An antipodean opportunity

Australia is certainly no stranger to private equity. Buyout firms have been interested in Australian companies for years: Recent headline-grabbing deals include a Macquarie-led consortium's bid for Australian airline Qantas, and the CVC/KKR bid for Coles Group, Australia's second largest retailer. Though both bids were unsuccessful, they were examples of the typical sort of private equity acquisition seen in Australia thus far.

But those two bids were soon overshadowed by a successful bid in the property sector, Morgan Stanley Real Estate's A$4.7 billion ($3.8 billion, €2.8 billion) acquisition in May of Australia's largest publicly traded office real estate investment trust, Investa Properties. The deal, which valued the Sydney-based company at approximately $5.5 billion, was the first private equity takeover of a leveraged property trust (or LPT, as REIT-style vehicles are known in Australia). Needless to say, the country's other LPTs sat up and took notice.

“When you've got a lot of funds and you're obliged to invest in real estate, you look for things like constitutional stability, predictable taxation structure and a mature industry where information is readily available. Australia has all of that, and the Australian LPT market is one of the most transparent markets in the world.”

“Though private equity has been very busy down here, surprisingly until recently there hasn't been much interest in the LPT sector,” says Peter Fullerton, an associate vice president at ratings agency Moody's who recently wrote a report on private equity and Australian public real estate trusts. “But some LPTs are logical private equity targets if the are underperforming in terms of their equity performance, but also in terms of their operations, including market share, margins and general operational performance.”

Deals aplenty
The Investa acquisition was quickly followed by another headline-grabbing real estate transaction, the A$4.3 billion bid for the construction and property company Multiplex Group by Brookfield Asset Management. In addition to its construction business, Multiplex has around A$7 billion in assets including grade-A office buildings throughout Australia.

There has been a spate of single-asset deals, as well. The summer saw Broadreach Capital Partners pay A$50 million for the Ocean Resort Cairns, a destination hotel with 314 rooms overlooking the Great Barrier Reef, as well as the GIC Real Estateled A$1.1 billion acquisition of the Myer department store in Melbourne.

With the up tick in interest, the heavy hitters of private equity are meeting with a number of Australian property trusts, and investors are pouring money into the trusts in anticipation of upcoming M&A. And with Morgan Stanley's recently closed $8 billion international fund including Australia in its mandate, much of the door-knocking could come from that firm.

It's not hard to see why. Australia's LPTs have a long and successful history, and to foreign private investors they may represent the perfect mixture of “hardware,” the properties themselves, and “software,” the people needed to manage, acquire, redevelop and build properties. Australian LPTs are also easily approachable and often come with managers who have decades of experience in the Australian property sector.

But it's not just the underperformance and expertise of the LPTs that's attracting private equity. The country which houses them is attracting foreign investors like never before, attracted to the land down under by its developed economy, liquid market, transparency and experienced managers. And thanks to Australia's commodities boom, which has now been running five years following the concurrent decrease in Australian supply and increase in demand from India and China in the late 1990's, western and northern Australia is exploding with growth.

“When you've got a lot of funds and you're obliged to invest in real estate, you look for things like constitutional stability, predictable taxation structure and a mature industry where information is readily available,” says Lloyd Baggott, who heads up the commercial real estate group for Australian law firm Minter Ellison. “Australia has all of that, and the Australian LPT market is one of the most transparent markets in the world.”

Grass is always greener
In a strange twist, the steady increase in foreign investment into Australia has come at the same time as local firms are looking abroad for opportunities.

“There are over 700 syndicated funds investing in real estate in Australia, and the investable universe here is not large,” says Baggott. “So the massive wall of capital from government superannuation schemes [see article p. 44] and LPTs is driving investment and making some properties overpriced. There's greater demand than there is supply, and the result is that a lot of these [Australian] funds are looking offshore.”

Trevor Cooke, director of capital markets for the Property Council of Australia, says that Australian real estate holders are selling off assets to foreign investors and then using that capital to buy foreign acquisitions themselves.

“Seventy percent of investment grade assets are already securitized, so there's not much left for the Australian funds to buy here,” he says. “But Australia has the fourth largest savings base in the world, and 10 percent of that goes to real estate. They need to find a place to deploy that capital, so now Australian LPTs own more than A$50 billion in assets offshore.”

“Many of the LPTs are selling to private capital, then using that money to go offshore and acquire property there,” he continues. “Against all of that, we've seen US, German and UK funds coming in and buying property in second-tier cities like Adelaide, where a good yield is still available. It raises the question, is the grass just always greener on the other side? Why have the LPTs allowed the German firms to come into Australian second-tier cities and deliver 7 percent returns?”

Cooke says that because so many LPTs have been selling shares to foreign investors in order to raise capital abroad, on average about 30 percent of listed capital today is held by offshore interests, and half of this is from the US. This wasn't the case two years ago, he says.

Go west
Despite the increase in offshore investing by Australian firms, the rise in investment in Australia by foreign firms suggests that there are plenty of domestic opportunities for development in the country, especially in the West. Looking at the property fundamentals, insiders say, one quickly sees where the opportunity in Australian property lies.

The first thing investors in the Australian property market will tell you is that the commodities boom changed everything. As demand for commodities from India and China has skyrocketed, the states of Western Australia, Queensland and the Northern Territory have seen a surge in business investment and demand for infrastructure. The resources boom has pushed up iron ore prices by 189 percent, copper prices by 300 percent and nickel prices by 400 percent in Western Australia. Last year the Western Australian economy was growing at 16 percent, translating to skyrocketing industrial land values with increases of between 100 percent and 160 percent in 2006, according to a recent report from Macquarie Real Estate. And according to a recent government report, the resources boom could continue for a number of years, making industry an attractive target for investors.

“The industrial sector is the most vibrant at the moment,” Baggott says. “Companies in Australia have enjoyed a decade of growth: They're cashed up, they're looking to improve the premises from which they conduct their industry. As a result the industrial sector is promising consistent returns.”

“We just completed an office market report, and it shows that Australian offices are busting at the seams,” says Cooke. “There's so much demand, particularly in Perth and Brisbane, that the markets are red hot.”

The state capitals of Brisbane and Perth have seen phenomenal growth over the past several years, and that growth is predicted to moderate but still remain quite healthy into 2008. And it isn't just industry that that has benefited from the resources boom in the West. Increased industrial activity has also meant an increased need for office space. Brisbane and Perth continue to see tight vacancy rates driving rents, making them an excellent short-term bet. Much of the increase has been recent and, in fact, three years ago the office sector throughout the country was in a slump. But the sector has now hit a development phase and, in the West in particular, the scarcity of institutional-grade assets is making construction an attractive option.

“We just completed an office market report, and it shows that Australian offices are busting at the seams,” says Cooke. “There's so much demand, particularly in Perth and Brisbane, that the markets are red hot.”

If you were lucky enough to get into a residential investment in Perth a few years ago, you're also in an enviable position. Perth house prices rose 40 percent in the year to September 2006 according to Macquarie, and for the first time in history the city is less affordable than Melbourne, Brisbane, Canberra or Sydney. But the deteriorating affordability is now a case of more concern than celebration, as prices have overshot considerably in the past year. However Macquarie predicts that a high level of construction should ease this problem and flatten prices over the next one to two years. Still, the western city is in desperate need of migration as it faces a labor shortage to fill positions opened by the commodities boom, and the affordability issue is stifling that necessary growth and will likely reduce the demand for housing in the city.

The resurgent southeast
The Southeast states of Victoria, New South Wales and Tasmania have not benefited as much from the commodities boom, but they have benefited from a dramatic increase in migration, prompting a growth that has narrowed the traditional East/West divide. New South Wales is now seeing its highest immigration rate in five years, with 21,500 people migrating into the state last year from Australia and beyond. With overseas migration concentrated on skilled workers, resulting in a healthy labor supply, the New South Wales economy grew by more than 3 percent in the year leading to March 2007.

Melbourne has also seen considerable growth, and the fact that it is now more affordable than Sydney, Perth and Brisbane means the city is likely to outperform the other state capitals in the residential market. As both Melbourne and Sydney enter into a stabilization phase following a three-year downturn in the housing market, the two eastern cities may represent a good long-term bet.

The Southeast office sector also represents a smart play in the medium- to long-term. With the state economy improving, there could soon be a need for rapid development of new, high-grade office space. “In Sydney and Melbourne the commercial office space sector is reaching a level where supply needs to come online, otherwise market rates will increase too fast,” Baggott says. “As a result, listed funds are looking more at that sector again, and they haven't been heavily involved in that sector for the last five years.”

The Southeast will also likely benefit from a demographic trend toward urban and seaside areas, as people move away from the hinterland and toward urban areas and the coasts.

“It's a trend in Australia that's accelerating,” Baggott says. “Some areas of Australia are suffering droughts for longer periods, people are moving away from country areas toward cities and transport hubs and investment is predicting this movement.”

As opposed to the other sectors, analysts say the retail space requires a much greater degree of caution. A likely rise in interest rates over the next two years could negatively affect sales and, more importantly, the sector is so tightly held that it's very difficult for investors, both foreign and domestic, to get into, says Cooke.

Defending the homeland
As foreign investors eye all of these opportunities, whether through direct investments or through LPT acquisitions, it's likely the Australian LPTs, who have been the dominant players in the space for so long, may make moves to give them more bargaining power with a potential private equity bidder.

“I think what's most interesting is how the LPTs are responding to private equity's entry into the market,” Fullerton says. “Last week, Goodman Group took a 9.7 percent interest in [LPT] ING Industrial Fund, largely as a blocking interest so that if other private equity players were to come in, they would have a stake in one of their peers and could influence them in that way.”

LPTs may also re-evaluate their strategy of selling off their domestic assets to invest abroad in light of the increased interest from foreign investors. It remains to be seen whether the Investa deal will be followed by a string of public-to-private real estate acquisitions in Australia, but the country has been put on notice. Private equity is knocking at its door.