Feature Stories | Jul 22 2022
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Rising interest rates have led to significant real estate sector de-rating but while cutting forecasts, brokers see the sector as oversold, however picking the right names is important.
-REIT sector has underperformed the index
-Defensive nature upended by stagflation
-Not all REITs are created equal
-Brokers outline their preferences
By Greg Peel
Real estate investment trusts (REIT, or A-REIT in Australia) primarily acquire, let and manage property with the goal of achieving positive “funds from operations”, which basically means earnings, to provide for distributions (dividends) to unitholders (shareholders).
On an historical basis, REITs are considered to be “defensives”, offering above-market dividends that exceed the yield on the so-called “risk free rate”, typically considered to be the ten-year government bond rate. They are attractive to investors looking for low-risk income more so than high-risk capital appreciation. And they come in many colours and flavours.
Note that standard REITs do not accrue franking credits.
In simple terms, REITs are spread across three categories – office, retail and industrial. Most REITs concentrate their investments in one of the three, but some have mixed portfolios across two or all three categories. Those categories can then be broken down further.
For office, most portfolios are concentrated in major city CBDs (Sydney and Melbourne primarily) but some also offer suburban/regional exposure.
Retail can be split between discretionary tenants and non-discretionary tenants – the latter including, for example, the supermarket chains. And into metropolitan and regional.
Industrial typically means factories and warehouses, but these days Australian manufacturing is minimal and warehouses (logistics) are most valuable as distribution centres for online retail.
And these days just about anything can find itself in a REIT, rather blurring the three category concept.
Sub-categories include residential apartments, retirement villages, aged care homes, childcare centres, healthcare & wellness centres, convenience stores, service stations, storage centres, data centres…
REITs do nonetheless all have one thing in common – real estate.
But just to complicate the matter further, some REITs/developers can also be fund managers, offering investors returns on unlisted property portfolios managed in the same way as a fund manager would manage portfolios of stocks and/or bonds.
Critical to the value of a REIT is the prevailing yield on the “risk-free” alternative investment of the government bond, typically the ten-year yield, as REIT portfolios are longer rather than shorter term investments. While REITs are typically seen as low-risk defensives, they are not at all without risk and hence become less valuable to investors if bond yields rise.
REITs raise equity on occasion for larger acquisitions but otherwise borrow to fund acquisitions, in simple terms assuming their rent returns (net of costs) will exceed their interest obligations. So the cost of borrowing (interest rate) vis a vis yield from rents is also critical.
Of course, the values of properties acquired do also rise/fall over time, which leads us to the predominant value comparison of REITs, being the capitalisation rate (“cap rate”). While there is more than one measure, a standard cap rate is defined as operational income divided by property value, or rent returns net of maintenance costs etc versus what that property is currently worth.
Cap rates are somewhat counterintuitive. One might assume that the more money you can make out of a property the better, ie higher cap rate, but the rule of thumb is a cap rate provides a measure of how long it takes to get your money (you being the REIT) back on a property investment. A one year cap rate of 10%, for example, implies it will take ten years to achieve full return.
In short, a lower value cap rate corresponds to better valuation and a better prospect of returns with a lower level of risk. On the other hand, a higher value of cap rate implies relatively lower prospects of return on property investment, and hence a higher level of risk.
REIT analysts will constantly focus on cap rate movements – compression and expansion – in their REIT valuations.
While REITs are historically seen as defensive, lower-risk plodders, they are not at all immune to economic cycles. For example, when the GFC brought about a credit crunch and an effective halt in lending, many a REIT went belly-up.
More recently, covid has caused chaos in REIT Land, particularly during the lockdowns – shuttered shops, empty offices, landlords having to provide rent waivers/furloughs and renegotiate rent levels in a new and unfamiliar post-covid age. It was not a time when REITs could be valued on typical measures.
Another critical factor for REITs are vacancies. To make the greatest returns a property needs to be fully (or at least close to fully) leased.
While in retail most of the lockdown damage was done in High Street shopping strips, where small, independent retailers could simply not hang on, major malls – popular as REIT investments – also saw shuttered shops.
As for office blocks, to this day many are suffering high vacancy rates and given covid has enlightened the world to a new hybrid work model – a mix of office attendance and work-from-home — it is assumed office space demand is now forever reduced.
By definition, industrial REITs should be subject to the vagaries of economic cycles, but lockdowns brought about what analysts assume to be at least a two-year pull-forward of online shopping demand, driving up demand for warehouses for logistics purposes. And as the world transitions to “the cloud”, data centres are not a passing fad.
The Inflation Beast
REITs are considered defensive because in a “normal” economic downturn, as valuations are supported by the central bank easing monetary policy to provide support, leading to lower bond yields. And REITs with long lease expiries, or weighted average lease expiries (WALE), will still collect the same rent.
“Normal” economic downturns are also disinflationary. The current downturn is therefore far from normal, featuring stagflation not seen since the 1970s, driven by the exogenous factors of war and pestilence. Central banks cannot control war and pestilence, so their only weapon to fight soaring inflation is aggressive rate hikes – the enemy of REIT valuations – even if this means turning a slowdown into a full-blown recession.
The RBA has hiked its cash rate by 125 basis points year to date, to 1.35%, and is expected to hike by another 50 points in August. The market is assuming the RBA will stop hiking somewhere in the 2.5-3.0% range, hence the Australian two-year yield, which is seen as a proxy, is currently trading (at the time of writing) at 2.75%.
By mid-July, the ASX200 REIT sector had fallen -19%. June alone brought a -10.3% fall compared to -8.8% for the ASX200 index. For the financial year to end-June, and measured in total return terms, ASX200 REITs lost -12.3% versus the ASX200 Accumulation index losing only -6.50%.
The good news is having traded as high as 4.20%, the Australian ten-year bond yield is now back down to 3.50%. The bad news is that while there is some expectation inflation may by now be peaking (June quarter CPI data due this month will still show a substantial increase on March), recession fears drive long bond yields lower, and despite the fact recessions are disinflationary, recessions are not particularly good news for landlords either.
The reaction from property analysts has been a widespread de-rating of REIT valuation assumptions, leading to sector-wide target price cuts and a rethink on ratings. However, consensus has the sector being oversold after such a sharp move. Many REITs are now trading at significant discounts to their net tangible asset valuations, or at least their NTA valuations as last reported.
Property valuations also come under pressure in a downturn. Analysts don’t have a lot to go by on that from presently, as there have been few property transactions in the sector recently because of economic uncertainty.
Yet while the sector may be oversold, there is divergence among expectations for the various categories of REITs as laid out above.
Factors to Consider
Balance sheet. REITs with high gearing are more exposed to further rate rises. High levels of cash provide a buffer and also the opportunity for further acquisitions at possibly distressed prices.
Tenancy. Low vacancy levels are a positive, as are “anchor tenants” – those unlikely to bail out and vacate the property anytime soon. In times of slowdown, defensive tenants such as the supermarkets are less risky than discretionary retail, for example, which could take a hit on demand.
Lease expiries. The longer it is until a tenant’s lease expires, the more certain are earnings from rent, unless the tenant is forced to bail out.
Rent linkage. Different REITs across different sub-sectors enjoy CPI-linked rents, providing a hedge against inflation.
Business type. This widens the scope between the simple retail staple/discretionary comparison. Aged care and childcare are receiving increasing government support. Healthcare is at some levels non-discretionary. Data centres are a growth industry. Distribution centres remain in high demand. Office blocks are under pressure.
Longer term themes. Aged care and retirement villages supported by ageing population. Childcare supported by growing number of women in the workforce. “Wellness” is growing in popularity. Online shopping may ease in a downturn but the trend will not turn. Will CBD offices ever be full again?
So, with all of the above in mind, which REITs do analysts see as worthy investments in the wake of substantial de-rating, heading into the August reporting season?
Wheat and Chaff
Stockbroker Jarden has outlined its top picks in terms of current growth expectations, valuations and an assessment of up- down-side risk versus consensus forecasts.
Jarden expects “mall retail” to deliver double digit earnings growth, ahead of the sector average. This means Scentre Group ((SCG)) and Vicinity Centres ((VCX)). Non-discretionary retail offers defensive earnings and conservative net asset values, which favours Shopping Centres Australasia ((SCP)), HomeCo Daily needs REIT ((HDN)) and Charter Hall Retail REIT ((CQR)).
Storage should show defensive characteristics, and the FY22 impact of acquisitions should be enough to offset interest rate headwinds. That means National Storage REIT ((NSR)) and Abacus Property ((ABP)).
Jarden expects fund managers to remain volatile and is not expecting much from results, but believes Goodman Group ((GMG)) will still deliver 15% earnings growth in FY23.
Manufactured housing REITs Lifestyle Communities ((LIC)) and Ingenia Communities ((INA)) are also looking at double-digit earnings growth supported by 100% exposure to inflation-linked rents and growing development books underpinned by affordability.
Charter Hall Long WALE REIT ((CLW)) and Centuria Industrial REIT ((CIP)) are trading at extensive discounts to net tangible asset value and offer attractive yields given their defensive nature and CPI-linked leases.
Most recent valuations from quarterly reports in June showed ongoing strength in asset values, JPMorgan notes, particularly for Industrial and Convenience Retail. Charter Hall Social Infrastructure REIT ((CQE)) announced a 5.6% value increase in the second half, followed by HomeCo Daily Needs with 4.6%, Charter Hall Retail 4.5%, Growthpoint Properties ((GOZ)) 2.2%, Dexus ((DXS)) 2.2%, Charter Hall Long WALE 2.0%, Vicinity Centres 1.7% and Shopping Centres Australasia 0.8%.
Growthpoint and Vicinity both announced earnings upgrades, the latter due to a strong rebound in retail trading. Abacus and Goodman Group improved their interest rate hedging positions, and capital management remains a key focus amidst rising interest rates.
JPMorgan’s top pick amongst all REITs is Mirvac Group ((MGR)), which the broker suggests is oversold on the basis of an implied loss of -24% of asset value. Mirvac boasts a strong development pipeline, and existing assets include an industrial portfolio that is fully let and all located in Sydney, and retail portfolio in high population density locations.
JPMorgan least prefers GPT Group ((GPT)), which borrowed late in the cycle to provide for a shift towards industrial assets and hence now has its highest gearing level since the GFC. It also has the lowest level of interest rate hedging in the sector, its office portfolio is 8% vacant and 30% of leases will expire before end-2024.
Macquarie notes a significant level of downside being priced into current valuations, implying more than 100 points of cap rate expansion which the broker sees as excessive, particularly for REITs with funds management or development earnings not captured in NTA values.
By sub-sector, Macquarie prefers retail and industrial over office and residential. The broker’s assessment of prior downturns shows retail rents and occupancy typically show greater resilience through recessions compared to office, and while industrial has been cyclical historically, Macquarie believes market vacancy at less than 1% provides a relative level of defence moving forward.
In residential, Macquarie continues to see headwinds as the cash rate rises, albeit is conscious of the potential for an undersupply given low vacancy rates, limited apartment supply and a return of immigration.
Macquarie remains attracted to REITs that have relatively greater earnings certainty, and therefore prefers Vicinity Centres, Goodman Group and Arena REIT ((ARF)). However, if bond yields show signs of stabilising, the broker admits a more defensive positioning may prove too conservative.
Hence, Macquarie would look to supplement with additional fund managers of Charter Hall Group and Qualitas ((QAL)), and the mid-cap REIT income vehicles of HealthCo Healthcare & Wellness REIT ((HCW)), HomeCo Daily Needs and Charter Hall Retail also screen positively on valuation.
While the broker is marginally more positive on the REIT sector as a whole, it is still seeking to avoid exposure to groups with greater downside risk to balance sheets and earnings, which include Scentre Group, Charter Hall Long WALE and Dexus Industria REIT ((DXI)), and while residential exposures are screening well on valuation basis and low vacancy rates are a positive for a medium term view, near term catalysts are limited.
Following a sector-wide reassessment, featuring a de-rating of valuations, Ord Minnett has upgraded Dexus ((DXS)) to Buy on a -21% discount to NTA, and minimal value being put on the funds management business and development capability. Hotel Property Investments ((HPI)) is upgraded to Buy on strong leverage to CPI, good interest hedging and a secure income stream.
Ord Minnett also upgrades Centuria Industrial and Mirvac to Buy, and downgrades Carindale Property Trust ((CDP)) to Hold, on valuation grounds. A Buy on Charter Hall Group is retained.
But wait, there’s more…
Credit Suisse suggests that among the retail REITs, Vicinity Centres screens cheaper than Scentre Group, but the latter has lower gearing.
Among the “diversifieds”, Credit Suisse prefers Stockland Group ((SGP)) based on its FY23 earnings outlook, suggests Mirvac is looking cheap on a longer term view, prefers Goodman Group among the fund managers and, for patient investors, continues to see deep value in Lendlease ((LLC)).
With cap rates set to expand, Citi prefers asset classes with positive near to medium term income growth outlooks given they will help shield the cap rate impact. This includes property types with favourable demand supply dynamics (industrial/logistics), shorter lease terms (storage) and with income benefitting from high inflation (convenience, certain long WALE assets).
The broker foresees higher investment demand in these particular asset classes as well, resulting in lower valuation downside.
For the fund managers, falling asset values create near-term challenges. Citi prefers Goodman Group and downgrades Charter Hall Group to Neutral.
Citi prefers convenience and dominant “nodal retail” supported by strong grocers. Shopping Centres Australasia and Charter Hall Retail have high exposure to defensive, growing food grocer anchors and should be better supported in a tough consumer market.
The broker suggests Vicinity and Shopping Centres are better positioned for rising rates; Shopping Centres has been double-upgraded to Buy. Scentre Group is upgraded to Neutral as the broker takes a more “constructive” view on omni-channel retail platforms. Scentre is trading at a -38% discount to NTA and boasts recovering post-covid trading numbers and inflation-linked leases.
While Charter Hall Long WALE has 46% of leases linked to inflation, Citi downgrades to Neutral due to rising debt cost. A Buy is reiterated on Abacus Property.
Wilsons believes that as the market grows more concerned about the economic outlook, the defensive nature of some REITs should “shine through”. But despite significant discounts to NTA, Wilsons remains concerned about structural challenges for office (occupancy may never return to pre-covid levels) and retail (covid has driven more households to shop online).
To that point, Wilsons sees ongoing tailwinds for industrial/logistics and notes REITs like Goodman Group should benefit from structural growth.
HealthCo Healthcare & Wellness presents an opportunity for investors, Wilsons believes, due to its defensive earnings, discount to NTA and ongoing structural tailwinds in healthcare.
Drawing from recent census data, Morningstar warns childcare REITs are vulnerable to demographic headwinds, given a steady decline in births since the previous census. However, the tide did turn, with Australia setting an all-time record for births in the September quarter of 2020.
It is unclear if the increasing number of births is a result of a shift toward working from home, high female labour participation rates, or women in the relatively large millennial cohort approaching a biological threshold to their fertility.
However, Morningstar assumes the currently observed increased number of births is a positive leading indicator for Arena REIT and Charter Hall Social Infrastructure REIT over the next few years.
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