Pricing Risk And Measuring ESG Progress Accurately In Australia’s Debt And Equity Markets

Reno Sio, Institutional Real Estate, Inc’s Managing Director, Asia Pacific, spoke with EG’s Executive Director Roger Parker and Head of Private Debt Philippe Sung. The interview was originally published in the January 2022 issue of Institutional Real Estate Asia Pacific.

Can you start by giving us an overview of EG?

Roger Parker: EG is an Australian-headquartered real estate funds management business with approximately A$5 billion of assets under management. EG was established 20 years ago by our chairman, Dr Michael Easson, and our CEO, Adam Geha. Originally, the firm was focused on value-add strategies centring on planning gain and rezoning. EG would identify income-producing sites near new or upgraded infrastructure, and then promote a case for land-use change over a period of years. Originally, we started with the support of high-net-worth individuals and family offices, with subsequent closed-end funds composed of institutional investors, primarily domestic superannuation funds. More recently, European and Asia-based institutional investors make up 50 percent of our investor support across funds that target investment opportunities up and down the risk spectrum. We have commercial office, industrial, ESG and core plus strategies, and expanded into debt investing in 2020, which is when Philippe joined to establish a real estate private debt funds management capability.

How has the COVID-19 pandemic affected your spectrum of strategies, and the landscape of risk and return?

Philippe Sung: Due to financial policy responses trying to offset health policy responses, the pandemic has allowed us to segment our strategies more than usual. Office and industrial had fairly similar risk-return profiles pre pandemic, but due to lockdowns and working from home requirements, office took a bit of a step back initially and overcorrected. EG’s view focuses on humans as social creatures and their preference for face-to-face collaboration. Work from home will always be a factor, but businesses will still need the same space if the team is to have even one full-desk day a week. Any mispricing of office in 2021 is now rectifying. Industrial assets became a proxy for online retail exposure, causing prices to hit highs not seen before. I doubt that we will see much more money weight or interest rate-led cap rate compression come through industrial, so rents will have to move to see price growth continue — possibly adding more inflationary pressure. With retail, our preference is for nondiscretionary-focused centres and well-located placemaking retail, which will have value for as long as people remain social creatures. That said, poor amenity or poorly located retail may be better suited to an alternate use, such as distribution centres. And then we have the big one — residential — where the low interest rate environment has driven prices far more disproportionately than the other major sectors. Housing choices have also had an impact — from people using work from home to favour location over commuting distance, to baby boomers choosing to retire early, or buyers taking advantage of lower borrowing costs “translating” to higher purchasing power. From a debt perspective, we are seeing some structural coolants coming through, so while interest rates are unlikely to spike back to long-term averages and cause an abrupt correction, fiscal policy will need to taper price growth in favour of stability. House price growth may decelerate, and there are some interesting studies on the possible impact of a 100-basis-point rise in interest rates — but my hope is for a soft landing, and I doubt residential prices will go too negative, given pent-up demand from net migration, which is Australia’s traditional residential price driver. We’re entering a landscape that requires a cautious approach with strong analysis, stronger relationships and good, old-fashioned hard work to help us uncover value.

There are a lot of new nonbank lenders now. What makes EG’s debt investment strategy unique?

Sung: It is our partnership approach. EG has its roots in planning and development, and it has developed significant property technology capabilities during the past decade, with a focus on ESG improvement. While we provide bottom-up knowledge, from planning advice, construction, or tenancy and demand, we also collaborate on strategy with our partners. Our approach is heavily driven by our commitment to using technology and data to help us identify and quantify risk. This culminates in a figure akin to a Sharpe ratio, where we input multiple points of risk and analyse their effect on each percentage point of return. Overlaid on that is an ESG focus to reduce environmental impacts, as well as create appropriate community environments for people — focusing on social impacts to address wellbeing. The common element among EG’s strategies is how we work with our partners — investors, borrowers, builders, councils and agents. We are very open and collaborative, often producing a significant improvement in the asset or project — both commercially, via more return to all parties, and on an ESG level.

Tell me more about how you implement ESG principles.

Parker: We have developed a framework to help guide us so we can identify assets with weak ESG characteristics that we can improve on and achieve strong outcomes on various metrics, all based on an expansion of the UNSDGs (United Nations Sustainable Development Goals). So, our question is: What can we do that will make a difference to meet the goals of our framework? We have scored, on a one to 10 basis, a number of different elements that are currently weighted towards the “E”. Sixty-five percent are environmental, and 35 percent, social. It is a lot harder to have quantitative measures for “S” outcomes — you can measure, for instance, that your supply chain is compliant from a Modern Slavery Act point of view, but some elements, such as impacts on mental health and community outcomes, are more subjective. That said, we believe the framework we’ve developed with our investors — which include a clean energy investor and a university fund that has partnered with us on research — removes a lot of the subjectivity from our ESG measures of success. One of our outcomes will be case studies that show you can have a positive impact and a good financial impact from repositioning assets. We hope the industry, both locally and offshore, can start to look at these strategies and adapt them — and share strategies and outcomes for the betterment of the sector. Frankly, the problem — and the opportunity — is bigger than one manager or investor. It is about winning collectively, and our hope and expectation is that in 10 years all funds will be ESG funds.

You’ve just started a debt strategy. How does that fit in with ESG?

Sung: As Roger said, the problem and the opportunity are greater than the few. Like electric vehicles, ESG real estate works best with widespread adoption, and there will generally be greater wins for the early adopters. As a lender, we can provide partnership or guidance on how to improve assets or projects from an ESG perspective. This improves the borrower position but, as a lender, we also get the benefit of that through an improvement in value and coverage — and this hands-on value-creation partnership is what few banks and nonbanks can provide.

What are the key demand drivers for debt versus equity?

Parker: There is a lot of interest in alternative strategies from institutional investors. Some strategies are quite interesting to look at from a debt perspective first, before going into an equity position, so we are looking at some nascent sectors where there is a lot of potential volatility in the return as the sector matures. If you are coming to the opportunities through a debt position rather than equity, you can, in some cases, have an improved risk-adjusted return through the buffer of equity risk sitting above you. It is a way for institutions to get access to a protected understanding of a sector that they haven’t traditionally played in. If you can come in at scale as a debt lender, you can become familiar with the sector — sort of dip your toe into the water of a new sector.

Sung: Our core focus in real estate debt is, again, about taking that capital-partnership approach. The only difference is how far up or down the capital stack we go, depending on macro drivers or idiosyncratic aspects of the deal. An opportunity may not work as an equity investment, but in many cases may work as preferred equity, a mezzanine loan or senior debt. The reason a debt strategy works for a manager like EG is because we can lean on 20 years of equity experience to help problem solve any asset hurdles. On planning and development especially, we can partner with a borrower to help de-risk, step-in or optimise projects with that partnership approach. On two recent occasions, we effected a better return outcome for both borrower and investor because our planning and development team found value left on the table in the design and build phases.

Do you target any particular sector with your debt strategy?

Sung: The first thing we think about is counterparty risk, rather than any particular sector. We look for borrowers we respect and can work with, because we are as much a partner as we are a lender at the end of the day. Next is understanding the asset. We have experience across all sectors and a deep skill set in understanding project risk, so while working with developer counterparties is a natural fit for us, it ultimately depends on the borrower and the asset specifics.

What would you recommend investors focus on, post-COVID?

Sung: Beware the winner’s curse. For us, it’s as basic as accurately assessing risk-adjusted returns. It’s not just a matter of looking at the return, but also pricing it correctly. A lender may “price-towin” a project or asset, but based on asset specific or borrower risk that isn’t cross-collateralised, they may be under pricing risk to win the deal — whereas EG’s platform allows more pricing accuracy and the flexibility of not participating in negatively mispriced opportunities.

Parker: Broadly, we will buy or lend in all sectors if we can get comfortable that we have properly identified and priced risk down to the specific asset level. On industrial, we still see some value in urban industrial locations where there is a finite supply of land and supply chains look to be lengthening, but we also see some very tight pricing. We have the same approach with office. The work from home freedom people saw initially has been coloured by the reality of how dysfunctional it can be, and how hard it is to recruit and onboard staff. We are also very interested in retail. It has been on the nose for so long, but we are seeing opportunities and are keen to get back into that sector. Retirement living, age care and healthcare are all sectors we are interested in for the big sector thematic of an ageing population.

Sung: That’s right. Interest rates reverting too quickly will be the big risk to watch. Building and input costs — especially food and energy — are going up, and whether current inflationary pressure is transitory or structural is yet to be seen. There are still some good fundamentals underlying the market. We think the traditional macro thematics hold true in Australia, so it is simply a matter of being cautious, careful and sifting through the market for the best opportunities.

Roger Parker leads the capital raising function at EG as well as being a senior member of EG’s Investment Committee and Executive Committee. Over the course of his career, Parker has been directly responsible for equity capital raisings exceeding A$4 billion and capital transactions totalling more than A$3.5 billion.

Philippe Sung leads EG’s Private Debt division, contributing his expertise in structured finance and nonbank lending to EG’s experience in development management and planning. This collaboration equips EG with the proficiency to provide nonbank construction and term loans to real estate developers and investors across all sectors at risk equivalent terms.

This article presents the author’s opinions reflecting market conditions. It has been prepared for informational and educational purposes only and should not be considered as investment advice or as a recommendation of any particular security, strategy or investment product.