Charter Keck Cramer and Precisely Property Podcast respectfully acknowledge the traditional custodians of country throughout Australia. We pay our respects to their elders past, present and emerging.
Richard: Hello, and welcome to another episode of Precisely Property. I’m your host, Richard Temlett. I’m excited to have you with us today.
If you’re here for the first time, thank you for joining us. I encourage you to listen to our previous episodes where we discuss all things property with a focus on dynamic discussions with industry leaders. In this episode, we’re diving into a financier’s perspective on the Build to Sell and Build to Rent apartment markets. I can’t wait to get into this episode. So, sit back, relax, and let’s get started.
Today, we will be speaking to Mark Power of Qualitas. Mark has a very impressive bio, and I’m going to read that just because it’s easier and I can’t remember it off the top of my head. But basically, he is the Head of Income Credit with responsibility for both investment outcomes and growth of Qualitas’ income credit business and investment strategies. Mark joined Qualitas in 2017 and was previously head of Qualitas’ Build to Rent debt fund. With over 30 years of experience in real estate finance, he has developed a strong reputation in structuring and delivering attractive capital solutions for clients.
Before joining Qualitas, Mark worked at several of Australia’s major banks, including senior roles in corporate and institutional property division at NAB, spanning over 20 years. Welcome, Mark.
Mark: Pleased to be here, Richard.
Richard: Well, Mark, before we get into today’s session, I’m very keen to just set the scene for our listeners because I think today’s podcast is very timely. I’m keen to just give everyone a bit of context as to where we’ve come from, but more importantly, where we’re going.
And the reason why I want to do that is because there’s a huge amount of negative media sentiment out there. You and I were discussing before we jumped onto the podcast, that’s not necessarily reflective of what we’re seeing in the markets, and it is very much submarket specific. I’m keen to just talk to you a little bit more about your background and your experience in the industry. I’d love you to just explain a little bit more about Qualitas, particularly the more recent announcements that were announced last week. But I must admit, I pick up the paper almost every day, and it seems that you guys are in the in the media for one way or the other, whether it’s picking up new sites or completing projects.
So I’m keen to get a little bit of a background on Qualitas. And then really for our audience today, I’d like to have a deep dive into both Build to Sell and Build to Rent apartments. It’ll be across Australia’s capital cities. I’m keen to unpack with you what you’re seeing on the ground with respect to land values, build costs, and prices. I’m also keen to unpack with you your views on Build to Rent and how it is actually stacking up for yourself because that’s one of the biggest questions we’re being asked in the industry.
And as we’re discussing offline, I still think that finance and also government does not fully understand BTR, and that’s no disrespect to anyone. It’s quite simply because it’s an emerging asset class. I’m keen then to also just talk about Qualitas’ outlook for the next 12 months across the various apartment markets. I’ll certainly be jumping in with my views of the world. I have had the privilege of working with yourself and working with Qualitas and presenting to a number of your current now and also hopefully or potential investors, and I hope to continue to do that, into the future.
So, with that in mind, could you please just tell us a little bit more about yourself and your background?
Mark: Happy to, Richard, and thanks for that introduction. So, as you’ve mentioned, I’ve actually been in real estate credit in the Australian market for the best part of 35 years now, and it’s been an interesting journey. I’ve seen a number of cycles over that period, started my career as part of the late 1980s boom and to see what real estate was doing back then and how it’s performing. So that was great.
But then experienced the downside being the early nineties bust with Paul Keating’s recession that we had to have. Then moving the clock forward, had the whole GFC piece from 2007 onwards, which was once again a very different market. And then more recently, we’ve had the whole COVID dislocation of the real estate markets. And very recently, what we’ve now entered into is a period of chronic undersupply as far as residential dwellings are concerned. So it’s been a very interesting career, 7 years at Qualitas.
And as a firm, it’s been tremendous to be part of Qualitas and to see the private lending market and Qualitas as part of that market grow very significantly over that period of time.
Richard: Fantastic. Well, before we get into a little bit more details of Qualitas, your points about having lived through and worked through a number of market cycles, I think, is very well made. I have had the privilege of working with you and certainly presenting to some of your clients, and the discussions that we’ve had and your insights and observations certainly show to me that you’ve been through a number of market cycles, and I’d encourage our listeners to just keep that in mind. The property market, I know I’m stating the obvious, is cyclical.
But when you overlay the cycles or where we’re at in the cycle right now, and we’ll get into that shortly, with the fact that the market has been severely disrupted. And as you said, it is very dislocated right now. It’s the reason why we’re getting very strange results. But in my mind, and certainly when I look at what Qualitas is doing, I think there’s a number of significant countercyclical opportunities to set projects up for the future. Could you tell us a little bit more or please tell us a little bit more about Qualitas, where they’ve come from, where they’re going?
Before you do that, I’ll again extend my congratulations to yourself and the Qualitas team, particularly Andrew and Mark, who I do know well, and they’ve also been really kind in my own property journey. I saw there were two significant announcements last week, probably three actually, one with one of the completion of your BTR projects or the GQ project as well as some of the capital raising. So, who is or are Qualitas, and where do you fit in the market?
Mark: Thanks, Richard. So Qualitas is essentially Australia’s leading real estate alternative funds management firm, we’re ASX listed. We’ve been in business for over 15 years. We’re a founder led organisation, so the two key founders of Qualitas, Andrew Schwartz and Mark Fisher, who remain very active in the business to this day. As a business, since inception, we’ve experienced very strong growth. And to give you a sense of that, when we listed back in December ‘21, we had funds under management of right about $4.1 billion. That’s now grown to $8.9 billion over two and a half years.
Richard: Congratulations.
Mark: Yeah. Thank you. And that growth is coming very much from our private credit strategies. So, if we look at Qualitas as a business today, around about 80-82% or thereabouts of our businesses and our private credit strategies with the remainder in our equity strategies. And the vast majority of capital coming into the business is from our institutional investors.
So, when I say institutional investors, that’s offshore sovereign wealth funds, pension funds, insurance companies. We have some local capital from institutional, but the majority of it comes from offshore. I think the other important piece to mention as far as quality has its concern, Richard, is that we’re very deep in the residential market. So out of that capital under management, around about 75% of that is in residential in both Build to Sell and Build to Rent.
Richard: Well, thank you very much for that background, and I hope the listeners now can see or understand why I feel you are ideally placed to actually talk about Build to Sell and Build to Rent and what’s actually happening on the ground.
So, let’s get into that. The first topic really today, I’m keen to understand, leaving the media headlines aside, what are you guys actually seeing on the ground? And I’m happy to also pass on my views. Let’s start with land values. Where are you guys actually active? What projects – you don’t necessarily have to name the projects, but what locations are you active in, and what are you seeing in those locations with respect to land values?
Mark: So land values have been, I’d probably say, a little bit surprising because people have expected land to come off pretty significantly over the course of the past one to two years. And the reason people have been thinking that is a function of what construction costs have been doing. Because you’ve had that dramatic escalation in construction costs, and you haven’t had pricing of end product adjusting at the same rate, theory would tell you that the price of land should therefore adjust so as developers can still get a reasonable return on their capital. But what we’ve found is particularly on prime sites so prime sites and holding well and that’s across the primary markets that we operate here in Qualitas, which is Melbourne, Sydney, and Southeast Queensland.
An example of that very recently is that we’ve had a borrower sell what I consider to be a prime development site with a DA in place, and the sale price we’ve actually managed to achieve on that sale is somewhere between 33-34% higher than the valuation that we had on that site undertaken only 12 months ago. So, I look at that as a case in point. That’s certainly not showing that land values are under pressure. Now I’m not saying that you can throw a blanket over the whole market and say that’s the case for all land. I think prime sites with either low planning risk or where planning risk is taken off the table, are very much in demand.
Whereas if you’re talking secondary site or has some challenges regarding zoning or eventual DA, I think that’s a very different story. And some of those sites, I believe, will have come under pressure. Having said that, they’re not the sort of sites that we engage with at Qualitas. We don’t provide credit on that style of site so, I haven’t got great insight into that, but I can talk to those prime development sites, which seem to be holding out well.
Richard: Just before I respond to that, is that across Sydney, Melbourne, and Gold Coast/Brisbane? Are there any locations where it’s actually increasing a little bit more than others, or what are you seeing?
Mark: I’d say it’s pretty consistent across all three markets. I mean, each market’s performing differently. Happy to talk to that as we sort of progress through the course of the session here today.
But I think it’s fair to say that providing you’re talking a site and sort of the inner city ring in all those locations, particularly sites that their ultimate highest and best use is residential, sort of Build to Sell, Build to Rent, anything leaning into that part of the market is well supported. And I think part of that is developers actually, have looked through the challenges over the course of the past couple of years, and they can see the chronic undersupply that we’re confronting, and I can see that we’re kind of right at the very start of the next cycle. So, for them to actually be giving up their future pipeline, which are their prime development sites, really reluctant to do that. So, they’ll hang on to those sites until they absolutely have to get rid of them because by getting rid of them, they’re getting rid of future pipeline, and that’s what we’ve seen play out over the course of the past couple of years.
Richard: I suppose just to add or build on that for our listeners, Charter Keck Cramer does have a national apartment database where we track all the supply across all of Australia’s capital cities.
We also have Valuers on the ground in, certainly, the jurisdictions that Mark spoke about. I chat with them at least every quarter to understand what’s going on with respect to land values, build costs, or pricing. I actually reiterate what Mark has said, the prime sites, just because of that lack of supply and the planning constraints, those sites certainly are holding their value or actually even increasing. There are B and C grade sites. They are at more risk of perhaps correcting slightly, but I’ve spoken with a number of our Valuers, especially in Melbourne. They have not actually seen any proper transaction evidence of that flowing through yet. Again, theory perhaps would say that they should, but we’ve not yet seen that. I do chat with some of the other financiers. It does sound like they may have tipped equity into some of the projects or whatever it is to actually support the developer to move through. And why I say that is because I’ve not seen or the Valuers have not seen any transactions of sales going backwards yet. Perhaps that’ll happen, but I don’t believe that’ll happen, certainly, with the A grade sites or the prime sites in the three cities, just given that supply shortfall. I suppose also for our listeners, please just be aware and you can reach out to my colleague, Brendan Woolley, in the Sydney office. New South Wales and Sydney in particular is going through some huge planning changes. There has been discussion with some of those planning changes that more sites may either become available for development, and I’d encourage you to reach out to him to get his views on whether you think or whether he thinks that some of that supply might actually make land values not so much fall, but just hold their value if more sites come to market.
But we’ll have to just wait and see. And, again, Mark’s points about knowing your submarkets and actually understanding what’s happening in the submarkets is very well made. Mark, in terms of build costs, that is something I know our listeners are extremely aware of and very anxious of. And, certainly, the stats that I’ve looked at and the builders that I have the privilege to speak to or advise, and some of them are even going to come on our show, have basically said that across the capital cities, the build cost for high density products have increased between 40-60% on a lot of these projects. That has absolutely destroyed their financial feasibilities because they really carried them out in 2019 or even earlier prior to the impact of COVID.
It sounds like the costs are worse in Brisbane in terms of either getting a builder or actually the build costs. It’s not much better in the Gold Coast from what I hear just because there’s a smaller labor pool, fewer builders that are prepared to take on that risk. And it is still very difficult across all the other states, whether it’s WA, which is also struggling, or Sydney and Melbourne. Can you please provide us with just some of your views on those projects, high density projects on the ground, Build to Sell, Build to Rent? What are you seeing? What are some of the risks? What are some of the opportunities?
Mark: So much like you said, Richard, we’re seeing dramatic escalation in costs over the course of the past three years. So, in terms of the projects that we’ve been involved with over that journey, I’d put the number somewhere between 25 and 40% over that three year period, depending upon what market that you’re actually operating in. To your earlier point, Brisbane and Gold Coast have both been most heavily affected, and that’s been a function of, one, you’ve got a lot of demand being created for infrastructure works up in those markets, particularly as we move through into the period prior to the Olympic games up in Brisbane.
And that infrastructure is just sucking a lot of material, but particularly labor, out of the traditional construction markets. Now, Southeast Queensland’s always been a bit of a thinner market, a thinner market to start with, and then you’ve had all these resources directed into infrastructure projects and the like, which is making it extraordinarily difficult. You also had a number of builders that were badly burnt up in that market over the course of the past few years as well that are very reluctant to move back into that market and providing fixed time, fixed price building contracts and the like, which is something that’s required by finances in order to support projects. So, the amount of dislocation in that market is by far the greatest. Terrific demand for dwellings up there, and there’s developers sitting on really great sites, but the main impediment to supply in that part of the market is actually being able to get a good strong builder.
So Hutchies really dominate that market up there. They’ve got very strong relationships with all the subcontractors and the like. So, it’s actually very difficult beyond Hutchies. There’s a couple of other builders that will do work up there, but a very, very thin market. So, we’ve seen dramatic cost escalation there.
Sydney, likewise, we’ve seen strong cost escalation as well. It’s a bit of a different market, Sydney. It’s more an owner builder sort of market up there, more so than Brisbane and Melbourne, which rely much more heavily on third party contractors. But once again, there’s been supply issues of materials. The story more so now, though, is once again about labour and labour shortages, for those builders, which is creating cost escalation through their businesses.
And as far as Melbourne, similar story again. There’s a much deeper pool of third-party contractors in Melbourne in that sort of high tier 2 and even moving to tier 1 category. So, the ability for developers to actually contract with contractors in Melbourne isn’t as difficult, but by the same token, those contractors are still experiencing difficulties with respect to access to labor and cost of labor and cost escalation. So, if you’re a builder I mean, in my 34 years of working in this industry, I can’t recall a time where it’s been such a difficult investment such a difficult environment for builders. If you think about the whole building model where they’re locking in fixed price contract on a fixed time, and they’re probably earning a gross margin of somewhere between 6-7%, and they’ve had costs escalate on them, anything from 25-40%, that’s a very difficult environment.
I think the positive to take away from all this is that, touch wood when I say this, but I think the worst is behind us. A lot of those projects which were deeply unprofitable have pretty much now been delivered. Each of the builders might have, you know, two or three legacy projects that they’re still hemorrhaging on. But our view is that by the end of this calendar year, they should be pretty much through those old projects. And if you look at the forward books of the builders, they actually look pretty healthy, and the margins they’re generating on their forward book look okay.
And we’re also in an environment where the escalation of costs seems to have stabilised. So, it’s not going backwards. Construction costs never go backwards in this country. It’s still escalating, but it’s escalating at a rate which is more consistent to what we’ve traditionally been used to.
Richard: There’s a couple of comments I’m keen to just add to that, and then I do have a question for you.
Certainly, the findings that I’ve had, they pretty much mirror what you said in terms of cost escalation now at least being able to be better quantified, but the cost is certainly not going backwards. Just a stat for your own interest because I do speak to a number of builders, and they’ve actually asked me to look because with our apartment database, we do track both the developers and the builders of apartment projects. And very alarmingly, at the height of the last cycle, whether it was Melbourne, Sydney, or Brisbane, where we had unprecedented levels of supply of apartments, but that doesn’t mean that we were oversupplied. But when you look at the builders there, I reckon about half of them no longer exist. And I actually have major concerns that we don’t have enough builders with the capacity or capability to actually build out some of these higher density projects.
I think that’s a massive worry, particularly if the government’s looking to have 1.2 million dwellings delivered over the next period of time. Perhaps there’s an opportunity for builders to get involved or consider how they do higher density work. The question I suppose a couple of comments also. What I’ve certainly seen, and it mainly applies to Melbourne when I speak with builders on the ground, gone are the days of investor grade product. What the builders are telling me now is that they are much more keen to actually get involved in the design at the design stages because they can have a much greater impact on, I suppose, its cost reduction or risk mitigation being involved at the beginning of the project. Many of them are either being asked to or actually looking to become more of the designers quite simply because of the quality of product that they’re being asked to deliver and design. That might be a flow on effect of the impact of Build to Rent where you’re getting higher quality buildings being delivered. But I suppose my question to you, just so the audience knows, my background is actually a lawyer, and I always did construction disputes and property development disputes for a number of years. I always go back to risks and risk mitigation. So, in the current points in the cycle, what are you doing on the ground to mitigate risks and maintain relationships with builders and subcontractors?
Mark: We have been hyper focused on builder risk over the course of the last two or three years. It’s always a key focus of what we look at and what we look to unpack as part of our due diligence and our underwriting process on any new investment opportunity at Qualitas. What is absolutely key for us is doing a very deep dive on the health of any builder that’s being put forward on any particular project. So, the sorts of things that we’re looking at, obviously, their track record, their capability, the people they have across their executive team, but also the people that they’re actually putting onto the particular job that we’re looking to fund. We look at the financial position of the business in terms of their financial strength, a huge focus on their liquidity position, a very significant focus also on their existing workbook because it’s not the deals of the past that’ll blow a builder up, it’s what they’ve got on and what they’re doing in the future. So, looking at that on a deal-by-deal basis to understand exactly where each of their projects are at and if they’re tracking in accordance to expectations or whether there’s issues on any particular projects. We look at their bonding lines, their utilisation of bonding lines, their general reputation in the market. We’re deeply connected into the market. And if we haven’t had direct experience with them recently, we’ll know someone in the market that has.
But it’s a key focus of ensuring that we’re comfortable with the ability and the financial strength of that builder to actually deliver what we and the developer require to be built.
Richard: Well, thank you for unpacking that a little bit more, and certainly feel free to reach out to Mark if you’d like to talk about some of this in a bit more detail. Just to close out the builder findings, I suppose there’s a bit of a shout out to the builders because I do speak with a bunch of them. I think that they’ve gone through a lot of the industry, but they’ve gone through hell over the last couple of years. The advice that I would give to the developers, financiers, and, I suppose, builders is make sure you work on those relationships. That probably sounds obvious, but more recently, I found that gone are the days of where you can just get a design and construct contract, flick all the risk onto the builder, and let them carry everything. What I found is that even if you still have that contractual arrangement, you much more now, you need to be managing that relationship with the builder. As you said, Mark, doing your due diligence. Try to keep communications open as much as possible because they’re an integral part of the industry. They do need to be supported like a lot of other parts of the industry, but they do need to be supported right now.
Mark: I would agree with that, Richard. I think they’ve done a tremendous job, the builders getting through navigating the period they have over recent times. And if you think about it, I mean, in the commercial markets, there’s been a few fall overs, but there hasn’t been a lot I thought we would have seen more, to be honest. So those businesses have managed to navigate their way through. Like the subcontractor market, there’s been a very significant amount of fall over in that subcontractor market, but the head contractors have really managed that process and absorb that risk within their own businesses.
So, I agree, big, big shout out to the contractors. I think they’ve done a terrific job.
Richard: Next discussion point I’m keen to talk about, I’ll give you my views, I’m dying to hear yours, is apartment pricing, apartment value rates. So, the context to this, as you said at the beginning of the podcast, we’ve discussed this a lot.
The market is very distorted. Certainly, I’ve been very outspoken based on the work that the team has done that the market needs to recalibrate upwards. If land values are holding, build costs have gone up, pricing does need to increase. And I’ve been saying that for a while and I keep getting asked, “well, when is that going to happen?” A lot of the industry are probably smiling if I’ve spoken to you about this, saying that, yes, it does need to happen because the apartment market is not going to collapse, but it’s basically a bit of a Mexican stand off right now with buyers and sellers and what I’ve described as recalibration pains with buyers going, “oh my goodness, my buying capacity has been diminished by 40% because of interest rate rises. You’re telling me now that the value rates have jumped up by 30%, and as a result, the pricing has jumped up by commensurate 30%, and they’re not able to yet to commit to a product or a new apartment.” What I thought was interesting, and just to give the listeners a bit of insight into my views and the finding at the end is I’ll tell you where I think the market’s going. I had the privilege of speaking with some of our Valuers across Melbourne, Sydney and Brisbane, and I also spoke with one of the sales agents, and I saw average value rates for Melbourne, Sydney, and Brisbane. And historically, in the past Sydney is the most mature apartment market. It’s had the highest value rates and prices, and it’s led the way.
Typically, there’s a discount and then Melbourne comes in second, followed by Brisbane. What I was astounded to see right now is on recently launched projects, the averages in Sydney are around about $25k a square meter. I know that that goes up significantly, and I sometimes forget when I do work in Sydney that they’re often getting over a $100k a square meter in Sydney. What was very interesting to see, though, is Brisbane is actually above Melbourne right now. Value rates of new projects in Melbourne seems to be around $14-15kna square meter depending on where you’re at.
What I was horrified to see is in Brisbane, it was actually at $16-17k a square meter. I spoke with the Valuers in the Brisbane office, and they’ve actually said that there’s still a huge amount of demand from the buyers in Brisbane. The issue in Brisbane is really signing up builders. In Melbourne, we’re having these huge debates about, can people push prices? When is when is the new $20k per square meter going to kick in?
And I’m also trying to give everyone an estimate of when that is likely to occur. I feel that it would already have started to occur if the government had taken the advice of Charter as well as the industry in terms of actually incentivising the market. And I think that right now is holding that market back. But from where I’m sitting, and I’m keen and I’ll hand over to you in a second on your views, I actually think there’s significant upside in Melbourne because that market in particular, whether it’s because we’ve been in lockdown for 265 days or because of all the taxes and charges coming in and loss of investors, that market of all the markets is significantly out of balance. I don’t know if Brisbane is potentially slightly over overpriced, but for Melbourne to be below Brisbane and land values in Melbourne are now actually quite close to Brisbane, which has never been the case. Brisbane has always been more affordable. It just suggests to me that when the market kicks off in Melbourne, there’s going to be an extremely strong run. And before I get too excited about all that, I’m keen to just get your views. What are you seeing on the ground there, and what are some of your views?
Mark: I’d agree with all that you said.
I think the pleasing thing that we’re seeing across all of the core markets at the moment is we are now seeing that price escalation in the presale market. So, turn the clock back 12-18 months ago, we weren’t seeing that. And that’s why just no projects were really getting off the ground because nothing was making commercial sense with dramatic cost escalation, land values, holding, end values not moving northward. So, the whole industry got into a bit of a stalemate. And that’s the supply issue that we’re now confronted with, with very little supply being delivered now and actually forecast to be delivered for a number of years be because of that.
What we are seeing is escalation, and it started in Brisbane and Gold Coast first. So, I’d say that started probably mid last year or thereabouts, and we’ve seen really strong price growth. So, you’re talking, sort of minimum 15% price growth in well-located markets, whether it be Gold Coast or Brisbane with good quality product designed more so for the owner occupier, I’d say, rather than the investor, a minimum 15%. In some markets, it’s been north of 20%.
And you’re right. It’s now more expensive than Melbourne, which for someone like myself that’s watched these markets over a very long period of time, I’m kind of astounded by that, to be honest. In a situation where Brisbane, which always traded at a discount to Melbourne, is now actually more expensive. And if you look at Sydney and how that’s been going, that probably started moving, I’d say, probably around September last year or thereabouts.
But once again, it was in that higher end owner occupier type market. So, if you’re thinking about Sydney and you’re looking at, say, the Eastern Lower North Shore, the rates there are now somewhere between sort of $20,000 to 25,000, and that’s something without views. I mean, if you’re talking views, it can be anything from $50,000 a meter up and over and above a $100,000 meter. They get amazing value rates in those parts of the market. What’s interesting in Sydney, though, if you’re talking the middle ring is somewhere between that $15-20k a meter.
But then if you’re going to Parramatta and then further out west, those sort of areas, those more investor style products, that really hasn’t moved. So, we haven’t seen the escalation in that part of the market. And I think that that sort of runs through to Melbourne as well. So, what we’re seeing in all three markets is that owner occupied downsizer market, price points really moving, and moving quite strongly over the course of, let’s say, the past 9-12 months. Melbourne’s been the laggard of all lows.
So, I think it was really just a function of the COVID shutdowns in Melbourne, it was so dramatic that we’re now finally starting to see Melbourne emerge from that slumber, essentially. That’s early days, but we are seeing signs of it. So, in that owner occupied market, we’re funding projects now where we’re getting sort of inner eastern type locations, sort of $25,000 a meter and north thereof, which is really encouraging. And even in what I describe as the lower end of owner occupier and higher end investor product, we’ve started to see that move as well over the course of the last few months. So, we’re starting to see that sort of $14,000 a meter, $14,500 a meter being achieved.
And even in locations where predominantly the more investor style product, which may have sold for $8000 or $9000 a meter sort of a few years ago, we’re seeing that increase by, in some situations, up that $12-13,000 a meter. Because ultimately, you actually need to get to that sort of price point to make these projects feasible. But I think the encouraging thing is in all three markets, we’re seeing signs of it. Definitely Brisbane and Gold Coast ahead, but seeing good activity in Sydney as well, and we’re starting to see activity here in Melbourne. I agree with your view about Melbourne being the countercyclical play for me. It hasn’t had the same level of escalation. It’s still one of the two gateway cities in this country. It’s the city that has got the greatest ability to absorb large levels of net overseas migration, which is countries built on, which will continue to run through. So, at some point, Melbourne, I think, it will play catch up to the other cities.
Richard: Thank you for that. Just to close that point off, I did an analysis in 2019 in Melbourne. Basically, value rates had to be about $8,500-9000 grand a square meter for project entry level to stack up. That figure is now close to $13k a square meter. Certainly, we are starting to see that, and projects are moving.
The question that I have for the audience just to think about is $20k a square meter in Melbourne. Do you think in 2 years’ time $20k a square meter will be affordable given where, hopefully, rates have stabilised and then been cut and the market has moved? My gut says that $20k will be very affordable in a couple of years’ time. I think Melbourne, when it does start, is going to have a very, very big jump to get back into balance.
And in terms of when that occurs, again, that’s the question of, how long is a piece of string? Certainly, it’s dependent on rate cuts, but more and more, and as I’ve been very outspoken, it’s the government incentivising supply, particularly bringing back local and foreign investors. They are more prepared to buy off the plan. They make the majority of the sales in Melbourne, and that is actually how supply will start to get mobilised.
Mark: It’s interesting, Richard, just on that Melbourne story, what we’re seeing on the projects one, buyers and owner occupier product, but two, if it’s investor style product, we’re actually seeing strong demand, not overseas at the moment, but from other interstate markets. So, you’re seeing a lot of buyers coming into the Melbourne market just recently, from Sydney and Brisbane because they’re seeing value in the Melbourne market.
Richard: It’s your value proposition. I have the privilege to speak with a number of sales agents. They have said people coming from Sydney and Brisbane see the value of Melbourne now, and they’re getting sales. So, again, some of those developers out there that are looking to launch projects perhaps consider not necessarily overseas but interstate markets.
Mark, let’s shift gear. One of the questions I’ve been dying to ask you, and I’d love you to articulate as much as you’re able to, obviously you know the financials behind it, but Build to Rent. As we know, it’s an emerging asset class. There are a number of people out there that I chat with that don’t believe in it. When I ask them why they don’t believe in it, it has nothing to do with the actual fundamentals of people living in apartments and renting for longer. They do not believe in it because of the financials. I’m really keen to just talk to you a little bit more about how you respond to that, what you think about the financials. And really, the question that I’m keen to talk to you about now is really to continue to educate both finance developers and the government. We absolutely have to derisk this Build to Rent asset class.
So, with that in mind, I’ve seen you have previously had a few slides that show your views of the world. But could you please explain to our audience, Build to Rent, how does it stack up?
Mark: Happy to, Rich. So, we’ve got really strong conviction in the Build to Rent sector here in Australia, and that conviction is primarily around the whole residential story, the chronic undersupply of residential accommodation that we have in this country, so if you’re looking at a market from a fundamental side of things, this has got such a strong fundamental basis to it where you’ve got relentless demand, structurally constrained supply, really tight vacancy, and robust rental growth.
And that robust rental growth is key to unlocking returns for the Build to Rent sector. I think there’s two issues in Build to Rent at the moment. One is on the developer side, that you’ve alluded to in terms of there’s a whole developer community out there that doesn’t really believe that you can get the sort of returns that you need to in this space. And then there’s capital issues as well in terms of pulling in both offshore, but particularly local capital into the sector. And it’s a sector that we desperately need to take off.
And if you think about our Build to Rent sector here in Australia, it’s very much in its nascent form. 0.2% of our housing stock is currently in Build to Rent. And you compare that to the UK where it’s 5.5% or the US where it’s 12%, and we’re living in cities which say Sydney and Melbourne, who both have more than 5 million people. We just haven’t got the amount of densification in those cities that we need, particularly compared to other cities around the world. If you think about Melbourne, where less than 10% of its housing stock is in apartments, and you then look at somewhere London, which is, say 38%, Miami is 32%, and you got Melbourne’s sub 10%. We need to find a way to bring greater supply into the market for rental, and Build to Rent is key part of that solution and a key part of driving supply into a market which desperately needs that supply. It’s interesting when we started we were very much one of the early adopters into this market. When we started getting into it at Qualitas, a lot of the feedback was “you’re crazy, you just can’t get the sort of returns that you need to.”
I’ll talk to it from a developer’s perspective because we’ve had some real life examples of how that’s played out. If you think about a developer who got in as an early adopter and funded something and underwrote a transaction, let’s say, 3 years ago and if it made sense back then, and back then you’re looking at development feasibilities where the development profit was relatively slim. If there was a profit there, it might have been somewhere between 5-10% on cost, but relatively slim. But move the clock forward and over those 3 years, you’ve had rental growth of in excess of 30%.
So when the project is then delivered, the actual rental stream is 30% higher than underwrite, which flows straight through to valuation. So, what you found is those projects that were done early days on yesterday’s construction costs with today’s rental prices have actually had incredibly strong value growth, and those developers that have done that and are actually trading out of those assets, and it’s still early days. We haven’t seen a lot of liquidity in terms of trading out, but I’m aware of some of the transactions that are taking place in the market. And those developers will get returns on those developments well in excess of what they would have got in Build to Sell, and that’s the develop and flick strategy.
But even if you take the development side away and look at it as an investable real estate asset class on a longer term basis and see what sort of returns you can actually generate out of it. And that’s potentially the better way of looking at it. Not necessarily comparing it to returns on Build to Sell but comparing it to returns on other income producing real estate, whether it be industrial or office or whatever it may be.
And I think the comparison to office is quite worthwhile. If you think about the US, the Build to Rent or multifamily sector is actually a larger institutionally owned asset class than their office sector over there. It’s a very, very large part of their market. If you then unpack it, people always say, well, the yield that you can get on residential is too low, so therefore, the returns don’t work. But I think that’s a superficial way of looking at it.
If you compare it to office, it doesn’t take into account the fact that in office, you’ve got very significant tenant incentives and CapEx and so forth that need to be spent on these buildings. Build to Rent doesn’t have anywhere near the same sort of incentives. In fact, it virtually has no incentives. It’s also got a very diversified tenancy base as well. So, if you look to adjust your IRR for things like incentives, CapEx, you still have got to take into account, tax leakage as well.
The analysis that we’ve done, whilst you might start with an initial yield on office of, let’s say, 6.5% and residential, let’s say, 4.5%, when you look at it from an income growth perspective, income growth in residential over a long period of time outperforms office. So, you might say income growth in residential, you might get 4% per annum. Office, you might only get 3% per annum. Then if you break down your CapEx and incentive leakage, our analysis shows that in office, you’ve probably got a 1.5% leakage as far as that’s concerned, because incentives are actually very, very significant in that space. Whereas residential, you’ve got leakage of around about 0.5%.
When you build all that together, if you’re looking at office versus residential or Build to Rent as a passive long term hold, you’re looking at an IRR in office somewhere of around about 7.5% versus Build to Rent of around about 8%. So, if I’m an institutional investor, and I can get 7.5% IRR in office, and I can get 8% in residential in the asset class, which is much more defensive in terms of its risk characteristics. That’s why we’re seeing strong inflows come in from offshore into this asset class because they can see that they’ve unpacked it. They’ve understood it. The issue from a capital side of things in terms of offshore money coming in is the taxation treatments, not necessarily a level playing field with other asset classes.
With the whole MIT piece and essentially the double taxation there. And our government’s been working through a solution, which has been imperfect at best. And it’s still got a way to go. But that really needs to be solved for additional walls of capital to come in from offshore. And then local capital here has also got its own challenges, and happy to unpack that a bit further if you’d like, Richard.
Richard: Well, we might have to do that on a separate episode because I know we’re a little bit over time, but I’ve loved the chat so far. Thank you for explaining in a little bit more detail to our listeners about the returns. Just to close that out, and I said this when I was speaking with Tim also about Build to Rent and the Fund-Through models, the government listeners, please reach out to myself, reach out to Mark. We do need to get clarity and certainty on things like MIT. There is such a significant pool of capital that sees the fundamentals both of Build to Rent asset class and of Australia.
A lot of it is still sitting on the sidelines and particularly with Victoria with the additional taxes and charges, and it’s creating uncertainty. And I have very real fears that some of it is going to go elsewhere. And it’s not because it doesn’t see the fundamentals, it’s just because the tax settings are not conducive for it to come in. I’d encourage the government to just take a more forward-looking view and realise that that capital coming in actually incentivises and gets supply mobilised. That’ll add to the dwelling stock. Additional dwelling stock puts downward pressure on prices and rents. And even though some of that BTR may come in at the higher end of the market, that should not be a concern to government because it’ll pull occupiers out of the lower end product and free up other dwellings for people to occupy. And, fundamentally, we need 1.2 million additional houses. I can’t see any way that a lot of the markets where they are right now are going to be able to respond as quickly as BTR.
There’s a role for Build to Sell. There’s a role for house and land and for townhouses. But right now, the way I see it and with the capital looking to actually come into Australia, BTR can be the first cab off the rank. I just wanted to close that out. I know that we’re a little bit over time, Mark, so let’s just close off.
You’re probably going to have to come back for another session, in due course, and I’d love to have you on the show. In terms of the next 12 months, what is Qualitas’ views both in Build to Sell and Build to Rent?
Mark: So our view in both those markets, Richard, is that it’s unquestionably positive simply because of that demand supply imbalance, and we think more projects will unlock over the course of the next 12 months due to the fact that you’ve got that construction cost escalation is kind of yesterday’s story to a point, and now we’re getting some strong escalation in terms of presale prices on apartments. Our view is that those developers that are prepared to back themselves now and move through into projects with a lower level of presales than what they would have ordinarily done, and that’s where the private lenders can support because we’ll support that sort of business model.
Our view is that they’re going to be handsomely rewarded when they deliver these projects in two to three years. And the final point we raised earlier was that countercyclical play. We’ve got a very strong view in Melbourne. Don’t know exactly when it’s going to play that catch up, but at some point, it will have to catch up to Sydney and to Brisbane and get back to a more normalised level in terms of where that trades relative to those other markets.
Richard: Thank you, Mark. You mirror a lot of my views, perhaps because we were discussing this sort of offline. The only other thing that I’d say to that is when I look at all the stats for a number of years, we’ve had undersupply, we’ve got such strong demand, even if demand does moderate back to more normal levels, and that’s probably likely to occur. And I suspect there probably will even be an early election call, but we’ll have to see, and that’ll be a key election issue. We’re so far behind, we need to build so many dwellings.
Build to Sell and Build to Rent have a significant role to play. They’re not going to be the only answer. We still need to get greenfield house and land up and running. But as it applies to Build to Sell and Build to Rent, I genuinely feel we’re on the cusp of an absolutely enormous cycle starting. And I know that I’ve said that, and some of the readers of our State of the Market Reports will probably say something like, “Well, Richard, 18 months ago, you said that.”
I must admit, I stand by what I said 18 months ago. Had we had incentives introduced by the government, I genuinely think that things would have started to kick off. I feel that when the market realises that rates have stabilised wherever they stabilise at and when there’s a cut, there’s going to be a very, very, very strong elastic response. I really feel that we’re on the cusp, especially in Melbourne, of having a 7-10 year cycle where we’re going to have peak levels of supply. And I suppose the industry needs to be aware of that.
Prices are going to recalibrate upwards. And from where I’m sitting, it is also about risk mitigation. So that’s getting the right sites, getting the right product on those sites, and having them derisked, but managing the builders, getting them on board, making sure that they can actually build out the supply when the market does start to turn. I’ll leave that there for now. The final thing I wanted to do is just close it with a couple of key findings.
I know we went overtime today. I’m not upset about that at all because there was such amazing stuff in here. But a couple of findings that I took out of it and I’d encourage everyone to just keep in mind. As Mark said at the beginning of the show, the market has been dislocated. It’s been dislocated because of the disruptions of the pandemic. I describe it as basically a hangover, and we’re still in that hangover phase, and I appreciate that it’s three to four years since we came out of lockdown. But I personally have underestimated how long things are going to take to get back into balance. I still can see the stats tracking in the right direction. It is taking a bit longer. It hasn’t been helped with things like wars overseas. I genuinely believe it is going to get back into balance, and there’s going to be that very, very strong response. When you look at population growth or prices bouncing back, I still feel the same thing’s going to happen with supply when it does get mobilised.
The second point I thought was interesting, a number of people have been very pessimistic, and I understand why with respect to value rates, but it’s lovely to hear on the ground that prices are starting to recalibrate upwards. I genuinely feel that there’s going to be momentum over the next period of time across different submarkets. And when I say period of time, probably the next 6 to 12 months depending on the submarkets where prices do start to recalibrate upwards, and there’s going to be a lot more activity in the market.
The final point again is just a shout out to the developers, finances, and builders, please continue to maintain their relationships. I can’t emphasise how important that is because I feel everyone is looking at when prices are going to recalibrate, but they’re not looking further into the market cycle and how they’re going to manage relationships, mitigate risk in terms of getting these projects built out for what I feel is going to be a very strong supply cycle, both from Build to Sell and Build to Rent. Mark, did you have anything else you wanted to add before we close off?
Mark: Nothing further, Richard. Just to say that I’d I echo all those comments that you’ve made.
We at Qualitas are very big supporters of the real estate market, particularly deep on residential. And we’re positioning our business to support that next cycle as it emerges, and our view is also that it’s going to be a very long and deep cycle in the residential space.
Richard: Great. Well, thank you very much for coming on, and I hope everyone enjoyed that episode. I will put links to how you can reach out to Mark and Qualitas. You’re probably well aware of them and if you if you’re not, you just need to open up the papers, and you’ll see a lot of what they’re doing in the market space. I’ll also put links to any show notes that we decide to put on. Please reach out to myself or Mark if you’ve got any further queries. I’m always happy to have a chat with you. Thanks everyone for listening, and enjoy the rest of your week.
Mark: Thanks, Richard.
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Precisely Property is a podcast presented by Charter Keck Cramer and is for educational purposes only. Nothing in this podcast should be taken as investment or financial advice. Please engage the services of an appropriate professional adviser to provide advice suitable to your personal circumstances. The views expressed by our podcast guests may not represent those of Charter Keck Cramer.
