Ask a Fund Manager
The Motley Fool chats with fund managers so that you can get an insight into how the professionals think. In part two of this edition, we're joined by Grant Nichols, fund manager of the $2.4 billion Centuria Office REIT (ASX: COF), Australia's largest listed pure-play office real estate investment trust (REIT). Today, Nichols explains two tailwinds the office market could receive from rising inflation.
The Motley Fool: In the first part of our interview, you mentioned that uncertainty around future interest rate hikes is the biggest issue among ASX REIT investors. Have rocketing inflation and fast-rising interest rates impacted the office market dynamics already?
Grant Nichols: The direct market, not so much. Though obviously, the COF unit prices have been impacted by the outlook for interest rates.
In terms of the recent transactions that we're seeing in the direct market, they're still quite strong. It really hasn't translated yet. I think you may see moderation in the amount of commercial property sales from this point for the next six to 12 months, until we get that consensus on interest rate levels I mentioned earlier.
Inflation potentially may generate some change to office markets on two fronts.
First, real estate is a very good inflation hedge. At the moment, there's concern about rising interest rates. But potentially, investors haven't seen that parallel to real estate offering protection from inflation. If we do get sustained inflation, that should translate to higher rents. And I think that's where the market has not completely made this connection.
The other potential benefit from rising inflation on office markets is that it will probably wind back supply. At the moment we're seeing a pretty dramatic increase in construction costs and interest rates. That will make future developments more difficult.
So, the economic rents that will be required to make new product will be much higher than they have been in the past. So, you probably will see a moderation in supply, which will be good for existing landlords.
MF: How do you see that playing out over the next 12 to 24 months?
GN: Like everyone else, we're trying to gauge what the outlook is, and we look at the other economic outlooks as much as we possibly can. We've got our own internal Treasury team who do a lot of research on interest rates.
For FY23, we have put out a forecast of what we perceive will be our floating rate interest rate. And we have made that pretty conservative.
We've adopted a 3% average interest rate for FY23. Now we adopted a conservative rate, because we don't want to see rates increase above that and to not be able to meet our forecasts. We're hoping that interest rates may not get to that level, but we certainly have that level of protection implied.
MF: Are you adjusting your REIT's investment and leasing strategies in the office markets with higher inflation and interest rates in mind?
GN: That's a good question, particularly in regards to inflation.
As I mentioned previously, we haven't seen a material change in the direct market in terms of levels or investors. But for tenants, we're already starting to see a change in their behaviours.
If you think about construction costs, it not only impacts the supply of new buildings. There's also an impact on tenant fit-outs. For a tenant to move in the market, if they're going to undertake a new fit-out, it's becoming materially more expensive than it was previously.
There are probably two impacts here.
Firstly, tenants don't have to move. They're probably going higher with renewals in the medium term to avoid having to undertake fit-outs. And we're seeing tenants willing to pay a higher rent to get a better quality accommodation.
Secondly, if they are going to move, they're probably going to look for space that already has an existing fit-out in place. Or at least a partially built fit-out. Because the most expensive component of a fit-out is joinery. So, if you just need to get furniture, you've got an advantage in terms of reducing that cost.
The benefits to COF, as an existing landlord with existing built office buildings, is we're highly occupied. So that opportunity for renewal, I think, is going to be enhanced.
Also, if we do have vacant space, we generally do have fit-outs that we can revive, refurbish and repurpose, which is giving us a leasing advantage over other spaces that don't have fit-outs in place. That's really a key driver for tenants in the market who are considering moving. If they can reduce that fit-out cost, they will take it.
That's something we're doing across our portfolio, trying to re-use and re-adapt fit-outs where we can.
MF: ASX REITs are often sought out for their income certainty, with COF paying a trailing, unfranked dividend yield of 9.9%. But rising interest rates have seen share prices retrace. What are your thoughts?
GN: The uncertainty with interest rates is creating some volatility at the moment. The more important aspect is where neutral rates will end up.
From the economists we're talking to and forecasts we're seeing, including those from the RBA, there's some indication that the neutral interest rate over the medium term will be between 1.5% and 2.5%. I think commercial property, generally, is going to be a really attractive proposition going forward.
If the interest rate does moderate between that 1.5% to 2.5% rate, I think the current softness in equity markets relating to REITs is completely overshooting the valuation in capital value.
A lot of REITs in the market are trading at a discount to NTA [net tangible assets]. So, if that's where rates do moderate, I don't think it will have the impact on valuation that the equity markets are currently pricing.
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Tune in tomorrow for part three of our interview, where Centuria's Grant Nichols discusses the threats and opportunities ahead for Australia's commercial office sector. If you missed part one, you can find that here.
(You can find out more about the Centuria Office REIT (ASX: COF) here.)
