In part II of the interview with VFMC’s Pete King, Florence Chong discusses retail property, club investments and the future of office real estate.
When global economies went into lockdown in March in a vain attempt to shut out COVID-19, stock markets took a dive. The correction was sudden and sharp, the subsequent recovery quick and strong.
That share-market bounce-back averted the so-called denominator effect, which would otherwise have forced fund managers to rebalance their portfolios – as they had during the global financial crisis.
As soon as any kind of correction happens now, it gets me thinking about our portfolio structure. It reminds us about liquidity, and the role of property in our portfolio
A decade ago, the global financial crisis-caused collapse in equities markets translated to the valuation of portfolios, and because the property market correction took 12 to 18 months to play out, real estate weightings rose disproportionately to their overall portfolio allocations.
Pete King, Head of Property with Victorian Funds Management Corporation (VFMC), which invests on behalf of 31 state-owned clients and related entities, remembers those traumatic days well. Lessons were learned, he says.
“As soon as any kind of correction happens now, it gets me thinking about our portfolio structure. It reminds us about liquidity, and the role of property in our portfolio,” he told [i3] Insights.
This time round the denominator effect on the VFMC portfolio was not ‘material’, he says, because fortuitously, VFMC had entered 2020 ‘a little underweight’ in property as part of an ongoing overhaul of its portfolio make-up in response to structural changes in the market.
Over the past three years, the fund has started to transition its $5-billion property portfolio away from assets facing structural headwinds, namely big end, discretionary retail (regional and super-regional shopping malls).
King says the winds of change were already blowing before COVID-19, and the pandemic brought existing problems into sharp focus.
“Traditionally, we had a significant portion of our portfolio in this (retail) sector,” he says. “But it is also fair to say that we had not made as much progress as we would have liked by the time the structural change in retail started to materially impact valuations in late 2018 and early 2019.”
Wholesale retail funds, managed by the likes of QIC, GPT, AMP, Lendlease and others, own some of Australia’s largest shopping malls, and these shed some 20 per cent of their valuation in the year to June, according to MSCI/Mercer indices. The slide continues.
“Generally,” King says, “there is a lack of liquidity in the big end of retail, so it will take a couple of years to lower our exposure.
“(But) our exposure will not drop to zero because we think there is a future for good discretionary retail. We think it will be a different future, and that change will continue.”
There is a lack of liquidity in the big end of retail, so it will take a couple of years to lower our exposure. (But) our exposure will not drop to zero because we think there is a future for good discretionary retail. We think it will be a different future, and that change will continue
VFMC has reduced exposure to large shopping malls in its property portfolio from 30 per cent to around 20 per cent through a combination of selling units in funds into secondary markets, direct asset sales and, in the past year, devaluation of its investment in shopping centre funds.
VFMC splits retail into three categories: discretionary (shopping malls); defensive (supermarkets and neighbourhood centres) and hardware retail (Bunnings outlets).
King says his portfolio weighting to defensive retail will stay the same, but exposure to the growing hardware sector has increased.
“We started pivoting to the hardware sector eight years ago,” he says. “We partnered with Telstra Super and Charter Hall initially to buy a small portfolio of Bunnings Hardware stores, and have since grown the Long WALE (Weighted Average Lease Expiry) Hardware Partnership into a $1.5 billion vehicle.
In November, Charter Hall purchased another six Bunnings stores, located on the Eastern seaboard, for A$353 million for the LWHP club and a separate mandate. VFMC is the major investor in the latest deal.
“We are attracted to the long leases and secure income from these assets. The rents are affordable for our tenants. Rental affordability, particularly in retail, is crucial going forward.”
Underpinning the durability of tenancy is what King sees as another defensive feature in these large-format outlets. “We like to buy in locations where land value growth will potentially outstrip rental and long term there are alternative site uses,” he says.
VFMC’s partnership with Telstra Super and Charter Hall, established nearly a decade ago, extends beyond the hardware vehicle to co-ownership in logistics.
“We have 13 per cent or 14 per cent of our portfolio ($600 – 700 million) invested in industrial logistics,” says King.
The industrial partnership, Core Logistics Partnership (CLP), contains a portfolio of approximately 20 assets, with strong tenant covenants like Woolworths and a portfolio average-weighted lease expiry in both the hardware and logistics partnerships of more than nine years.
The icing on the cake is the quality of tenant covenant.
Over the years, VFMC has gradually shifted its investment from comingled funds to partnerships or clubs.
In the process, the number of managers has been whittled down to around 10 today. Between them, they implement VFMC’s 15 active property strategies.
Aside from Charter Hall, VFMC is invested with Investa, the Sydney-based boutique manager Corval, and ISPT, among others.
Currently, 45 per cent of our portfolio is in active club-style investments or partnerships. We see that increasing to 65 per cent over the next 18 months to 2 years
Says King: “Currently, 45 per cent of our portfolio is in active club-style investments or partnerships. We see that increasing to 65 per cent over the next 18 months to 2 years.
“We like this style of investing because we get better liquidity, we are involved in the decision-making, and we can be nimble when opportunities arise.
“In the last three to five years, our active strategies have outperformed our core strategies by up to 3 per cent annually.”
The fund’s office investments are managed by a number of different managers, including Investa and AMP.
“It is fair to says that office has stayed solid over the last 12 months. It was stronger in the first half, but weaker in the second half of FY 2020.”
King expects the office sector to show a “small amount of weakness” in the next 12 to 18 months. “A return to the office environment will be staged. Some businesses are being affected economically, and that will lead to weakness in tenant demand.
“Having worked from home since March, and unlikely to return to the office materially for the rest of 2020, I have seen first-hand how important the office environment is to organisations,” he says.
“I do see a bright future for office occupancy. The future of office is currently a big topic of conversation, and everyone has an opinion because their normal working routine has been disrupted by the pandemic.”
“But while many of us in a white-collar role are working effectively remotely, I don’t think we can sustain this in the long term.
“Three things resonate with me when I think of full-time office remotely. They are the concepts of collaboration, culture and connection.”
To nurture each of these requires a material component of face-to-face contact in a traditional office environment for most organisations, King says.
“Overall, we still see strong demand on the capital side for office buildings.”
King told [i3] Insights that recent transactions had reinforced investors’ appetite for office buildings.
“We are comfortable with our office portfolio beyond this period of weakness generated by the pandemic,” he says.
“We are evolving our portfolio slightly – moving more to properties with long WALE and quality tenants, like government and strong corporates.”
The best performer for VFMC in recent years has been the fund’s investment in the Corval funds.
“We have had high-teens returns out of that active strategy,” says King. “That tells us that if we can get aligned investors who work well together supporting a high-quality manager, then we can see the results performance-wise.”
King says VFMC is open to selling assets if it makes sense to do so. Returns, he says, are augmented with sales and value creation.
“You can’t underestimate the value of having managers who are able to buy and sell well.”
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.