Patience and discipline: the key ingredients to make the right acquisitions

Author: Xavier Everett, Transaction Manager

At Quintessential Equity, I am always on the lookout for properties with strong ‘fundamentals’ that provide solid returns. We won’t transact just for the sake of it and will remain patient and disciplined to wait for the right asset. This is particularly relevant in the current market, being quite volatile and unpredictable.

Below are some thoughts on how we are navigating the current market and economic climate.

Broad economic outlook

We expect interest rates to continue to increase over the short term due to inflation caused by lingering supply chain disruptions. China’s ‘COVID-zero’ policy, new emerging COVID variants and global geo-political turmoil will most likely see inflation and higher interest rates be an ongoing hurdle.

Debt markets are now pricing in the outlook of higher interest rates. This may lead to upwards pressure on capitalisation rates, which have been at a cyclical low and quite steady due to strong demand.

We expect any continued growth in property capital values will need to be achieved through substantial rental growth.

What does the current office market look like?

We are starting to see office occupancy levels steadily increase across most major cities following the disruption caused by the COVID pandemic.

As people start to return to office, there will be a flight to quality as tenants demand superior quality space, providing greater amenity, end of trip facilities, collaboration spaces and wellness areas.

Workspace requirements which can be adapted for hot-desking purposes will also be essential as workers opt for the hybrid working model, working from both the office and home.

The hub-and-spoke model is returning in some instances, as demand for flexibility increases as there is greater migration towards select metropolitan markets.

With this in mind, QE will look to focus on office buildings with ‘good bones’ that can be aesthetically and mechanically refurbished to an A-grade standard at minimum. In our opinion, paying a relative premium for core-plus office assets that are reasonably well leased is a better investment case than taking on secondary assets with substantial vacancy in the current market.

While each situation is different, having a captive tenant audience to drive income stream in a good quality building that provides the ability to undertake amenity enhancements presents a superior risk-adjusted reward in comparison to buying secondary assets trying to chase a higher return.

And industrial?

Industrial property prices have increased significantly over the last few years due rental growth as a result of the demand-supply imbalance.

Industrial vacancy is at a historic low nationally, with a substantial increase in the rate of absorption due to increased e-commerce penetration, coupled with supply chain disruption and ‘onshoring’ leading to greater inventory requirements – consequences from the pandemic.

While I believe in the industrial growth story, we also need to be conscious of the downside risks if rental growth does not eventuate to the extent projected and the market recalibrates to softer rental growth projections.

We also need to be conscious of what our terminal capitalisation rates are given the industrial market is currently trading at historically tight yields, particularly in light of rising interest rates and bond yields.

In navigating the current market, we will continue to focus on acquiring land-rich assets within premium infill locations and continue to assess if the asset’s value is capable of further uplift following enhancements and upgrade works.

So, what does this mean?

Despite increases in the cost of debt and higher bond yields, pricing of commercial real estate is holding relatively firm due to the strong demand.

We have not yet seen the risks associated with secondary assets or those assets requiring significant capital expenditure being adequately priced into values. The return spread between prime and secondary assets remains narrower than it should.

Given the upcoming risks related to interest rates, yield softening, and inflation (all of which impact the overall income return profile), acquiring assets with strong fundamentals at a low-cost base is more critical than ever to deliver good value for investors.

QE has always viewed that no matter the market conditions, there are always opportunities for our skillset. It’s critical, however, to be disciplined and patient to wait for the right assets.