Kathryn House
Hello and welcome to Talking Property with CBRE. I'm Kathryn House, your podcast host, and in this episode I'm sitting down with the Commonwealth Bank of Australia's George Vallas. George recently took the reins as CBA's Head of Real Estate, Institutional Banking and Markets. He's going to give us his take on a range of topics including commercial property trading activity, recent market challenges, his expectation for rate cuts and the three asset classes he'd pick to invest in over the next 12 months.
George Vallas
I'm optimistic around asset values holding up and I actually expect you might see some increases in some sectors.
Kathryn House
There were so many takeaways for me. I hope you enjoy the conversation. So George, it's great to have you join Talking Property.
George Vallas
Thanks for having us on, Kathryn.
Kathryn House
Before we dive into some questions, you've been at CBA for over two decades. I'd love to hear what led you into a banking career.
George Vallas
I had a general interest in real estate as a teenager and after a failed sporting career, which ended when I was 18, it was suggested that I should consider the real estate valuation profession. As a result of that, I started working as a cadet property valuer for one of the small suburban firms in Sydney while studying. And after a year of some cold calling and a bit of hustle, I landed a job for one of the larger commercial agencies as an assistant valuer. And that was just a fantastic experience because the work was quite varied. One week I was working on a shopping centre, the next it was compulsory acquisition work for local government and a fair amount of residential development site work for some of the larger mortgage funds at the time. This really provided me great foundations in valuing and understanding real estate. After about three years of that, I moved into real estate development with a quite well-known development company called CRI, working for Peter Barnes, who many of your listeners would know.
Kathryn House
Yes, I saw him the other week.
George Vallas
There you go. You're always seeing Peter around town.
Kathryn House
Yes.
George Vallas
I was primarily involved in a serviced apartment project in North Ryde and we ultimately sourced the funding from CBA's institutional team and soon thereafter I was working for that same team and that was just over 22 years ago.
Kathryn House
The cold calling and the hustling, a big part of real estate.
George Vallas
Always helps.
Kathryn House
Yes. So could you give us a helicopter view of some of the changes that you've seen in the commercial real estate lending space during your time in the industry?
George Vallas
Yes, you probably actually have to go back 35 years in terms of events and developments that shape real estate lending in this country. And the first one I'd say is really the '90s recession. That had the most profound impact on real estate lending here in Australia. The second I'd go with the GFC and that was my first experience of what happens when you have market dislocation. The third, it's really regulatory change with the introduction of Basel II and III in '08 and 2023 respectively. And more recently the growth in private credit over the last 10 years, which has really accelerated over the last few years, but well behind other offshore markets, particularly in the US where it makes a materially higher percentage of overall lending. Now, in between all of these developments and events, we've also seen the impact of the advancement of technology and COVID-19, which has impacted lending appetite across the various real estate sectors.
Kathryn House
So you mentioned private credit and we'll get onto that later in the podcast, but you did really emphasise the'90s recession. Why did that event have such a profound impact on lending?
George Vallas
Yes, that '90s crash, the Australian banks suffered material losses given their exposure to commercial real estate and that was a function of their credit underwriting standards and how they managed their exposures across the organisation and their subsidiaries. One of the big four banks nearly went under, literally. Now, if you think about the GFC and the impact bank failure had in the US with Lehman Brothers failing and just think about what it would have been like here in Australia to have one of the Big Four come so close to collapsing. And the stories that I heard from some of the old timers that were still at the bank when I first started, particularly when I was proposing some more speculative opportunities reflective of my experience, or I should say lack of.
Kathryn House
They're going, hang on.
George Vallas
Yes, that's right. That value destruction that occurred was really enormous. So as a result of that, the bank's credit underwriting standards in consultation with the regulator were immediately tightened and the regulator has continued to monitor the sector with great vigilance and this is one of the reasons why the sector has fared so much better than other offshore markets.
Kathryn House
So just to close off on this topic, you mentioned the regulation brought about as part of Basel II and Basel III. Can you just expand a little on that?
George Vallas
Yes, I won't spend too much time on it, but it is important. Bahl II was introduced in 2008, a bit of conjecture on how you pronounce that. Anyway. Now that was interesting because it actually provided some relief for various industries in terms of the assessment of risk-weighted assets and how much banks needed to hold in terms of capital, but it did not apply to the real estate sector and that was partly as a function of the lessons learned during the '90s crash. Whereas in 2023 Bahl III changes, again I've gone with Bahl instead of Basel, were positive for the commercial property sector because risk-weighted assets and capital was more aligned to the underlying security, which meant lower LVRs resulted and less capital needing to be held by banks. So, that's a bit of an overview.
Kathryn House
So it's obviously been a challenging period more recently for the CRE sector, but it was interesting to see CBA, as Australia's largest CRE lender, increase its sector exposure by around 4% in the December half to $98.4 billion. What drove that and can we expect to see a further rise in 2025?
George Vallas
Transaction volumes are up in the second half of last year and we expect more of the same through the 30th of June. There is definitely more confidence coming back into the market. The growth for us has not been specific to one sector. It's been quite broad. We're really focused on build to rent at the moment. It's a strategic initiative of ours to support housing supply in Australia. We're doing more in the traditional residential build to sell sector and one transaction that we supported, which we're extremely proud of, is Stockland's acquisition of the Lendlease Communities business, which was great to be part of given the scale of the portfolio, which will support the development of many thousands of homes across the country. Growing allocation to self-storage, that continues to power ahead. We've also continued to grow the industrial and logistics exposure where we have historically been underweight and we executed on a number of transactions pre-Christmas with ESR, one of which was the Moorebank Intermodal. Now, this is a core piece of infrastructure that's currently being built out and we'll see that estate ultimately accommodate over 800,000 square metres of logistics space. Retail has also been important. A fair amount of activity, particularly amongst domestic investors. And I know the REITs are operating at very high occupancy rates, which is supporting higher operating incomes. And notwithstanding all the noise in the office market, we've been involved in a number of transactions with both domestic and offshore groups. We've supported Deka in their acquisition of 333 George Street. We've selectively increased exposure across the portfolio for some of our clients amongst many transactions. And we're also supporting new development. We're pleased to be involved with Charter Hall and some of its key partners in the Chifley South Tower, which will include class-leading tenant amenity, which is really what the market is after.
Kathryn House
It's great to see that development activity starting to come through and also that trading activity. So we're seeing the institutions, offshore buyers all starting to weigh back in. Obviously it's baby steps, but can we expect trading to get back to pre-COVID levels, do you think?
George Vallas
The deal flow has definitely increased, but it's not back to pre-COVID levels and I think that will take some time. I don't think anyone's calling that just yet. Pre-COVID we were seeing a lot of flows coming from greater China and that's come off materially. Singaporean investors have continued to invest over the last couple of years and they've executed on some material transactions. The domestic syndicators have started to be quite active again, and we expect this to continue. And we're seeing a fair amount of flow from Japan and we would expect this to continue as the majority of it has come post-COVID and where it came in earlier, it's been in sectors or assets that have actually performed quite well and therefore you would expect to see more flows from that market. Again, pre-COVID, you're seeing a lot of the larger offshore North American and European institutional investors targeting gateway cities in Australia, but that really ground to a halt. But in the last six months, we've seen a few transactions that have taken place. PGIM's acquisition of 20 Bridge Street, BGO alongside Investa are acquiring 10-20 Bond Street. Both sizable transactions. These investors clearly have a view that the office sector has bottomed and we expect to see more activity in the next six to 12 months.
Kathryn House
That's good to hear. So we've talked about some of the positives, but let's touch on some of the challenges as well. In this post-COVID period, have you seen many stressed or impaired loans?
George Vallas
As a general comment, whilst increases to interest rates and vacancy rates, particularly in some sectors did create challenges for the loan book, it's actually performed really well. It's worth noting that in the half year results presentation, troublesome and non-performing exposures represented 0.7% of the portfolio and that is down from 1.3% in the previous half. So that is a positive and it reflects well on the bank's near $100 billion real estate portfolio. It's also worth mentioning that there's a deep credit pool of funds, particularly with private credit. So where borrowers are quite definitive around the leverage that they're after, which in some cases will sit outside of where bank appetite sits, those borrowers have other financing options, which also I think has helped the market.
Kathryn House
0.7, that's very low.
George Vallas
Yes, that's great to see. And just one more thing. If it wasn't for writing more business...You're not writing more business if you've got troublesome and impaired loans.
Kathryn House
Yes.
George Vallas
That will be brought back, but that's not the case.
Kathryn House
So I guess getting back to the positives, the recent RBA rate cut was one of those. Do you anticipate that we'll see another cut in the coming months, getting your crystal ball out, or do you think we'll have to wait until later in the year?
George Vallas
I reached out to the economics team ahead of our chat and the bank's house view has not changed post budget. So right here and now, the bank continues to anticipate the RBA to leave the cash rate on hold in April and resume cutting the cash rate by 25 points in May, provided the first quarter inflation data comes in line with our forecast. Our economists continue to talk to the risks on both sides of the forecast as economists do. You have an upcoming federal election due shortly and that brings uncertainty and obviously the labour market remains very tight. But at the same time the global picture is evolving with downside risks to global growth given the escalating trade war. Overall, our economists are expecting three more interest rate cuts this year with the cash rate moving down to 3.35 by the end of 2025.
Kathryn House
Three cuts. I think there'll be a lot of people in the industry who'll be glad to hear that.
George Vallas
You're not wrong.
Kathryn House
So just one last question on rates. Has there been any immediate impact on borrowing costs in the CRE space as a result of the February cut?
George Vallas
Kathryn, most borrowers would actually have felt the impact ahead of the RBA cut on their unhedged debt because it would have been priced into the base rates which are set having regard to the forward curve, which was anticipating the RBA cut.
Kathryn House
So maybe let's switch tack and do a bit of a deep dive into some of the different property sectors. We've touched on it a little bit with the transactions that have occurred recently, but let's look at office. Arguably being the most challenged sector, but there seem to be a lot more positivity about the Australian office sector in the latest REIT results. What's CBA's view of office as an asset class and how much does that differ when it comes to A grade versus B grade, CBD versus fringe and even by geography?
George Vallas
I mentioned earlier that notwithstanding the concerns around office, we have continued to execute transactions. So we well and truly believe in the sector and office represents just over 20% of our portfolio. We do have a strong focus for high quality assets, particularly with green credentials in core CBD locations. However, suburban and fringe office markets play their part, and we have such exposures, but similarly our focus is on those better-quality assets which tenants have been gravitating towards with a view of attracting their workers to come back to the office. Yes, I accept vacancy is at elevated levels in aggregate across the country. It has started to trend down in some cities, and this should continue as we expect less supply and assets being taken out of the market as they're repurposed into other uses and we're seeing a fair amount of that at the moment. Just one more point I wanted to cover on this. Over the last few years, we had a lot of questions coming in around whether the dislocation that we were seeing in the US, particularly for office, would play out here in Australia. And what I mean by that is in the US there are reports around owners handing back keys, assets selling at 50% discounts to their pre-COVID prices. Our response as a business was that we would not see that here in Australia and we had a lot of conviction around our position and really for two key reasons. First, the majority of our office space is in core CBD locations, and this is where the return to work momentum has been really strong. It's circa 65% of our office is in core CBD locations, whereas in the US it's more like 35% and some of these locations in the US are quite remote. The other point is that the majority of debt held against commercial real estate in Australia, it's held by regulated banks. It's circa 85% with very strong underwriting standards, which goes back to my comments earlier around the impact of the '90s recession and what was implemented thereafter by the banks and the regulator. In contrast, banks in the US account for circa 40% of commercial lending and the private credit market represents a greater proportion of all lending and typically leverage is higher, there is more prevalence to covenant light arrangements where you have an ICR, an Interest Coverage Ratio covenant, but you have no LVR covenant. So if values fall materially, the lender is at risk. So the key point here is there is simply less leverage in the Australian system and some of the terms and conditions just provide us greater levels of protection. I recently caught up with a US investment manager. I provided them an overview of the market, as I do, and I actually put the question to them. I sort of said, "why do you think the key reason that Australia has performed better than some markets, including the US?" And his point was exactly that. He said, "there's less leverage in the system, the banks really manage their exposures and that has helped."
Kathryn House
Well, it's great to see that we didn't go the way of the US. Like seeing some cities, particularly cities like San Francisco and how much they suffered during this period. And I think we did have a much quicker return to work acceleration. We did touch on earlier the bit about markets bottoming here and we have come through a period of some quite significant valuation adjustments in some sectors. Do you think the softening of valuations has eased and what is the impact on bank lending on these adjusted valuations?
George Vallas
Yes, I definitely think it's eased for office given we're seeing more transaction activity, which is positive and obviously given some of the recent office sales, it's clear that investors out there believe things should only improve from here. And that might well be the case, but it will really depend on the individual asset and the cashflow quality. As for residential development sites, there's a strong demand for the end product, whether it's apartments, whether it's townhouses, and there are supply constraints. So you would expect values should improve. But the caveat here is that construction costs...and I note another major builder in Roberts & Co. went into administration a few weeks ago, which creates uncertainty for developers and that will feed into their feasibilities.
Kathryn House
Yes, construction cost has been such a hurdle for the industry and getting new supply and that supply that we really need in the housing sector. So are there any sectors or asset classes that CBA is concerned about?
George Vallas
I'd say there's cautious optimism as many of the sectors are experiencing tailwinds given recent expected interest rate movements, population growth, and the high costs associated with building which has the impact of reducing supply. So generally I'm optimistic around asset values holding up and I actually expect you might see some increases in some sectors.
Kathryn House
So if you're an investor, what asset class would you pick to be in in the next 12 months?
George Vallas
I'm going to go with data centres and there is just simply a lot of debt and equity chasing that asset class. And secondly, every time I want to get something done, which is a bit unique, the response is we need to consider an AI solution. It's really been ingrained on us at the moment and understandably so, given AI solutions are scalable and really drive productivity. I'm really positive around retail, particularly fortress style retail assets with great transport infrastructure surrounding them, which will benefit from strong population growth, more density that is likely to be built around those locations and really I can't see more supply being brought in the short to medium term.
Kathryn House
Well, it's interesting you say that because we've got a podcast coming up with Vicinity Centres where we're going to be talking about fortress style assets and why premium retail has been performing so well. So yes, I'm glad to know that that's topical. So getting back to the data centre question probably takes me into alternative property assets, which data centres wouldn't be considered as part of now by many, but by some. What's CBA's definition of alternatives? We do have these varying views on what falls into that bucket. There's been that blurring of the lines between what's real estate and what's infrastructure. How does CBA view alternatives?
George Vallas
I'm going to keep it simple, Kathryn. Everything outside of the traditional asset classes of office, industrial, retail, and residential are considered alternatives at CBA and that includes data centres.
Kathryn House
Right. Okay.
George Vallas
Now, as for your question around whether data centres could be considered as infrastructure, well what I'd say is that the data centre tenants have high barriers to exit given the investment they need to make in the data centre. So they're typically purpose-built, long-dated pre-commitments from large hyperscale users, so there's strong cashflow certainty. So yes, I do agree that they're more infrastructure like.
Kathryn House
Turning back to something that we discussed right at the very start, and you mentioned the private credit space. We have seen a number of global groups invest significant capital into the private credit space as growth in the NBFI market accelerates. What impact do you think this will have on Australia's domestic banking sector?
George Vallas
I think the first thing I'll say is that in terms of competition, the Australian bank's biggest competitors are really the offshore banks from Europe, North America, and Asia. It's a very competitive market. These groups are attracted to Australia given its stability and many have been operating here for many, many decades and supporting both their domestic clients who are operating in Australia and also the local property owners. Now, as for private credit, here in Australia, for the most part they are supporting transactions where the key credit metrics really sit outside of our risk appetite and our key underwriting standards. So whether that be higher loan to value ratios, lower interest coverage ratios, shorter WALES, lower tenancy pre-commitments, that's really the sector that they're playing. So I think we are very much focused on different styles of transaction.
Kathryn House
I've got one final question. ESG and sustainable financing. When originating CRE loans, how much of a consideration is CBA placing on this and is this influencing credit availability?
George Vallas
It's a material consideration for the bank. Identifying and assessing the ESG risks that our customers are exposed to as well as assessing how our customers are mitigating and managing these risks is an important component to our lending processes. It's worth noting though, commercial real estate owners have actually been at the forefront of managing these risks. And to be clear, the owners acknowledge that sustainability can drive real value in their organisations through areas such as improved tenancy outcomes and reduced operating costs.
Kathryn House
Well, thank you so much for joining, George. It was really great to get your perspectives. I'm particularly pleased to hear that we might see another three interest rate cuts and also great to see there's a lot more positivity coming through. So thanks again for being on Talking Property.
George Vallas
Thank you for having us on, Kathryn. Really enjoyed it and hope to be back sometime.
Kathryn House
Absolutely. We would love to have you back. We've got some great episodes coming up, so make sure to follow Talking Property wherever you get your podcasts. That way you won't miss our Q2 House View with Phil Rowland and Sameer Chopra and the upcoming episode I mentioned earlier with Vicinity Centres on why premium retail has become the biggest game in town. Until next time.
