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1 EY Real Estate Advisory Services Multi-Family as an Asset Class in Australia: Are We There Yet? June 2017

2 Preface In the US, if you ask a commercial property practitioner, What are the primary institutional real estate asset classes? they will invariably list offices, malls, warehouses and multi-family. In Australia at the moment, it is the former of those three property asset classes only, although for some reason we like to call our malls shopping centres. To date, there have been sound reasons why the multifamily real estate model has failed to gain traction amongst institutional developers and investors in Australia. These include commensurately higher returns historically being available on other property types (e.g. office), an established institutional market mentality (across developers and financiers) of realising capital growth up-front through sell-down of residential properties, and limited experience in the operation and management of large-scale residential portfolios under lease, particularly in vertical, apartment-style properties. However, as we discuss in this piece, the hatching of innovative lease frameworks and delivery models is paving the way for multi-family real estate development that is economically viable, and with this, new avenues are also emerging for enhancing housing affordability. 35 Spring Street, Melbourne (view from south-west) 1 EY Real Estate Advisory Services: Multi-Family as an Asset Class in Australia: Are We There Yet?

3 Multi-Family as an Asset Class in Australia: Are We There Yet? Build-to-Sell In Australia, there is a growing prevalence of high density residential property developments, particularly in the Sydney and Melbourne markets. One only needs to look at the likes of Cbus Property s 35 Spring Street development in Melbourne, a 43-storey residential tower comprising 241 apartments, completed in Ahead of its construction by Multiplex, this property was marketed for sale in 2013 and fully sold at that time. Here, the development feasibility is predicated on a build-to-sell model, where the ultimate ownership of the property is sold to a large number of individual freehold strata apartment owners. Under this model, apartment owners pay their proportional share of rates and taxes, operating outgoings, as well as contribute to an owner s corporation responsible for the upkeep and management of common property. The vast majority of apartments currently being built in Australia are utilising the build-to-sell model with product either being sold to investors or owner-occupiers. Build-to-Rent Fundamentally, the main distinguishing factor under the multi-family or buildto-rent model from the build-to-sell example, is that instead of the individual apartments being sold down, the developer / sponsor retains freehold ownership of the property in one-line and offers the individual apartments for lease. A long-established asset class in the US for many decades, the multifamily model has recently been publicly backed by a number of major Australian property industry players. Salta Properties recently announced its intention to deliver a mixed-use highrise tower in Docklands, Melbourne in 2020, featuring 260 apartments and a 170-room hotel. UBS-Grocon announced as far back as 2014 its plans for the Parklands Project, a $550 million master-planned development being delivered for the 2018 Commonwealth Games to be held in Gold Coast, comprising a mixture of 1,252 apartments and townhouses and a retail and dining precinct, to be financed via an unlisted co-mingled fund. A Shifting Market Landscape Over recent years, we have observed a closing of the capitalisation rate spread between the commercial and residential sectors. This has improved the relative value equation for institutional real estate investors contemplating an allocation to large-scale residential leased property. This is also compounded by the limited supply and tightly-held nature of investment-grade commercial property in Australia. The above right chart shows the median rental yield for CBD apartments/units in Melbourne and Sydney, current as of 26 May The data indicates that a 1-bedroom unit in the Melbourne CBD is currently offering a healthy 6.6% gross rental yield, while a 3-bedroom unit in the same market is offering a comparatively lower gross rental yield of 4.8%. A key takeout of this data is the critical importance and impact that unit mix has on development feasibility and income performance. Synonymous with optimising the tenant mix of a shopping centre, multi-family developers must likewise strive for the right mix of units and floor configurations to ensure they are meeting the market demand of target occupants whilst also optimising completion yields. Gross Apartment Rental Yields by Number of Bedrooms as at May br unit 2-br unit 3-br unit Sydney CBD Gross Effective Rental Yields Prime Office vs. Residential Apartments as at May % 4.9% 4.3% Sydney CBD Offices 3.8% 3.9% 4.6% 4.8% 5.5% Melbourne CBD 5.6% Melbourne CBD Apartments 6.6% Source: REA Group, Savills Research, EY. Data is based on median rents and unit sale prices. Office effective yields reflect average for Premium and A-Grade and are before tenant incentives and CAPEX allowances. City average apartment yields are based on 60%/30%/10% weightings to 1/2/3 bedroom units, respectively with no allowance for incentives or CAPEX. As illustrated in the chart above, in the Melbourne CBD market currently, apartments are showing a positive yield premium to prime offices of circa 50 bps. This is based on gross effective yields after tenant incentives and before CAPEX. In Sydney, gross apartment yields are much firmer, reflecting notable house price growth experienced in recent years. EY Real Estate Advisory Services: Multi-Family as an Asset Class in Australia: Are We There Yet? 2

4 ...for existing landlords of retail and commercial assets that include surplus land holdings, opportunities may be available to develop multi-family property and in the process, realise a higher use on balance land whilst also driving symbiotic benefits to existing uses. Australian market participants should also recognise that the market yields for multifamily should justifiably be lower than the commercial sectors. Why? Well, if we base our learnings off the US market, we see that the multi-family sector is regarded as the lowest risk amongst the property asset classes. This itself is premised on the ability to frequently mark-to-market rents, maintain high occupancy rates (>95%) even in economic downturns (e.g. through dynamic rent pricing and a strong market demand profile stemming from the growing millennial cohorts (people today in their mid-20s to early-30s). This explains why the implied capitalisation rate for US multi-family has historically been the lowest amongst the four main property classes. Portfolio Considerations Australian institutional investors (particularly the $2 trillion superannuation industry) with real estate allocations are unable to source sufficient investment grade stock in the traditional asset classes. Core property funds are generally closed to new investment and many funds are also backed up with large commitment queues. All the while, market returns for real estate are compressing to all-time lows but remain defensible in comparison to returns available on bonds and cash deposits. Noting this, the multifamily asset class opens up a significant volume of investment opportunity. By example, a net apartment yield of 3% to 4% (before CAPEX) combined with rental growth of 2% to 3% p.a. provides a total return of 5% to 7% p.a. before gearing and underlying land value growth is considered. For greenfield developments, a reduced cost basis 1 can enhance the expected yield and total return profile further and perhaps enough for some investors to justify (or at least more seriously consider) a long-term multi-family allocation within a diversified investment portfolio. When expected enhanced diversification and reduced income volatility is also taken into account, the risk-return equation starts to make more sense. Finding Millennial There is an undersupply of suitable rental housing in inner-city locations favoured by the millennial cohorts. This creates a viable source of tenant demand to support market rents, occupancy rates and in-turn, development feasibilities further. Again, borrowing from the US, the subprime mortgage crisis and resultant tightening of lending standards pushed large numbers of homeowners into the rental market. In Australia, a similar effect is now being observed via a run-up in house prices. For example, data sourced from REA Group as at 24 May 2017 shows an average price for a 2-BR unit in the Sydney CBD of $1.24 million. Whether or not you subscribe to the view that we have a housing bubble in Sydney that is a lot of money to most Australians. If one was to purchase that property with a 10% cash deposit with the balance funded by debt on an interest rate of 4.0% p.a. the annual debt repayment would be $83k. Even for a couple with no dependents and a combined annual gross income of $165k (roughly the current ABS average), it is unlikely they would have the disposable income to sustainability service that amount of debt. We also note that rental reforms have been canvassed by state governments, including permitting lease terms above 5 years (further discussion below). This is particularly significant in that it offers the longer term income security required to attract participation by domestic developers and financiers, albeit with the trade-off of foregoing frequent rent reversion opportunities. Other reforms such as introducing a mediation framework for rental disputes and limiting rent reviews to once annually under long fixed-term leases would move the residential leasing framework more in-line with commercial leases, further supporting the Australian multi-family investment thesis. 3 EY Real Estate Advisory Services: Multi-Family as an Asset Class in Australia: Are We There Yet? 1 For example, depending on the procurement model, cost reductions can include a lower development margin, lower marketing or agent costs, no GST on end property value, lower interest and holding costs, etc.

5 Overcoming Challenges to the Multi-Family Model Under the build-to-rent model, the risk/ return dynamic associated with retaining long-term ownership of the developed property is vastly different in comparison to a sell-down scenario where the return is realised over a much shorter timeframe, driving up internal rates of return (IRRs). On this front, the market mentality in the US is substantially different to Australia. US investors are more than happy to accept low absolute yields and IRRs in order to access longevity of income. In Australia, participation by long-term income focused investors supported by a lowering of riskadjusted return expectations is perhaps the most important precursor to the establishment of a genuine and sustainable multi-family asset class. As with all rental properties, the owner wears ongoing risks and responsibilities around leasing (including market rent reversion and vacancy), marketing expenses, tenant management, property management and R&M. All of these factors impact the net yield to the freehold owner as well as working capital requirements. Currently steep and growing land values in preferred multi-family locations adds a further challenge to making feasibilities stack up. Changes to residential lease terms and innovations in the delivery model are integral factors for sustainably addressing many of these risk factors and fostering an economically feasible model for multi-family development and ownership. Leasing risk: longer fixed term leases provide requisite income security to incentivise developers and capital providers (although this is not a precedent of the US multi-family market as discussed below). Clear and enforceable market rent review provisions and a government-backed mediation framework provide greater certainty to tenants and bring the rent review framework to parity with established commercial lease contracts. It is noteworthy that the US multi-family model is centred on short-term leases, mainly 6 to 12 months. There is very limited tenant and landlord demand beyond this tenure. For tenants, they want to keep their options open for new product hitting the market and are usually averse to locking in their rental expense over a long period. For landlords, the latter is also true, they prefer to markto-market rents more frequently and manage rent-roll through dynamic pricing (e.g. daily pricing of rents). Property management: this can be undertaken efficiently even for large-scale properties and portfolios. A blend of on-site property and facility management and centralised off-site asset management is the preferred model employed by successful US multi-family fund managers. Make-good: as with all property, the landlord is usually required to wear the make-good costs associated with tenant use and fair wear and tear. This cost however is usually implicit in the market rent, and leases typically require tenants to post cash bonds (e.g. 1 or 2 months rent) providing some protection to the landlord for more material R&M expenditures. Land values: another major challenge for multi-family development is the currently high cost of land and suitable development sites. However, for existing landlords of retail and commercial assets that include surplus land holdings, opportunities may be available to develop multi-family property and in the process, realise a higher use on balance land whilst also driving symbiotic benefits to existing uses. One fund manager anecdotally noted to EY the example of adding high-rise residential to an existing retail asset, offering direct footfall benefits to the retail component whilst at the same time, significantly improving the feasibility of the multi-family component. In Australia, participation by long-term income focused investors supported by a lowering of risk-adjusted return expectations is perhaps the most important precursor to the establishment of a genuine and sustainable multi-family asset class. EY Real Estate Advisory Services: Multi-Family as an Asset Class in Australia: Are We There Yet? 4

6 Another issue impacting the economic viability of multi-family property in Australia based on a current reading of the Residential Tenancies Act (2010) relates to the inability of landlords to recover land tax from tenants. For inner city locations where land values have recorded significant step-ups in value over the past few years, this becomes a more significant dampener on the development feasibility and net rental yield. It is therefore a key policy area of opportunity noting the raft of other rental reforms being canvassed by state governments at present. Impact on Housing Affordability As alluded to earlier, Australian housing affordability is a serious and growing issue, particularly in the Sydney and Melbourne metropolitan markets. Governments and regulators to date have focused regulatory measures on curbing residential investment demand through initiatives such as: Imposing higher stamp duty rates on offshore buyers for land transfers in NSW and Victoria (a 7% slog in Victoria). In Victoria, stamp duty has been abolished for first home buyers on properties with a dutiable value of less than $600,000. The intended introduction by the State Revenue Office (SRO) in Victoria of a 1% vacant residential property tax (VRPT) to be levied on certain properties which remain vacant for more than 6 months in a calendar year. Whilst these measures are likely to alleviate foreign purchaser demand, in and of themselves they do not materially lower the entry point for domestic purchasers seeking to enter the owner market at existing market pricing levels. As such, supply-side measures are also required to effectively address housing affordability without government assistance. This is where a multi-family residential model is able to deliver a real paradigm shift for housing affordability by opening up the available supply of rental housing. Multi-Family Delivery Models There is further work to be done in Australia in terms of refining delivery models and residential lease frameworks to allow each of the key multi-family participants to achieve an appropriate risk-return outcome. This relates to achieving an appropriate funding mix through the development phase, as well as the post-completion stablised phase one ownership model is not always fitting across both phases of the asset lifecycle. In addition, regulatory or financial involvement by government and / or independent housing associations, may significantly improve the viability of the multi-family funding model while at the same time offering affordable housing alternatives to key workers. Their participation could allow for: Partial re-allocation of certain risks away from financial investors. For example, a Housing Association (HA) could acquire a share of the units in a multi-family development, allowing those units to be offered on a below-market rent, in order to address affordability without directly compromising the return to the developer/owner. Alternatively, the HA could offer a head lease over the entire complex (with a guarantee from a government entity) and sub-lease the apartments to key workers at say 20% below market. The rights and responsibilities allocated to each party within the operating model must be carefully designed to ensure equitable participation is achieved. In the US, there is also an acceptance that multi-family units generally ought to be designed to a lower spec than traditional build-to-sell units. This view is enshrined in legislation with most US states having separate building codes in place for each model (planning applications need to specify whether a new development will be for-sale or for-rent). Optimisation of the design spec is therefore another important lever available to enhance the development feasibility, as well as tenant affordability. 5 EY Real Estate Advisory Services: Multi-Family as an Asset Class in Australia: Are We There Yet?

7 About EY Transaction Advisory Services How organisations manage their capital today will define their competitive position tomorrow. We help create social and economic value for our clients by helping them make more informed decisions about strategically managing capital and transactions. EY has the largest integrated real estate, hospitality and construction practice of any accounting organisation, with approximately 10,000 professionals around the globe providing specialist services to real estate owners, investors, lenders and users including fund managers, institutional investors, REITs, developers and builders. Selected Contacts Ernst & Young Australia Luke Mackintosh Partner EY Real Estate Advisory Services Tel: Tony Singh Manager EY Real Estate Advisory Services Melbourne Tel: Marco Maldonado Partner EY Real Estate Advisory Services Sydney Tel: Paul Tuckey Director EY Real Estate Advisory Services Brisbane Tel: John Burger Associate Director EY Real Estate Advisory Services Perth Tel: Richard Bowman Partner and Oceania TAS Real Estate, Hospitality and Construction Leader EY Real Estate Advisory Services Melbourne Tel: Selina Short Partner and Oceania Region RHC Market Segment Leader EY Core Business Services Sydney Tel: EY Real Estate Advisory Services: Multi-Family as an Asset Class in Australia: Are We There Yet? 6

8 EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com Ernst & Young, Australia. All Rights Reserved. APAC no. AU ED none S This communication provides general information which is current at the time of production. The information contained in this communication does not constitute advice and should not be relied on as such. Professional advice should be sought prior to any action being taken in reliance on any of the information. Ernst & Young disclaims all responsibility and liability (including, without limitation, for any direct or indirect or consequential costs, loss or damage or loss of profits) arising from anything done or omitted to be done by any party in reliance, whether wholly or partially, on any of the information. Any party that relies on the information does so at its own risk. Liability limited by a scheme approved under Professional Standards Legislation. ey.com/au