Time To Look At REITs, Selectively

Feature Stories | Jul 22 2022

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.

REIT Returns

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.

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