ensure a flexible working model can be facilitated. Greater diversity of spaces is needed to support focused work, collaboration, and flexibility, with implications for building layouts and landlord-led fitouts.

Sustainability also continues to increase in importance, with a wider array of organisations focusing on both the financial and social benefits it can provide, including staff attraction and retention.

Greater diversity of spaces is needed to support focused work, collaboration, and flexibility, with implications for building layouts and landlord-led fitouts.

Not always the more sustainable choice

The preference for sustainable space is becoming more tangible and spans a variety of stakeholders, including end users, occupiers, and investors. Premium buildings often have the highest sustainability ratings (e.g. NABERS), something which is used to support the view that occupiers will increasingly gravitate to these assets over time. But again, these ratings don’t tell the whole story.

While new Premium assets are top performers from an operational emissions perspective (e.g. energy usage), production of building materials and construction activities are the largest producers of embodied carbon emissions⁶. As the grid decarbonises, embodied carbon’s share of built environment emissions is expected to increase from 16% in 2019 to 85% by 2050⁶ – in the pursuit of net zero, minimising the demolition of existing buildings and the construction of new ones will become far more important than building-specific energy efficiency. As the importance of embodied carbon becomes more well known and stakeholders adopt a whole-of-life view of emissions, newly built Premium assets may not be considered the greener option.

Embodied carbon: the emissions generated during the manufacture, construction, maintenance and demolition of buildings – Green Building Council of Australia (GBCA)

Look beyond the headline

“Flight to quality” has been a popular theme in the office sector. While positive net absorption has been used to support the notion that Premium buildings are outperforming lower grade assets, the metric can’t be looked at in isolation. Investors gain a more comprehensive understanding of market conditions by also considering other factors such as vacancy, supply impacts and occupier demand trends. We believe the flight to quality is occurring across all grades – not just Premium – as occupiers seek space that is well-located, offers high amenity, and enables a flexible approach to working, but within their price bracket. In our view, the A Grade segment of the market is best-positioned as it occupies an affordability-quality sweet spot, supported by ongoing demand from smaller occupiers and a smaller supply pipeline.

Empty spaces and hybrid places (McKinsey, Jul-23); U.S. Office Occupier Sentiment Survey (CBRE, May-23)
Australian Office Footprint Analysis (CBRE, Oct-22)
ABS (May-23); Cromwell. Main office-using industries includes: Information media and telecommunications; Rental, hiring and real estate services; Professional, scientific and technical services; Administrative and support services; Education and training (private). Financial services employment breakdown is not published by the ABS.
SMEs defined as businesses with 5-199 employees, within the same office-using industries as previously defined.
What Occupiers Want (Cushman & Wakefield, Jul-23)
Embodied Carbon & Embodied Energy in Australia’s Buildings (GBCA; thinkstep-anz, Aug-21)

September 14, 2023

Industrial: Still delivering the goods

Colin Mackay, Research & Investment Strategy Manager, Cromwell Property Group

Industrial has been Australian real estate’s star performer for a decade, notching up an annualised 10-year return of 14.2%¹. While the rate of new supply has increased, the availability of space has been unable to match pace with surging demand. Australia has become the lowest vacancy industrial market in the world², contributing to record rental growth of almost 25% in the year to March 2023³. The sector’s strong momentum continues, and the outlook is bright, as several long-term tailwinds drive demand.

E-commerce

The shift in retail activity from physical stores to digital channels drives demand for industrial space in several ways:

warehouse space is needed to store inventory which would have otherwise sat in a store;
e-commerce tends to offer a wider range of products, rather than the curated selection that a specific retail store might be limited to, necessitating more storage space; and
goods purchased online have higher rates of return, and space is needed to handle the reverse logistics.

Increased storage and space needs mean pure-play e-commerce requires three times the distribution space of traditional retail⁴. Customer preferences are primarily driving the shift to online, particularly as demographic change sees ‘digital natives’ become the dominant consumer segment. As scale and investment lead to greater efficiencies and profitability, the shift may gain another momentum boost.

E-commerce in Australia is following a similar trajectory to Great Britain – it is on track to hit a market share of 20% of all retail sales by 2030 despite growth slowing from pandemic peaks. With 70,000sqm of logistics space needed for every incremental $1 billion of online sales⁵, e-commerce alone could generate industrial space demand of almost 600,000sqm p.a. over the next seven years⁶.

Customer proximity

The time it takes to reach the customer is of critical importance in modern supply chains. Customers increasingly expect products to arrive faster, more flexibly, at the time promised, and with lower delivery costs. While not a driver of aggregate space demand, the focus on customer proximity does contribute to stronger rental growth for well-located properties.

Transport accounts for 45-70% of logistics operator costs compared to 3-6% for rent¹⁰. This low proportion of cost means well-located industrial assets with good transport access and proximity to customers have long runways for rental growth, as occupiers prioritise lower (cheaper) transport times – an up to 8% increase in rent can be justified if a location reduces transport costs by just 1%.

But what about supply risk?

While the demand drivers for industrial are clear, the supply-side response is just as important in determining asset performance. In previous cycles, downturns have arisen from excess speculative development creating too much stock and dampening rental growth. But there are several reasons why the sector is insulated from a supply bubble this time around. Firstly, labour and materials shortages are making it challenging to physically build new assets, even though development is commercially attractive. Secondly, there is a lack of appropriately zoned, serviced land available for development. While land is becoming available farther out from metropolitan centres (e.g. Western Sydney Aerotropolis), this land is not appropriate for many occupiers or uses which require closer proximity to customers. It will also take time for this land to become development-ready, due to planning, infrastructure (e.g. road widening), and utility servicing (e.g. water connection) delays. Finally, the sector has matured and become more ‘institutional’ over the current cycle, with a shift in ownership from private capital to large, sophisticated owners and managers. Institutional owners take a more cautious approach to development, contingent on higher levels of tenant pre-commitment, reducing the risk of a speculative supply bubble. These factors will make it difficult for supply to keep pace with – let alone surpass – demand.

Demand story remains intact

Industrial has been the “hot” sector in recent years, and it’s reasonable to question whether it’s been squeezed of all its juice. The pandemic provided a boost to many of industrial’s demand drivers (e.g. e-commerce) and introduced new ones (e.g. supply chain resilience). While these tailwinds have abated somewhat from their pandemic highs, they continue to contribute to a positive demand outlook. Arguably more importantly, the supply response remains constrained by shortages (e.g. labour/materials/land) and delays (e.g. planning), and it will take several years for the sector to return to a more normal supply-demand balance. As a result, Cromwell expects healthy rental growth to be a key driver of industrial returns, and for the sector to remain attractive despite expansionary pressure on cap rates.

_Footnotes

^{1. The Property Council-MSCI Australian All Property Digest, June 2023 (MSCI)

2. Australia’s Industrial and Logistics Vacancy 2H22, December 2022 (CBRE Research)

3. Logistics & Industrial Market Overview – Q1 2023, May 2023 (JLL Research)

4. What Do Recent E-commerce Trends Mean for Industrial Real Estate?, Mar-22 (Cushman & Wakefield Research)

5. Australia’s E-Commerce Trend and Trajectory, September 2022 (CBRE Research)

6. Projection based on historical 15-year retail sales growth of 4.0% p.a. (Cromwell, Jun-23)

7. Is ‘Just-in-Time’ a relic of a time gone by in Australia?, March 2023 (JLL)

8. Global Reshoring & Footprint Strategy, February 2022 (BCI Global)

9. Australian Infrastructure Budget Monitor 2022-23, November 2022 (Infrastructure Partnerships Australia)

10. 2022 Global Seaport Review, December 2022 (CBRE Supply Chain Consulting)}

September 14, 2023

An office space evolution

George-street-final

We know the office space landscape is changing. It’s up to Cromwell, as a real estate investor and fund manager, to a listen to the modern requirements of tenants and invest in upgrading our assets to meet these needs while also adding value for investors.

In Edition #42 of Insight, Cromwell’s Research Investment Strategy Manager, Colin Mackay, examined how the office is increasingly becoming a place for collaboration and social connection, rather than focus work, meaning a greater need for meeting, gathering, and collaboration spaces. There is also a need to lower density and make workplaces more comfortable from an employee wellbeing and retention perspective.

Earlier this year, Insight examined ‘The physical office in a hybrid world’ – how white-collar employees divide their working week between home and office, and how the role of the office space has changed forever, largely due to work from home requirements during the COVID-19 pandemic.

The conclusion reached was that, as demand continues to concentrate on the minority of space suitable for modern occupation, the supply-demand mismatch will widen. It was proposed that investors who own or can acquire or create the space occupiers want, where they want it, are well positioned for future rental growth – and, importantly, are more likely to retain and attract tenants.

So, what do tenants want?

Spaces occupiers want

Understandably, tenant requirements can be as diverse as the building occupiers themselves. However, there are a number of reoccurring modern office space requirements that require attention.

A May 2023 research paper by global real estate services firm JLL revealed that incentives being offered by landlords to either encourage tenants to stay, or entice them to new premises, remain at historically high levels across many markets¹.

According to the research, upgrades to the base building, including end-of-trip facilities, improved ground entry and reception areas, improved lifts and amenities, event spaces, health and wellbeing facilities, business lounges, and cafes are high on the agenda for landlords seeking to keep their occupancy levels stable.

Sustainability is also increasingly a consideration for tenants, including requirements to source all power from renewable sources, or undertake capital upgrade works to the building infrastructure.

In addition, research from Swinburne University of Technology and Third-Place.org in January announced that “working from cafes and pubs will be a 2023-defining trend”². These kinds of work environments have been termed ‘third spaces’ – or ‘third places’.

The researchers found that, on average, people who work in third places will typically do so between two and three times each week. These workers will stay anywhere between 15 minutes and four hours – most of the time, they’ll go to a third place on their own.

The top three benefits to working in a third place were reported to be mental reset, community and social connection, and great food and coffee. When asked to what extent working from a third place positively contributes to their overall wellbeing, the average response was 86%. By extension, 98% of respondents said they’d continue to use a third place for work in the future.

Meeting market desires

Cromwell has a strong track record of adapting office spaces to meet tenants’ requirements. Our exceptional in-house property development, project management, and technical capabilities allow us to identify and deliver value for our tenants, our investors, and capital partners through innovative development and construction projects, whole- of-building refurbishments, and adaptive re-use and asset transformations, all of which incorporate market leading sustainability initiatives.

The office market latest

Vacancy rates in Australia’s capital cities have increased modestly over the last six months, driven by an uptick in new office supply, according to fresh data from the Property Council of Australia (PCA).

The July 2023 edition of the ‘Office Market Report’, which is released twice a year, showed overall CBD vacancy increased from 12.6 to 12.8% nationally³. Non-CBD areas saw an increase from 15.2 to 17.3%.

PCA projects that the supply of office space in CBD markets is expected to remain close to the historical average throughout 2023, with an anticipated increase above the average in the second half of 2024.

Encouragingly, the office market in Brisbane – where Cromwell owns a number of assets – is particularly robust, with tenant demand outpacing available supply, decreasing the vacancy rate from 12.9% to 11.6%.

“Notably, the results show Premium and A Grade stock remains in high demand, reinforcing businesses’ desire to provide attractive and enjoyable workplaces for their people,” Property Council Chief Executive Mike Zorbas said as part of the July Office Market Report launch.

“These organisations recognise that maintaining a physical office presence in our cities is vital for conducting business effectively. We know that face-to-face teamwork supports deeper team relationships and brings about positive outcomes for organisations, the economy, and society
at large.”

Continuing to improve our spaces

Attracting Government and blue-chip tenants on long-term leases continues to be a key focus for Cromwell. As with our George Street property, works have been undertaken at several other assets to retain existing building occupiers – and attract new tenants.

Cromwell has actively completed a number of property upgrades of this kind already in 2023, including the recent completion of several speculative fitouts.

Speculative fitouts are new office fitouts built by the landlord or building owner, designed to accommodate a broad range of new tenants. If building owners can show potential tenants a functional, modern space that requires no further work, it makes the property a much more attractive prospect.

Recent completed works include:

207 Kent Street, Sydney
Cromwell’s Projects Team has successfully concluded construction activities on levels 18, 19, and 20. These enhancements are in preparation for the upcoming occupancy of new tenants in the forthcoming months.

The tenancy areas have undergone upgrades, featuring environmentally conscious carbon-neutral flooring and energy-efficient LED troffer lighting. Additionally, significant improvements have been made to lift lobbies and amenities across various floors. Both cold shell and warm shell office spaces have been prepared for future fitouts.

These recent endeavours build upon the substantial base build refurbishment that was previously undertaken in 2022. This refurbishment included a lobby refresh inspired by a First Nations Indigenous design, with the addition of end-of-trip facilities. These facilities encompass a spacious bike storage area, expanded shower amenities, and the installation of numerous new storage lockers.

95 Grenfell Street, Adelaide
Cromwell Direct Property Fund’s Chesser House property, located in the heart of Adelaide, has recently seen the completion of speculative fitouts in two tenancies.

The suites boast neutral colour palettes, highlighted by gentle blues and calming green tones, contributing to a serene ambience. The layout of the 360sqm and 200sqm spaces has been strategically planned to maximise functionality. This includes dedicated areas for meeting rooms, quiet spaces, and collaborative zones.

475 Victoria Avenue, Chatswood
Cromwell’s Projects Team has successfully managed the realisation of six speculative fitout tenancies spread across three levels. The sizes of these tenancy floors span from 100sqm to 520sqm, with each suite thoughtfully adorned with a distinct colour palette, instilling a sense of individuality to every area.

Space planning was thoroughly conducted in collaboration with both internal and external leasing teams. This strategic approach responds to the growing demand for collaborative spaces while underlining the importance of design flexibility to facilitate enhanced reusability.

Furthermore, sustainability remains a paramount focus. A notable achievement in this regard is the recycling of 52% of construction waste, which includes repurposing existing furniture items.

100 Creek Street, Brisbane
Three speculative fitouts, completed in December 2022, were well received by the market; prompting the building of a further four speculative fitouts, across two floors, this year.

The design of these suites focused on breakout areas and collaboration zones to address market requirements in addition to providing quiet rooms to those wishing to concentrate on tasks or avoid distraction.

To enhance the value of the space, carbon-neutral flooring inspired by First Nations Indigenous culture was carefully selected and incorporated.

Continuing to improve our strategy

In response to market dynamics, Cromwell is reshaping our speculative fitout approach. Our primary goal is optimising financial efficiency, particularly during periods when tenants are yet to be secured.

As part of this process, we’re introducing a fresh concept: pre-lease design concepts – that is, potential tenants can influence final touches after pre-commitment. By addressing tenant preferences, we enhance experiences and minimise post-move changes. This strategy balances financial prudence, tenant engagement, and functional design, exceeding expectations consistently.

Our designs offer lasting allure, catering to diverse needs. Easily upgradable components reduce major modifications. Further, ESG considerations remain paramount to our business decisions – we integrate eco-friendly practices and repurpose elements to cut waste.

In essence, our approach emphasises sustainability, functionality, and tenant satisfaction. Adaptable designs create appealing, eco-conscious spaces.

In conclusion

As the office market continues to evolve, Cromwell is committed to ensuring that our assets adequately meet current and future tenant requirements – we will adapt office spaces to meet tenants’ needs, improving our vacancy rates in a highly competitive market.

By developing our approach to improve the occupancy of our assets, we will deliver favourable outcomes for investors now and in the future.

_Footnotes

^{1 Choosing the best fit for your organisation, May 2023 (JLL Research)

2 Third Places – A health alternative to working from home?, January 2023 (Swinburne University of Technology and Third-Place.org)

3 Office Market Report, July 2023, (Property Council of Australia)}

August 3, 2023

June 2023 direct property market update

Peta Tilse

Economy

chart_austcpi

At the risk of sounding like a broken record, the outlook for inflation and interest rates was again the key focus for markets over the June quarter. It does appear that central banks are winning the fight against inflation, with CPI prints in the US and Australia coming in below market expectations and Canadian inflation dropping below 3%.

Australia’s June quarter data showed goods inflation continues to slow, with services inflation stickier (as expected). Annual inflation is now sitting at 6.0%, down from 7.0% in the previous quarter. Surging insurance premiums (14.2%), elevated food prices, and the highest annual rent inflation since 2009 were the key drivers.

The softer-than-expected inflation print provided the RBA with breathing room, with markets now expecting a pause at the August meeting. At this late stage of the cycle, it’s prudent that rates are only hiked when compelled by the data, and most indicators such as hiring plans, consumption, and confidence point to slowing ahead.

The strong labour market will potentially force another rate hike in coming months if it remains tight, but it’s important to remember that unemployment is a lagging indicator. The RBA is conscious of our highly indebted household sector; the high proportion of fixed rate mortgages which will be rolling onto higher variable rates; the 400bps of tightening which is still yet to fully hit the economy; and rising rents putting pressure on household budgets.

The challenge of rising rents is in part due to a mammoth increase in population, driven by estimated net overseas migration of 400,000 people for the year to June¹. While the very strong population growth will expand the demand base of the economy, it does place extra strain on a housing sector which was already behind the pace in supplying adequate dwellings. There isn’t a quick fix, so residential rents will likely continue rising at a solid pace for some time. There is a limit to how much rental growth households can stomach, and relief will likely be seen via an increase in the average household size. After decreasing to record lows over the year, a reversion of household size to the pre-COVID average (~2.52 people) would “free up” around 100,000 dwellings, while an increase to 2.55 would account for all estimated population growth in the year to June.

chart_overseashousehold

Office

It was a mixed bag for office data over the latest quarter, as rental growth proved resilient despite early signs of softening across space fundamentals and yields. According to JLL Research, national CBD net absorption totalled over 13,000 sqm, with four of six markets recording positive demand. The resource-based markets of Brisbane and Perth comfortably saw the strongest levels of demand, with expansion from the public sector, mining and professional services driving their positive results.

Sydney CBD recorded the weakest result, as large occupiers across financial services and technology contracted their footprint and/or offered excess space for sublease. Prime stock continued to record stronger net absorption than Secondary stock on a national basis.

chart_netabsorption

The national CBD vacancy rate increased negligibly to 14.4%. Reflecting the large occupier trends noted above, Sydney and Melbourne both saw an increase in the vacancy rate. The other CBD markets recorded a lower vacancy rate compared to the first quarter of the year, with Brisbane and Perth seeing the most tightening consistent with their stronger net absorption outcomes. Despite elevated vacancy, rental growth was broadly positive. Prime net face rents grew across every CBD market for the quarter, led by Brisbane. Prime incentives were largely stable, leading to positive net effective rental growth across half the markets and the strongest growth in four quarters on a national basis.

chart_totalvacancyrates

chart_primenetgrowth

The impact of higher interest rates was reflected in a softening of Prime yields over the quarter, resulting in lower valuations across the sector despite supportive income growth. Transaction volume remains very low, with 44 Market St, Sydney the only notable Prime asset which traded over the quarter.

Retail

The impact of higher interest rates is starting to be felt by consumers, with retail sales declining -0.8% in June. This was the fifth consecutive month of sub-1% growth, bringing annual growth down to 2.3%. Growth was weakest across the discretionary categories of Department Stores and Clothing, as their very strong run through the pandemic starts to lose steam. Groceries was the top performing category over the month with its more resilient inflation drivers, while eating out held up relatively well considering the headwinds facing consumers.

Positively for retail real estate, income growth continues to recover from COVID impacts. Retail sales are still 16% above the level implied by the pre-COVID trend, and leasing activity reflects the outperformance which accrued to tenants over the period. Retail has not been immune from the expansion of yields seen across real estate in the June quarter. However, retail’s higher starting yield means the movement is less impactful to valuations on a percentage basis.

While income recovery is strongest across discretionary-focused assets, investors continue to prefer centres underpinned by a strong convenience offering. A 50% stake in Westfield Tea Tree Plaza came to market this month and will provide pricing evidence for large shopping centres.

Industrial

Industrial continues to generate significant face and effective rental growth, albeit at a slowing pace. The strength of the sector is due to its favourable demand-supply balance, with national vacancy remaining below 1%² . Space take-up continues to be led by Transport & Warehousing, Retail Trade, and Manufacturing occupiers. Pre-leased space, particularly in Brisbane, continues to be the main driver of take-up, however this is skewed by the lack of lettable space – Sydney vacancy is near zero and impacting the ability of occupiers to move or expand.

Supply is expected to reach record levels in 2023, with high levels of completions also expected in 2024. Vacancy is still expected to remain well below long-run averages despite elevated development, with most of the pipeline for 2023 already pre-committed. There is also a risk that some of this supply is delayed in coming to market, particularly in Sydney, due to labour shortages and planning delays.

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 is 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. Capital continues to view Australia as a favourable investment destination given its attractive demographic profile, growth prospects, and relative social and political stability.

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.

How did Cromwell Funds Management fare this quarter?

The Cromwell Direct Property Fund (CDPF) was fully revalued this quarter by external valuers with 54% of the portfolio completed as at 30 April 2023, and the remainder as at 30 June 2023. The portfolio of assets as at 30 June reflects best available information. Despite good leasing outcomes, valuations were impacted by some recent sales which saw a further widening in cap rates of between 0.125% to 0.75% (depending on the individual asset fundamentals).

After the quarter’s end (7 July), Cromwell Funds Management Limited (CFM), as the responsible entity of the CDPF, entered into a Merger Implementation Deed (MID) with Australian Unity Property Limited (AUPL). If successful, the trust scheme under the MID will see the Australian Unity Diversified Property Fund merge with CDPF creating a 15 asset portfolio across the Industrial, Retail Convenience, and Office sectors, and increasing location diversification with three assets located in Western Australia.

View further information about the proposed merger here: Cromwell Direct Property Fund Proposed Merger – Cromwell Funds Management

The Fund continues to distribute 6.75 cents per unit p.a., or 6% p.a³ (payable monthly), and has generated annualised total returns since inception of 7.2% p.a. The Cromwell Direct Property Fund continues to demonstrate excellent risk adjusted returns for investor portfolios.

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

Year	Cash (AU)	Bonds (AU)	Shares (AU)	Cromwell Direct Property Fund
1	2.89%	1.24%	14.4%	-11.0%
3	1.01%	-3.51%	11.07%	2.70%
5	1.17%	0.51%	7.12%	3.60%

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

_{1. 2023-24 Federal Budget estimate

2. CBRE Research, Australia Industrial and Logistics Figures Q2 2023

3. Based on current distributions of 6.75 cents per unit p.a. and a current unit price of $1.1156 as at 30 June 2023.}

Learn

December 2023 quarter ASX A-REIT market update

Market Commentary

Market outlook

About Stuart Cartledge

Performance commentary

Research and Insights

Biodiversity: a fundamental part of our natural capital

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Large format retail: Sticking to the fundamentals

Population growth is a powerful driver of demand

The growth of the under 35 demographic is central to household formation and the retail activity that comes along with it, which is more heavily represented in Large Format assets (e.g. furniture/appliances).

Clean income and an attractive yield

Omnichannel-ready

Large Format is an omnichannel hybrid of retail and industrial, offering consumers a “touch and trial” shopping experience and retailers a cost-effective shopfront and inventory storage.

Supply is constrained, good news for existing owners

Large Format Outlook

Register your interest

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September 2023 quarter ASX A-REIT market update

Market Commentary

Market outlook

About Stuart Cartledge

Performance commentary

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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

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September 2023 direct property market update

Economy

Office

Retail

Industrial

Outlook

How did Cromwell Funds Management fare this quarter?

Learn

Redefining the office flight to quality: A Sydney CBD case study

Net absorption is important but doesn’t tell the whole story

On face value, it’s easy to see why the “Premium is best” narrative has emerged – but there’s more to the story!

Vacancy paints a different picture

Good things come in small packages

Price doesn’t always equal quality

Not always the more sustainable choice

Is this only a Sydney theme?

We believe the flight to quality is occurring across all grades – not just Premium – as occupiers seek space that is well-located, offers high amenity, and enables a flexible approach to working, but within their price bracket.

Look beyond the headline

Learn

Industrial: Still delivering the goods

E-commerce

Supply chain resilience

Infrastructure

Customer proximity

But what about supply risk?

Demand story remains intact

Footnotes

Learn

An office space evolution

Spaces occupiers want

Meeting market desires

The office market latest

Continuing to improve our spaces

Continuing to improve our strategy

In conclusion

Footnotes

Learn

June 2023 direct property market update

Economy

Office

Retail

Industrial

Outlook

How did Cromwell Funds Management fare this quarter?

_Footnotes

_Footnotes