Kathryn House
Hello, and welcome to Talking Property with CBRE. I'm Kathryn House, your podcast host, and in this episode, I'll be examining Australia's property investment case, the risk of a weaker economy, the renewed appeal of traditional property sectors, and the ongoing impact of recent tax and fiscal policy changes. I recorded this episode after last month's Property Council Congress in Brisbane, which attracted more than 850 attendees from across Australia.
David Harrison
We will power up our land as we have just done in Victoria. Someone comes and gives me two hundred million for a site that I paid sixty for. Happy days. I'll take the premium, make money for my investors, and go and buy more generic industrial assets, whether it's land or built form.
Kathryn House
That's David Harrison, managing director and group CEO of Charter Hall, Australia's largest property owner with $94.3 billion of assets under management. David was a panelist on the View From the Top session at Congress where he compared Australia's property market to Steven Bradbury, the unlikely Australian speed skating gold medalist. I hope you enjoy our conversation, and make sure to tune in for a second Congress podcast, which will go live on November 19, examining the infrastructure required to realise Australia's growth ambitions. David, thanks so much for joining Talking Property. It's great to have you back on the show.
David Harrison
No problem, Kathryn.
Kathryn House
So let's start with that Steven Bradbury comparison. Can you explain the analogy?
David Harrison
Well, we speak to a lot of global capital, and what I say to them is... Because as you know, I'm a good listener. So after I've listened to how they're seeing the world, what I've pretty well decided from both domestic institutional capital and offshore capital is that when people screen markets around the world, and let's just talk about Asia Pacific, specifically, they look at the markets in Asia. For the first time in 30, 40 years, bond yields have really backed up in Japan. So now there's terminal value risk in Japan after decades of virtually having pretty static, almost zero interest rates. But with their bond yields at record levels, people are worried about what a valuation's going to be in the future with such a large lift in bond yields. And then they look at Mainland China and even Hong Kong, and many people would say, well, we're not really looking to invest in more volatile markets like Mainland China or Hong Kong. When they look at Australia, because our interest rates have gone up and we've probably got higher interest rates than any other part of Asia, our cap rates or initial yields are relatively high, and therefore, our IRRs or total returns are relatively high compared to other markets. So in many ways, I often, you know, say to my team and my board, you know, Australia screens as the Steven Bradbury of Asia Pacific because whilst we're relatively small, just under 30 million in population compared to many other countries, our institutional universe for investing in property is actually quite large. Here's a stat for you. Out of all the global rate markets, Australia is bigger than any other REIT market in Asia.
Kathryn House
And we really pioneered when it came to REITs as well.
David Harrison
Yeah. Well, they used to be called listed property trusts or LPTs, and they came up with a new fancy acronym called A-REITs, which, you know, as we know, is Australian Real Estate Investment Trusts. But at the end of the day, most of the institutional capital doesn't invest in the listed REIT sector. It invests in the direct market with managers like ourselves and a few others. And if you're an institutional investor trying to get long term exposure to property, fundamentally the reason why the property class emerged from 40 years from virtually nonexistent to being a core component of a pension fund allocation, is it was a volatility diversifier compared to liquid markets. And if you think about listed equities and bonds, they're liquid. So every day you look at the volatility. So we've obviously got, in the last four or five years, a growing acceleration of capital coming from Japan, both development capital and core capital. We've got a growing allocation of European pension capital and insurance money investing in Australia. And obviously the Canadians have been investing in Australia for a long time, both in infrastructure and real estate. And I think what's also happened is the domestic super fund sectors that have tested the water investing offshore have had some spectacularly disastrous property investments. So you put all that together, I think Australia screens reasonably well. If you think about global capital the way we think about the Aussie super sector with 12% compulsory super, and we're now just under five trillion, you know, expected to go to ten trillion in the next ten years. Some part of that, call it 10%, is going to be allocated to predominantly direct property. So for us, a lot of the CIOs, heads of real asset, heads of property that we deal with are basically saying, I wanna invest in direct real estate. I'd like to either go into a pooled fund or a club or even a mandate with a manager like Charter Hall.
Kathryn House
So you argued at Congress that investors should look beyond the cost of debt, which has obviously increased, and consider Australian real estate on an unlevered basis. Why do you think that's how people should be viewing the market at the moment?
David Harrison
Well, unlike when you invest in the stock market, you could buy today, sell tomorrow. When institutional capital is investing with us or any other manager, they're generally looking at a minimum ten year investment horizon. The whole real estate market globally does analysis on ten year discounted cash flows. Yes. You know, we do twenty years sometimes, but the valuation community or what they call appraisers elsewhere in the world do ten year DCFs, and virtually every capital partner that we talk to wants to see ten year forecasts. So if you're thinking about a ten year forecast for an illiquid asset, like a shopping center or an industrial portfolio or an office portfolio, there's no point worrying about what debt costs are now. You're trying to work out through the next ten years what the average cost of debt's gonna be, what the average spot bond yield's not gonna be. No one prices their capital based on today's spot yield. If you look at the last forty years and the fluctuation in bond yields, we've been high single digits down to virtually sub one percent in COVID within the pandemic. Yeah. Obviously, at around five percent, it's elevated. But in a world where technology is disinflationary, and this is the other thing that we get told by instos all the time, fundamentally, technology has been disinflationary. So, yes, we've got a spout of inflation. You could argue it's a combination as the Reserve Bank Governor has done from supply led shocks in terms of Iran, etcetera, but most of it's excessive public spending, both handouts but also public sector employment growth, which has actually dwarfed private sector employment growth. And it's the only thing that's kept unemployment in the sort of low to mid fours. If you took out the public sector employment growth, we'd be at five and a half percent unemployment, and interest rates would be falling. And that's where I think we're going in the next twelve months. I think we're going to have some sort of economic recession. We've had four years of of an economic recession per capita. If you look at GDP per capita, we've been going backwards for nearly three, three and a half years. And I think we're going to have the technical definition of two quarters of negative GDP growth at some time over the next twelve months. I think we're gonna have rising unemployment. And as I said, as you see further and further capital investment in technology, ultimately, that's disinflationary. That's why our capital is not looking at spot bond yields. It's looking at where things are gonna be over the next ten years, and there is generally a view over the long term that we're gonna see bond yields fall, interest rates fall below current levels. And therefore, whilst, yes, it's relevant to look at a three swap rate and add the bank margin and say you all that cost of debt's x, that doesn't necessarily mean that long term capital's predicting that debt costs are gonna be at six percent for the next ten years. So that's why many pension funds and insurance companies always look at things on an unlevered basis because ultimately through the cycle, it's the unlevered total return that is gonna drive ultimately what they get as an equity IRR. And we've got some capital now talking to us about investing on an unlevered basis. Virtually saying, well, if I can get six plus three and that's a nine percent total return over ten years, I don't really need to introduce debt to amplify my returns because that's not a bad risk adjusted return for an unlevered investment. And if you compare that to the infrastructure sector, which is generally double the gearing of the property sector, a lot of their historic returns have come from the spread of unlevered IRRs to the cost of debt, and that's produced the sort of reasonably good equity IRRs. But we are in a world where I think there will be a lot more capital looking to be unlevered. And even at the private end, we got three point six trillion in this country invested in rented residential, all owned by privates. There's virtually no insto capital in that three point six trillion. And, you know, for the first time in decades, debt's a dirty word. Can't negative gear anymore. Just seen our capital gains tax rate double. So a lot of that capital will move into assessing investments on an unlevered basis, and this is why I think there's a seismic shift in capital flows. No one's gonna accept two to three percent passing yields in residential in the hope that I get seven or eight percent capital growth, which is why people have typically accepted lower yields, and they've been able to use that loss versus the cost of debt to reduce their tax from other sourced income, that's all over. So I think we're gonna see a lot of capital move into commercial property, retail, industrial, social infrastructure, and office because they can get higher yields than what they can get in term deposits. They can get rental growth and capital growth. And why do you need to, you know, introduce debt? So that's why I think unlevered total returns are really important.
Kathryn House
So you mentioned that move into, say, office industrial. There has been that rapid expansion in alternative real estate strategies, and I was interested in Congress that you talked about perhaps that shifting a little and more of a move back to core from alternative. What's your view on the alternative sectors at the moment?
David Harrison
Well, look. There's some alternative sectors outside of your three core sectors of industrial, retail and office that have some strong long term macro and micro drivers. However, it doesn't matter what the alternative is. If you're pushing capital into a new sector, let's call it any part of the the living sector, any part of health care, a whole bunch of other, dare I say, data centres, whole bunch of other fad investments that have emerged over the last ten years, One of the problems with that is they're generally subscale sectors. There's no proof of terminal values, whereas in core sectors, we've had four or five decades of proof of sales evidence, cap rates, etcetera. So if you're going into an emerging sector, alternatives, whatever you wanna call it, you should be pricing that at a much higher return. It's like if you talk to a pension fund about investing in stock markets in emerging economies, you want a higher return for the risk than going into the US or Australia or most parts of Europe. And I think, you know, the demise of Healthscope has been a good example of, you know, you take that risk in emerging sectors and the private health hospital system is getting crunched from four angles, the insurers, the government, the consumer, the cost growth of providing services, surprise, surprise, a highly leveraged, Healthscope both from debt and from setting rents too high, collapsed. And the private equity owner handed the keys back and obviously created issues for the owners of those assets. So we're seeing quite a shift in appetite from, oh, yeah. Let's put some money, not a big part of our total allocation, but let's put some money into alternatives. People are starting to learn the lesson that if you're gonna go down that path, you need to be getting a much higher initial yield and total return than core to justify the risk. Otherwise, why not stay in core at nine percent, ten percent unlevered IRRs? And virtually all of our offerings at the moment across core, you know, with, you know, modest gearing of thirty, thirty five percent can still deliver eleven, twelve percent equity IRRs over a ten year period. So you gotta be getting a lot higher than that to take the risk to go into what I call the new fad alternative sectors and the proof's in the pudding. And I I think we're gonna see it play out in many parts of the living sector as well, where people have been accepting passing returns or yields well below core in the hope that there'll be much higher rental growth. And, yep, I get it. Residential built to rent, you know, technically, you shouldn't be seeing incentives in that sector. Well, we're starting to see vacancies rise. There's an affordability crisis for renters in this country. There's a ceiling to which people just can't pay the rent. They'll just go back home. I've got two kids at home now. I'll probably have all four of them, plus grandchildren soon.
Kathryn House
I don't think they ever move out these days, do they?
David Harrison
It's pretty expensive. And, obviously, we don't mind, you know, the social infrastructure sector, but I don't really see that as an alternative because the majority of our social infrastructure is government-leased assets for essential services, whether it's, you know, Brisbane City Council leased bus depots, which is hard stand that they store the, the buses, whether it's, you know, geoscience, Australian Federal Police. Well, these are triple A rated government leases. Yes. There's a little bit of anxiety around childcare at the moment, but the one thing about the childcare sector at four or five million per asset and generally in residentially zoned areas, there's plenty of alternative uses. So whilst the tenant covenants are not great, even when we've had tenants that have had difficulties, we've been able to sell the assets or replace them very quickly because there's key money that gets paid in the childcare sector to buy leasehold interests.
Kathryn House
So let's talk about data centres. Not dwell on it, but just talk about data centres because you said something interesting at Congress about how you approach data centres. What makes you a little wary about the sector, and where's your head at with data centres at the moment?
David Harrison
Look. It's like everything. You have to be an expert in what you do. You can't attract high net worth capital, mom and dad capital, insto, super fund capital unless you're an expert. I'm not an expert in data centres. And let's peel back the myth. Everyone wants to be a data centre developer and make a development profit, and then they wanna find some capital to buy the end product. That's why we've got a whole bunch of data centres that are trying to do IPOs in the listed market, because very few of them can find long term insto capital that wants to own these things long term. So we don't pretend to be experts. I'm not gonna be a built form developer of data centres. We will power up our land as we have just done in Victoria. Someone comes and gives me two hundred million for a site that I paid sixty four. Happy days. I'll take the premium, make money for my investors, and go and buy more generic industrial assets, whether it's land or or built form. So for me, it comes down to, are you an expert? Have you got a long term track record to be able to not only secure land, get the power, get the council approvals, which is obviously proving more...
Kathryn House
Challenging.
David Harrison
More challenging, particularly near residential zones. But then also get your offtake agreements and...or what we would normally call just lease agreements. They come up with all these fancy words, but they... it's basically just preleasing your data centres like we prelease industrial. So if you put all that together, I just take the view there's other people out there that are better experts. The one issue for me is I'm a real estate investor, and I always look at what is the price per square metre of what I'm paying. And I also look at whether I over capitalise a block of land. Because over thirty, forty years, the one thing I can tell you that's driven all market value growth is the growth in land values. Because ultimately, it sets the the rent you need to be able to do a development. And generally, over multiple decades, land value growth outpaces CPI. So we take a view that there's too much terminal value risk in built form data centres. It'll work for some. I don't have to be in every sector in Australia. I'm pretty comfortable being in the sectors we're in. We don't need to be everywhere, and we're nearly a hundred billion of funds under management. And we've got that way because people trust us to invest their capital in sectors that they think we have expertise. It's that simple.
Kathryn House
So data centres are being powered by AI and the growth in AI. You mentioned earlier, automation. And then at Congress, you were talking about the fact that, I guess, combined, this could reshape the bargaining power between employers and employees. Is this gonna speed up the push to bring workers back to the office?
David Harrison
Of course, it is. Whether you're an old fellow like me or a young university graduate in your twenties, the whole world of employees are gonna have to reeducate themselves and respect having a job. Because as unemployment rises, you're not gonna get away with just sitting at home in your jammies or telling your boss, oh, if you're lucky, I'll agree to come into the office two or three days a week. That's not gonna happen. So traditionally, the labour force has been in competition with other people in the labour force. They're now in competition with robots. And if, as I explained, with what's happening with automation in warehousing, if the cost of labour and the lack of productivity from people wanting to work from home instead of coming into the office and basically be part of an ecosystem that trains the young people, creates productivity, has the collaboration that allows you to connect with your customers, whoever they are, then you'll get replaced by robots. As a US multinational company CEO said to me about an office they had in suburban Sydney. When I've got twenty percent of my workforce coming to the office, why do I need them? I might as well replace them with robots. And, you know, look, my HR department don't like me saying this. I'm sure a lot of others don't. But the reality is that when all of us started work pre pandemic, no one wrote in their employment contract, hey, I'll be able to work wherever I like. So the pandemic has thrown into the ecosystem a new expectation that is noncontractual. And no matter what the unions and all the do gooders say, the reality is that employers have a choice. Employees have a choice. If you wanna work from home or work three days a week, you go and knock yourself out. But if the employer has options and labour options that are prepared to work in the environment that that employer wants them to work in, which is honestly most beneficial for the younger people because they get mentored, they get trained, etcetera. I just think the whole world went completely woke in the pandemic. The whole ecosystem got turned on its head, and it's gonna get turned on its head back the other way very, very quickly.
Kathryn House
But with that AI influence, we're seeing redundancies related to AI. What's the Charter Hall view on what that could mean for office demand in the longer term?
David Harrison
Well, one of the interesting things in this country, because of the silly pandemic, Look at the FT numbers of the major banks. It was in the newspaper the other day. They've had a massive explosion in employee numbers in the last four or five years, and none of them have increased their footprint. So the workspace ratio for a lot of large corporates is at unsustainable levels. Like, one of our major banking clients has got staff in the corridors because they don't have enough space. So the first impact's gonna be people need to get to a more sensible workspace ratio. Let's call it eleven square metres per person. You'll recall before the pandemic, we all went down that stupid hybrid, agile. If you leave your desk for an hour, you've lost it. For most corporates, definitely Charter Hall, that's over. So most of our tenants are planning their space on the basis of fixed desks. Yes. You'll have neighbourhoods, and you might have a little bit of interaction within neighbourhoods, but no one's doing what they used to do prior to the pandemic and allow for sixty, seventy percent of my headcount for bums on seats. That's all over. So we are moving. And so the first impact is I think we're gonna see workspace ratios get back to more normal levels. Now that might be seeing headcount losses, but not reducing space demand. I think we are definitely seeing the vast majority. I think, you know, I said this at our results. I think ninety three percent of all leasing we've done in the last two years has had the same amount of space or more space. So there'll be a few examples where people either have got a contracting business or are offshoring or whatever. So I'm not too worried about the impact on space demand. On top of that, you know, everyone talks about a supply crisis in housing. We're gonna go through the next five or six years with one of the lowest levels of new, brand new supply in office markets I've ever seen in my career. You know, once we finish our second Chifley Tower next year and Mirvac finish their one at Pitt Street, there's virtually nothing gonna come online in in Sydney for five years. Now, you know, if you look at new supply and absorption stats over many decades, that's very rare. So I think we've got a combination of things that, yes, you'd say headwinds could emerge over the longer term if office workers are laid off and that's replaced with automation. The only thing I'd say is through all of my four decades of working, every time I've seen automation disrupt a particular sector, job growth comes in another sector. You ask the major banks how many people are now employing compliance after the Royal Commission. It was the biggest headcount growth sector, and now they've worked out they actually need customer relationship people. So, you know, we're back to focusing on the revenue line as much as compliance. So I'm really not too concerned about a drop off the cliff in in office demand, particularly in core locations. But, you know, if I'm thinking about Prime Sydney CBD, Brisbane CBD, even Melbourne's, much maligned Melbourne, I think there's still gonna be demand. One way or another, we're gonna have a change of thinking in the Victorian government no matter who gets elected because their crazy ideas around telling employers, you know, by legislation where they can employ their people is absolutely ludicrous. And even the beneficiaries of that policy are gonna vote against Labor. So I think we'll have a change in sentiment. As someone said to me the other day, you know, we'll take a black mark off investing in Victoria if there's a change in government.
Kathryn House
I mean, I was... hat was gonna be my final question for you is about Victoria and... because you did talk about there being a capital strike at Congress. It was interesting to hear Development Victoria CEO Anne Jolic acknowledging that Melbourne was challenging, but in her view, it may be near the bottom. I mean, what signal would tell you it was time to cycle back into Melbourne?
David Harrison
As I said before, I'll try to be apolitical. I don't care who's in government as long as we have a change in policy. The Victorian Government is taxing the crap out of the property industry. It's the most ridiculous concept I've ever seen charging foreign investors nearly seven percent land tax for the privilege of investing in the state of Victoria. I've said to both the prior treasurer and the current treasurer, it is nuts. Your stamp duty revenue has collapsed. So whatever you think you're picking up in land tax, multiply that by twenty, and that's what you've lost in stamp duty revenue because no one wants to invest in Victoria. So I think that alone will help change around the deficit, if you like, that this current policy has created in stamp duty revenue. I think there's, as many offshore investors have said to me, it'll just be a signal if we have a change in government that there might be some light at the end of the tunnel in terms of a reemergence of Victoria. And as Anne said at Congress, you know, it's still the second biggest population capital city in Australia. It's still getting, you know, a reasonable chunk of net migration. It's a diverse economy that could actually pull itself out of its current quagmire. But like the Federal Government, they've gotta stop spending more than they generate. We can't do that in the corporate world, so I don't know why the government thinks they can do it. So I'm quietly optimistic that there'll be a turnaround in sentiment, but you need some real changes in the way the property industry is taxed if you wanna remove the capital strike on Victoria.
Kathryn House
Well, David, thank you so much for joining Talking Property. It is always great to catch up.
David Harrison
No problem, Kathryn. I welcome the opportunity and, hopefully, I haven't offended too many people.
Kathryn House
Not at all. I'm sure everyone will be tuning in to find out what you have to say. To our listeners, it's clear that Australia continues to offer many of the fundamentals sought by global real estate investors, but that advantage cannot be taken for granted. Capital is weighing relative value against policy risk, economic weakness, and the ability of individual markets and sectors to convert demand into sustainable returns. And there is also much to watch when it comes to whether we're in for a hard landing and what's in store when it comes to AI, data centres, and the return to office. We have a second Property Congress episode coming up, so make sure to subscribe to Talking Property wherever you get your podcasts. Until next time.
