REST’s Offices, Canary in the Coal Mine or Water off a Duck’s Back?
Summary
Are REST's unlisted property valuations strong and versatile like the mighty Pangolin's external armour? Or are they soft and rubbery like a slow-cooked Pangolin curry?
REST have been the catalyst for media coverage on pending impairments for Office commercial property valuations, stemming from the pulled sale of an asset in Melbourne in late 2022.
Nevertheless, using REST Disclosures, we can try to figure out what the fund is carrying this asset at (and others) and how that aligns with media reports from the AFR of a potential unbooked impairment of 15%.
It's a valid question, REST have significant amounts of property, on my calculations REST holds circa $3.34 billion or 5.3% of all active FUM in unlisted Office properties alone.
The REST MySuper option holds circa 11% in Property, which is comparatively high relative to peers.
Personally, I think Industry Fund's unlisted asset valuation process is significantly more disciplined, more versatile and more conservative than the wealth management industry claims.
However, rising interest rates mean institutional investors can achieve comparable yields with significantly less risk via government debt, which when combined with the new paradigm for flexible working arrangements must impact evaluations.
How realistic are the media reports of an office apocalypse? How conservative are REST's valuations? Were REST simply trying to get ahead of a cooling market with an opportunistic sale and are happy to retain the asset? Or is this a foreboding sign of brooding trouble for the asset class?
Introduction
Let me preface this by saying, that I am in no way a property expert nor an actuary. Additionally, I am very pessimistic in the short and medium-term outlook for office blocks, particularly for 2nd and 3rd-tier assets.
Like many, I was somewhat spooked when I read the articles circulating and commentary on Twitter about the impending apocalypse for office building valuations.
More specifically, super funds which we’re led to believe have truckloads of office tower investments, which are held directly (unlisted), with opaque and potentially unrealistic valuations. This is the theme that’s been doing the rounds in the press and on the bird app.
With respect to office property investments, two things matter for super funds, how many of these assets they hold and almost as importantly, what they have valued these holdings at, specifically, how either realistic or unrealistic these valuations are versus the current environment.
Industry funds, juicing returns with unlisted assets, it’s a common line and not one that I buy. I’d argue that those who do blindly wheel it out and parade it around, don’t have your interests in mind, but their own commercial agenda. That said, it doesn’t mean they’re wrong in this specific case.
You can’t look out my office in Martin Place and not see empty desks, deserted meeting rooms and substantially fewer people. I share the concerns around valuations.
So, I thought I’d try to figure out which funds were most exposed to unlisted property, especially Office exposures, and additionally, try to get a feel for how conservative and thus accurate and versatile the funds’ valuations appeared to be.
Despite what some might tell you, Industry Super funds aren’t black boxes with no transparency and no visibility, super funds produce all kinds of disclosures.
These include annual reports and pleasingly ‘Portfolio Holding Disclosures’, which list a fund’s investments in detail, as well as the values they ascribe to them. Good funds also publicly display their financial statements.
I wondered, given all of the discussion around REST, had anyone actually checked REST’s statements & disclosures? Lets note, REST do hold substantially more than other funds in property, along with CBUS.
The 17 Storey Canary
This is 717 Bourke Street and we are told it is the canary in the coal mine. It’s a Melbourne office tower owned by industry fund REST that was according to one article, carried on the books for $460M.
This building was apparently put up for sale for $490m in 2022 only to be acrimoniously pulled from sale when the best offers allegedly came through at a lowly $390m. Ergo, assuming a $460m valuation, REST would appear to have a $70m impairment on their books, which would represent a 15% haircut - should the reported figures be correct.
Ironically, the chief tenant of the building is Nine Entertainment Co Holdings Ltd, the publisher of the AFR, who is in turn published & is publishing the articles relevant to this post. Perhaps more ironically, as it’s Melbourne newsroom, it’s also the workplace of the Property Editor who filed the initial article. On location in the coal mine.
A silver lining, if the coverage gets enough views, REST might be able to push through a rent increase.
Let me confirm, the AFR is the best financial news in the country, their journos are top tier.
Now, let’s just pause, and consider that a 15% discount is (in my opinion) generous to a building that is at least partly responsible for producing and distributing this:
$460m? According to whom?
But less trash TV and more trash assets.
I’ve no doubt about the proposed sale price, I couldn’t speak to the $390m offers but sound pretty reasonable, definitely a buyers’ market at the moment.
The key thing I want to know is what REST value the building at.
It’s important, because if it’s a conservative, low valuation (which would be my hope ), this single investment isn’t a big issue, however, if they’ve ascribed a valuation that isn’t as versatile or conservative, is the fund then sitting on a yet-to-be-booked impairment (paper loss of value)?
The articles reference REST carrying the building on the books for $460m. I don’t know if this is from the fund itself or from a different source.
What we do know, courtesy of me collating all of the investment options for both super and pension from REST’s Portfolio Holdings Disclosures is that at 30 June 2022, REST held $1,681,251,633 of Internally managed property on their books.
This $1.681 billion was split between the 4 separate properties outlined in the picture below, including our friend, 717 Bourke.
REST own 33% of Quay Quarter Tower Sydney (50 Bridge Street) and own 100% of the other three properties. Again, collectively these four buildings (only 33% share in Quay Quarter) are carried on REST’s as being worth $1,681,251,633 (30 June 2022).
So, what we can do, is make a puzzle, where the 717 Bourke St piece is worth $460m, and see what that does to the whole picture, to figure out if it’s on the money or not.
After we’ve given $460m to 717 Bourke Street, we’ve got to make some assumptions. Disc: I’m not an actuary. I’m not a real estate valuer. I’m guessing.
Let’s assume of the remainder (i.e. $1.681 billion minus $460m), 52 Martin Place and 140 William Street are both worth 35% and REST’s 1/3 share in 50 Bridge Street is worth 30%.
These are essentially random numbers, I’m not an actuary, and I have zero experience in commercial property, but, it can help give us a feel for what REST unit holders might be headed towards.
Estimates, rounded for illustrative purposes only.
Doesn’t quite come out how I would have thought…
The square meterage of the three buildings is relatively close, I would personally assume that the other buildings’ CBD locations would in their favour, albeit, that might be discounting the larger land size of 717 Bourke and the much newer build date.
It is possible they revalued it midway through the year versus the 30 June 2022 numbers we’re working off.
With another warning I’m not a property expert, I’d offer the following:
52 Martin Place is one of the most coveted addresses in the country, it’s across the road from the RBA and Macquarie’s global headquarters respectively. Granted, you’d need to apply a discount for the crimes committed by it’s street level tenant…
Looking out from… 52 Martin Place, Sydney
140 William Street is also in the CBD. Granted, it is riddled with lawyers, you’d want some heavy-duty fumigation for that, but it’s not responsible for any reality TV, so that’s a plus.
The fourth, 50 Bridge Street, aka Quay Quarter Tower Sydney, is a little different. It’s bigger, brand new and in a better part of town.
Quay Quarter is a good example, again note that I am not a property expert, but I would be astounded if there’s not a paper loss incoming for this one. Solely due to its completion date of April 2022, incredibly poor timing. No one’s fault mind you, these things take years to build. All the same, I’d have guessed a third share would be worth more than 717 Bourke.
But, let’s confirm, it’s a premiere address, in a premiere location, with (excluding AMP) premiere tenants. It’s a Grade A asset that the fund would have a multi-decade investment horizon, and most importantly, REST own a 1/3 share, they have done the prudent action of sharing the risk with other investors, albeit, its huge cost almost mandated they do so.
The timing isn’t great, but again, construction on 50 Bridge Street started long before anyone served up some pangolin tartare and changed the dynamics of the modern workplace.
Again, there is a 100% chance that there’s pain coming for property investors, especially those invested in office blocks which I fear will incur serious pain.
But, how many Offices are there?
More than one.
Whilst the first focus is on RESTs internal properties, i.e. those which they own directly and run themselves, it should be noted that REST have quite a bit of other exposure to offices.
Source: REST Website
In addition to their four direct holdings, per their collated Portfolio Holding Disclosures, REST hold the following investments which are almost exclusively in office buildings, I’ve opted to include shopping centres in this example as well.
Office & Shopping centre exposure within total FUM of $67.725 billion, Source: PHDs
Total office expsoure alone is $3,341,976,042, which lets note, is spread within $62.725 billion in total assets in office exposure, which, isn’t small at 5.3% of the total fund - just office.
Although they’re all Australian office buildings, the exposure is diversified as follows:
Source: GPT, Charter Hall and REST
Charter Hall & GPT Group are very well known and independent of REST, they’re two of the largest in the country and they count super funds, institutions, ultra-high net worths, and everyday Australians as their investors.
It’s worth pointing out, even though Charter Hall & GPT do everyone, big super funds get the best pricing and best products. If your financial adviser has put you in a fund of a similar name, you’re paying much higher fees and you’re not getting the same terms or access that are given to big funds like REST.
What are the potential outcomes?
It’s pretty compelling that Office blocks are probably worth less today than they were 12 or 18 months ago.
This is simply based on the fact we’re coming off extremely high valuations, a product of decades of ultra-low interest rates making investors desperate for yields. We’ve also got an increasingly likely recession and let’s not forget the radically different dynamics of the workplace post-COVID.
We’ve also got rising interest rates, which rather than higher debt repayments for the owners of the properties, provide us the single most important problem facing office block investments:
Rising interest rates mean institutional investors can get comparable or potentially higher returns from incredibly low-risk government bonds. This seriously evaporates the desire to pay huge multiples for depreciating assets that are expensive to run like office towers.
Be a fair assumption that there are fewer buyers and more sellers.
In order to model what a correction might mean for REST’s members, let’s make some assumptions:
Let’s assume that RESTs book values need to take a 13.125% cut.
I don’t personally think this is assured, we don’t know the quality of their buildings and we don’t know if they’re conservatively valued - they may have very realistic valuations attached which will incur minimal pain.
Let’s include RESTs shopping centres fund, and give them a 13.125% cut as well.
Again, I don’t think this is guaranteed by any stretch of the imagination but let’s be conservative.
We’ve used 13.125% because we’ll assume 25% of the properties are ‘top grade’ and thus fall 7.5% and 75% of the properties are 2nd grade and fall 15%, ergo, giving a 13.125% drop in values overall.
Remember we’re using June 2022 figures.
Well, given all of the above, for the Core MySuper option, subject to the 30 June 2022 Portfolio Holding Disclosures and the above assumptions, you’d say the investment would lose 0.85% overall, or $459,980,199, based on $3,504,611,041 in Office & Shopping Centres and $54,297,345,349 in the Core MySuper option (figure is rounded).
This is predicated on the fact that all of the valuations, which include 4 separate properties as well as three external funds run by independent managers are all overstating their assets by significant margins%, which is in no way guaranteed, assured, based on anything other than assumptions for illustrative purposes.
So what should you do if you’re invested in REST?
Hard to say.
REST owns quality assets, also, like most industry funds REST has incredibly strong cashflows. In FY22, they received $6.652 billion in net contributions as well as $2.432 billion in interest, dividends and distributions.
Just remember, REST owns 3 buildings outright, they own a 33% share in another and then they own a circa 10% or 6% share in 62 different office towers and shopping centres around the country, they are diversified.
Rest also owns billions of other property and infrastructure investments, residential property, apartment buildings, wind farms, airports, gas pipelines, electricity networks, telecommunications infrastructure rail yards, ports, airports, student accommodation for almost 27,000 people, hotels and farms.
Their incredible cash flow and scale let them buy incredibly profitable assets for retail funds and financial advisers can only dream of.
Rest’s Core Strategy has returned 5.13% in 3 years, 5.26% in 5 years 6.96% in 7 years and 7.19% in 10 years (as at 28/02/2023).
Their fees are very competitive. REST use some of the best investment managers in the globe, ones that financial planners can’t access.
Are they my favourite Industry fund? No. But they make their members enormous amounts of money and are still exceptionally good at what they do.
Are they overexposed to property? Potentially, in hindsight, which is a luxury no super fund has. Also, it’s possible they’ve bought incredibly cheap and have disciplined valuations resulting.
Summary
So, is Rest a canary in a coal mine or is all the negative press just water off a duck’s back? I can’t say and I’d wager neither can anyone else until we see what numbers REST reports for the next quarter and what they value their office holdings.
I’ll guarantee any adviser criticising them have their clients in similar style funds, the only difference is any client of a financial planner is paying an adviser fee (which REST doesn’t charge) and the fund your adviser recommended is certain to be more expensive than what REST give their members and likely to be far inferior to what REST give their members.
But, if that fund is invested exclusively in office REITs, no matter how good, then it’s hard to say that they’re not in for a rough 2023, but it doesn’t mean they won’t still be hugely profitable in 5 years.
Lets also remember that now more than ever, situations change, and with rates being a key driver and expectations wildly fluctuating, nothing is for certain, let alone sell side research.
This isn’t a crack at a really good journalist, it’s emphasing how quickly things change, and when you’ve got very tall piles of steel and concrete, you do not buy and sell on a whim.
Finally, there’s also the counter opinion, that fears are overblown, I really like Kristain Fok’s (CIO of CBUS), line, I 100% agree with it,
But, in this instance the issue is isolated to office towers, it’s not realistic to think a correction in office towers isn’t warranted, whether it’s 1%, 15% or in between we’ll have to see and have to appreciate will depend, what will be interesting is to see how rigorous super funds have been with their valuations. It’ll also be interesting to see what happens to interest rates, and finally, with plenty of super funds with lower exposures, they might use their vastly superior liquidity and cashflow to pickup some bargains.
Both sources in the articles above are extremely incentivised to give those opinions as well, frankly, I agree that your super shouldn’t be correlated to your job, but that’s another topic for another day and another apocalypse.
I think this office discussion is a topic worth discussing, so I’ll be doing two further posts in the next few weeks, looking at one of the biggest funds in the country and then all funds generally, showing who’s most exposed in property and importantly, what the valuations of those funds look like…
Then I’ll be back to writing what I think is most important, fees.
Thanks,
Andy
Some important disclaimers: This blog and its posts are written to educate Australians on their financials, anything in this post is solely general information and commentary. All of the information referenced and provided has been sourced from publicly available information and all attempts have been made to ensure everything is accurate. All information is current as of the publishing date of 31 March 2023, and may change in the future, it is important readers conduct their own research and ensure that any figures below remain current at the time they read. There is every chance the fees displayed and discussed may change in the future.
