The MSCI World Real Estate Index is down nearly 30 per cent since the start of 2022.

Some of Australia’s biggest landlords are grappling with a slew of challenges in their property portfolios as the sector is buffeted by headwinds in a rising interest rate environment.

Top super funds including Australian Super, Australian Retirement Trust (ART) and Cbus have already been forced to write down some assets by up to 20 per cent as commercial real estate valuations slide and expose structural problems like falling demand for office space and the rise of online retail.

Large profit-for-member funds, many of which own significant chunks of commercial property across the country (much of it unlisted) are also having to deal with issues of uncertain valuations, poor income growth, liquidity squeeze for portfolio managers and growing ESG risk.

The challenging environment is accelerating a change in investment flows to different segments of the asset class, as some fund managers pare back exposure to office or retail or shift focus to less traditional segments like build-to-rent, logistics and medical or student housing.

“We continue to diversify our property holdings beyond quality office and retail, with investments in key healthcare assets and offshore,” says Jeff Brunton, head of portfolio management at HESTA. “This aims to provide a mix of investments that can deliver returns in a range of economic conditions and across multiple market cycles.”

The $72 billion industry fund has been reducing exposure to property in recent years but still has about 6 per cent of its default MySuper option invested in real estate.

Commercial property has been bleeding globally since the pandemic, but the downward trend became conspicuous after central banks started lifting rates last year. The MSCI World Real Estate Index is down nearly 30 per cent since the start of 2022.

Valuations have slid as much as 40 per cent in some markets in the US, but the impact in Australia has been far more modest. Still, super funds are betting that commercial property will post negative growth for a second year in a row.

Preference for unlisted

ART’s chief investment officer Ian Patrick says the current environment is proving difficult to assess value in certain segments of the market.

“We want the ability to deploy capital but we want to do so getting a sense of the future fundamentals,” he said. “Understanding when to buy and how to price is probably the most challenging right now.”

The fund, Australia’s second biggest with $240 billion of assets, has 8.5 per cent of its default MySuper option invested in real estate.

ART recently wrote down some of its office towers by as much as 15 per cent, but had already been cutting exposure to the segment in recent years after deciding to diversify beyond the typical commercial/retail/industrial portfolio to other segments including residential, medical office and self storage.

The issue of uncertain property valuations is likely to be widespread given the superannuation industry’s bias towards investing in unlisted assets. APRA estimates unlisted assets make up about $650 billion, or roughly 20 per cent of Australia’s $3.5 trillion retirement savings pool.

Unlisted assets have traditionally helped industry funds deliver better returns for their members. But valuations of privately-held commercial property can take months to respond to rising interest rates or changes in demand and supply. Rising rates and bond yields have also raised the spectre of liquidity risks for funds.

Fund investment heads insist they have adequate independent valuation processes in place as they continue to boost exposure to private assets.

But risks are serious enough for Australia’s prudential regulator to last month seek closer scrutiny of such holdings and ask funds to undertake valuations more frequently, particularly during times of market upheaval.

Difficult transition

The combination of rapidly rising rates and falling demand for the heavyweight office and retail sectors is throwing up a challenging period of transition for super fund managers.

Kent Robbins, head of property at Unisuper, says some funds are likely to struggle to generate adequate returns as commercial property cap rates rebound after years of declines.

Capitalisation rate is the annual percentage return on investment. It declines either when income from the property falls or more commonly when the asset value goes up, which has been the case in recent years as low interest rates have encouraged investors to bid up prices of commercial real estate.

“For the last decade, there were incremental, total return outcomes based only on cap rate compression,” he said. “Teams haven’t had to focus on growth of net operating income but they’re no longer going to get bailed out.”

“In fact, people will have to actually generate income growth to offset increased outgoings and increased debt costs.”

Meanwhile, fund managers looking to cut exposure to office or retail and shift to other segments are being hampered by the lack of liquidity in the sector.

“We’re constantly trying to optimise the mix of assets and investments but where there’s less liquidity in the market that becomes more of a challenge. It’s more difficult to rotate the portfolio,” says Andrew Bambrook, head of property at super fund REST.

REST holds the bulk of its property portfolio in the big three sectors of office, retail and industrial but has been looking to boost exposure to other segments like residential and student housing, which currently account for 25 per cent of its holdings.

Funds using external managers face a similar problem as property operators stare at falling asset values and declining returns while high interest rates dry up funding.

“Some big investors could turn up to their managers and say we need to rebalance the portfolio, we want you to realise liquidity for us. Those operators will come under pressure either by virtue of being faced with liquidity demands or by having their mandates terminated,” ART’s Patrick says.

ESG worries

Given their long term holding of assets, a real risk that super funds face in their property portfolios has been the growing importance of ESG. While the spotlight in recent years has fallen on decarbonisation and shifting to renewable energy, the real challenge could lie in the sustainability of their buildings.

Alek Misev, head of property at Aware Super, says the current focus on the lack of demand and falling valuations for office buildings is really part of a bigger issue related to sustainability.

“The main thing that tenants are looking for these days is sustainable buildings. That is going to be the the main focus point and challenge, because if you sit on very old assets, it’s going to cost a lot of money to bring them up to speed,” he said.

The $150 billion Aware Super, one of Australia’s third-largest pension funds, has been one of the few to emerge unscathed from the tumult in commercial property, having sold down most of its older office buildings as well as offshore office and retail asset over the few years.

REST’s Bambrook says his team is similarly focused on the ESG credentials of assets across the portfolio, which ranges from assessing energy ratings to the need to refurbish assets or even investing in more modern assets.

“We’re certainly conscious of the risk of having stranded assets or assets that end up with some kind of brown discount because they don’t meet the requirements of the new generation of users,” he said.

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