Toby Lewis Response to Roger Montgomery
Addressing recent opinion pieces in the Media around the sustainability and longevity of the commercial office sector (Part 1)
Toby Lewis (Founder & Managing Director of Marquette Properties) responds to Roger Montgomery
Introduction
Change doesn’t mean death. In fact, it can mean fertile new grounds for growth and opportunity, if you are educated enough and astute enough to look in the right places.
Like a fire that ravages through a forestland, changing dynamics are also having an impact on the commercial office investment market. Whilst we see many mainstream press and the equities commentary on the “ravages of the fire”, we look patiently for sensible investment value and opportunity sets - where those green shoots may next appear.
When we approach real estate investment at MP Funds Management, we overlay our data - analysis with both the philosophical and the practical approach of those investors who have laid a framework that has demonstrated historical success. It has bode us well with our investment track record of 21% average weighted IRR (annualised investment return*).
Using prolific investor Ray Dalio’s framework (which can be referenced in his book Principals) for reference for sound ‘truths’, he suggests that we look to nature, biology, or the way a machine would work as a sound frame of reference of truth. For example, when a bush fire ravages the forest, the heat of the fire escalates with dead wood, sturdy live trees often survive (albeit also affected). The most amazing thing about bushfires is that the heat of the fire activates the dormant seeds which lead to virile growth, meaning a more prolific forest growth after the fire. After the fire, trees left standing are way ahead of those weaker trees ravaged and green shoots appear which bring virile new life. Suddenly, the forest has regrown, and the fire forgotten...
Natural evolution of any market will mean that over time risk and opportunity should be at attractive pricing levels. At MP Funds Management we seek exposure to high-quality property assets that have high ongoing utility, demand or occupancy levels. We look to an entry value that we feel, based on sound property fundamentals, represents strong risk-adjusted value and then we look for a value-add strategy to create as much compounded investment growth as possible over the investment term on a risk-adjusted basis.
One of our loyal MP Funds Management investors sent me an emotive opinion piece article by Roger Montgomery which was published in The Australian “Why City Towers aren’t good investments” August 7th, 2023. The Article annihilated the sustainability of the commercial office sector as a total investment sector. Whilst there were some demonstrated general level knowledge of land-to-building value ratios, the content did not provide an acknowledgement nor in-depth analysis of the complexity, value- and risk drivers within the sub-sectors of the commercial office market. It also lacked any helpful data-driven insight around value and risk dynamics. Again, I refer to renowned investor Sam Zell “We buy deals, not markets”.
The Article made a direct comparison between Industrial or Storage Property vs high quality CBD Commercial Property (shortened here for ease of reference) that as the land component of a commercial office tower is generally much smaller than say an industrial logistics warehouse or storage facility that already the investment economics are favourable to the warehouse or storage facility, purely due to the larger land component and the smaller depreciating asset value (ie smaller building to land ratio).
Here are some property-fundamentals- based comments to counter the assertion above:
Whilst a high quality and well-located CBD commercial office may be a large depreciating asset or building on a small block of land, we believe the Floor Space Ratio (FSR) on a well-located (albeit it often smaller CBD block of land) should be considered. We would argue that based on the high, (sometimes unlimited) Floor Space Ratio (FSR) and generally broad zoning and planning guidelines, a smaller well-located land site in a CBD would retain a significantly higher utility value on a rate per sqm than an Industrial site. Aside from a higher FSR, the flexible use zoning will generally mean a hotel, a high-rise residential development, a commercial office, or a combination inclusive of ground floor retail can usually be built on a prime CBD land site, meaning that the utility value of that CBD block will in most cases mean a significant premium on industrial land.
The Article likens an investment into premium commercial office with investment into an airplane – ie given the large component of depreciation, which the article notes as a negative aspect. As we all know tax is the largest eroder to real wealth accumulation and compounding (read my note on the golden ticket to compounding here). Compounding is what we all strive for as investors, no matter how savvy or educated we are, ultimately, we are all seeking the most compounding possible. With respect to property specifically, we seek assets that will provide the following attributes:
Income Production (ie rent)
Capital Appreciation (growth in asset value over time) and
Tax Deferral (income and capital that is not subject to tax).
Having a large component of tax deferral in a high quality and well-located commercial office asset is very attractive. For avoidance of doubt, in our view a commercial office tower is not comparative to an investment into an airline or aeroplane and drawing a comparison like this is flippant and inaccurate. The key difference being there is a value to the land component underpinning the utility value of the commercial office asset, which from an investment perspective behaves entirely unlike an aeroplane or airline.
In addition to the severe pressure on the commercial office sector, from both interest rates, from the work from home pressures, as well as an oversupply of older-style B-grade property, we are entering a recessionary environment. Employers need staff to come to work. On that basis many high quality employers are moving to new premium commercial office to attract their staff back to the office and many like Bell Potter are enforcing a return to the office. From an occupier perspective teams need to work cohesively, and, in a CBD, which is why societies have been built around main CBDs and main areas of trade since the beginning of time. This also stems from humans needing connection as social creatures. This is why those CBD blocks of land that commercial office towers sit on (and which have a range of uses but given the nature of a CBD its highest and best use is generally for commercial office or a central place for people to do business) command a significantly higher multiple on a rate per sqm than say a block of land for a storage or logistics warehouse. The utility value is higher for the CBD block of land which is reflected in the price. An industrial property or storage property will usually be built in a fringe location and whilst it has its investment merits, the FSR will only enable a very limited amount of building area and height.
Noting that mainstream press has its place and, as does free opinion we feel it’s our duty as pure play property investors to also look to both risk mitigation and mispriced investment value during these changing times and so that you can be a more deeply informed investor.
This deep dive into the commercial office sector is going to be a multi-part series of high-quality content with a range of the most prolific property fund managers in Australia so that we can all get a real sense of truth around value and risk.
Here is Part 1 with Marquette’s Toby Lewis:
About Toby Lewis and Marquette Property
As a quick orientation to Toby, he is the Managing Director of Marquette Property. We first had exposure to Marquette via Post Office Square which was acquired for $67million in 2014 and sold for $95.5 million in 2016 netting a circa 20%pa net IRR (read the deal analysis via the MP Report Premium here). I also have some of my personal SMSF invested with Marquette Property in a commercial office tower in Southbank, Brisbane (read the deal analysis via the MP Report Premium here) which in this past June 2023 Quarter had a $5million improvement to initial purchase price of $104.5million with occupancy rate of 90%. A distribution of 6.3% was paid as at June 2023 consistent with the information memorandum. As additional reading you can read Toby’s Q 4 September 2023 Portfolio Q and A on Commercial Office Investment Value and Risk here.
Marquette Property’s views on commercial office
Here’s Toby’s response to Roger Montgomery’s assertions on the commercial office sector risk, value and longevity.
Toby Lewis Marquette: A Deep Dive on Commercial Office Property Fundamentals:
“Roger Montgomery is an investment manager and columnist that has expressed a summary opinion based on his observations, and various external reports. My views refute, debunk and challenge most of his assertions using data which we have collated over decades as property investors and specialists.
I often ask our clients to be cautious about what they read in the papers and base investment decisions on what they read about the investment product, the terms, risks, and data specific about the product – for example, media articles on stocks are merely stock tips from journalists that give a perspective.”
To address other points raised in the Article, Toby offers the following observations:
Office buildings are always rising and falling in value just like any other property types do during the cycles. If they are depreciating assets, why do we….