Howard Marks, renowned value investor and co-founder of Oaktree, once said ‘I think it’s essential to remember just about everything is cyclical’.
Heavily influenced by economic growth, commercial property is certainly a cyclical beast. Whilst historically low interest rates and the allure of listed property trust dividends mean many investors may have forgotten this, it seems Greg Goodman, chief executive of global industrial property owner and manager Goodman Group (ASX:GMG), hasn’t.
Development a focus
Greg Goodman recently said that ‘at this point in the cycle, development provides the best risk adjusted returns’.
To understand why, you only have to look at the company’s average capitalisation rate (the lower the capitalisation rate, the higher the value of its properties and vice versa), which stands at 6.6% while its developments have an 8.3% forecast yield on cost.
In plain English, this means an industrial shed that costs $100m to develop will generate $8.3m in operating income once completed and occupied, yet the market is currently valuing a similar pre-existing shed at over $125m. So instead of buying existing properties, it makes sense for Goodman Group to develop new properties and then flog them off to third parties or to its managed funds.
The company intends to maintain the current volume of developments – $3.4bn worth of properties are currently being built – but it’s actually reducing the amount of development it undertakes directly, preferring to develop more properties in its managed funds. To help this along, the group is exchanging development sites it owns directly for increased stakes in its managed funds.
Why is it doing this?
Reducing development risk
Firstly, most listed property trusts want to increase their funds under management because the ‘recurring’ nature of management fees and the higher returns they generate are viewed favourably by investors. So to the extent a development that would have been sold to a third party is instead developed and held in its managed fund, this helps increase funds under management.
It also allows Goodman Group to exploit its likely expensive development sites for increased stakes in its managed funds without having to fork out any cash.
Whilst Goodman Group will receive fees for managing developments on behalf of co-investors as well as management fees on the completed asset, the main consequence is that it transfers much of the cost of funding the development along with the risk involved – including rising construction costs and/or falling property prices – onto its co-investors.
All things equal, if I were an industrial property developer and believed prices would remain high or increase even further, then I’d want 100% of the development profits rather than, say, 25%. To me, this just supports Goodman Group’s belief that prices of existing logistics facilities are ‘currently expensive in most markets’.
The group is also sensibly keeping debt levels low enough so that if commercial property prices do fall, it won’t have to quickly raise capital to satisfy its lenders like it was forced to at knockdown share prices during the global financial crisis. This is particularly important given that more than half its earnings before income and tax now come from development (35%) and management (21%).
I don’t know where interest rates and commercial property prices will be in five or ten years. We could indeed become like Japan and interest rates could remain at historically low levels for decades. If so, then investors in listed property trusts like Goodman Group may well earn respectable returns.
Yet if I were to guess, I’d suggest the cycle will eventually turn, whether it’s because long-term rates rise, credit becomes harder to obtain, supply increases faster than demand or because of some other factor.
We’ll have to wait and see whether the industrial property market – and other parts of the listed property market – follows Marks's dictum.
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