Changing times for property trust investors
The volatility in equity markets late last year led to a shift in investors seeking more defensive investment options, with Australian real estate investment trusts (AREITs) regarded as a viable alternative.
AREITs generally provide a good source of predictable income driven by long-term lease agreements and supported by tangible assets. As such, they have been an attractive option for advisers and their clients who are seeking stable income as well as capital growth.
For investors, listed real estate has the attraction of more predictable income streams than many mainstream equities, given contracted rent under lease agreements such as annual fixed increases, CPI inflation increases and, in some cases, inflation plus increases.
The other attraction of AREITs is the real tangible nature of real estate. If gearing is low there is the appeal of knowing that there are real assets supporting value. This is transparent through independent valuation processes.
AREITs comprise listed real estate entities across various sectors of property including commercial office, large scale retail shopping centres, industrial and logistic facilities, childcare, retirement and rural-based assets. In addition, several AREITs undertake other activities such as development and third-party management, which create additional sources of income.
Before the global financial crisis, AREITs had more elevated gearing in a higher interest rate environment and considerably higher pay-out ratios. As a result, there were adjustments to pay-out ratios for mainstream AREITs using the metric Adjusted Funds from Operations (AFFO), which has proven to be a more appropriate measure for determining sustainable pay-out ratios. In addition, balance sheets are now in better shape in a lower interest rate environment.
However, investors need to understand the sources of income streams, as well as the assets and balance sheets that support the investment, particularly as the property cycle reaches its later stages, as some of the drivers of the recent growth may start to taper off.
Our view is that we are at a late stage of the property cycle, evidenced by:
- Capitalisation rates are below levels previously experienced in prior peaks;
- Capitalisation rates have converged across sectors as well as quality types;
- There have been strong investment flows towards industrial and office property, which will ultimately drive a supply cycle; and
- The market is prepared to assign high multiples and growth expectations for higher risk and more cyclical activities, such as development and funds management.
At the moment there is considerable pricing dispersion within the AREIT sector and, on our analysis, this is at the widest level since the global financial crisis. Investors and their advisers therefore need to review the drivers of growth for AREITs to ensure they fully understand the risks as well as the opportunities.
The market is ascribing a considerable premium for what are considered higher growth groups, with earnings from development and funds management in particular. This is late cycle behaviour and warrants caution.
At the other end of the spectrum, we are also observing high quality and lower risk groups trading at discounts, which we believe provides a real opportunity.
Across AREITs, there are some REITs that have had more investment support than others - in particular, industrial and office-focused REITs. However, our view is that the rental growth story is more short-term than long-term, as pricing is very conducive for development, which will lead to increased supply.
On the other hand, high quality retail REITs, which are traditionally defensive, are trading at discounts to their asset backing. The combination of high quality assets and discount to valuation are, in our view, attractive.
Drivers of performance
There are several factors that have been driving the performance of AREITs.
Low interest rates
The continuation of historically low interest rates both locally and globally is skewing the fundamentals, leading to pockets of rising valuations past all-time peak levels. Hurdle rates of return demanded by some investors have subsequently reduced, diminishing a margin of safety one should ordinarily and prudently proceed with. On face value, this is via industrial and office exposure, versus retail and residential
Low capitalisation rates/yields
This has subsequently manifested itself over the cycle via a reduction in the spread in capitalisation rates/ yields between different property classes.
E-Commerce and the evolution of retail
Some investors are seeking industrial exposure over retail, given a view of online retail superseding physical retail. This thematic has prevailed to such an extent that bottom-quartile industrial property is outperforming top-quartile retail property in the United Kingdom, with Australia on the verge of demonstrating the same phenomenon. Such an outcome is unprecedented and unwarranted, and over long-term, retail produces a far more stable income stream than office and industrial.
Flow of capital
There is currently an abundance of institutional capital (especially from offshore) seeking Australian property exposure. This capital is not only playing the online retail thematic but also views Australia more generally as a more transparent and increasingly liquid market. Global (institutional) capital has focused on Australian office and industrial assets.
AREITs with funds management operations catering to this institutional capital have been the chief beneficiaries. This has been via acquiring assets and/ or developing product, with the AREIT deriving management, performance and transactional fees for the service, along with direct exposure to the asset(s).
OPPORTUNITIES AND RISKS
Pay-out ratios across the AREIT sector are largely self-sustaining, with trusts having diversified their sources of debt, with substantial hedging in place, as well as tenure.
Despite this approach, as with all investments, there are risks, namely the potential for sustained rises in interest rates over the long-term. The offset to this is that interest rates generally rise as economic conditions strengthen and inflation pressures emerge. This can be positive with rental growth partially mitigating the risks.
There could also be market-based risks such as overbuilding or a sharp fall in occupancy demand, albeit this is not likely in the short-term. In the case of office properties, the current buoyant conditions supporting new supply will need to be monitored.
The best opportunities for distributions are in the top-tier retail portfolios. Traditionally, the income is less volatile as retail property development tends to be demand-led, with more stringent planning. Development typically comprises extensions within an existing centre, with major tenants signing longer-term leases and high occupancy levels from specialty tenants.
However, there is negative sentiment towards retail property at present, with lower retail sales growth and the increasing penetration from online sales putting pressure on bricks and mortar tenants. Higher-quality shopping centres, however, will continue to do well, albeit at lower growth rates.
Our assessment after the Federal election for the retail and residential sectors is that consumer sentiment will improve, cash rates are likely to fall, there is likely to be a bottoming out in residential, and that some tax offsets are likely to be implemented. Therefore, the retail spending environment should improve along with residential sales activity. This will provide a more positive backdrop for retail and residential-exposed REITs.
We are cautious towards those groups with higher sources of non-rent income and particularly given that, in the current environment, the market is prepared to assign very high multiples on some of these income streams.
In summary, we are at a late stage of the cycle, and given this we would prefer exposure to:
- High quality assets;
- AREITs with less cyclical factors; and
- AREITs trading at discounts and that are out of favour.
Grant Berry is a director and portfolio manager of AREITs for SG Hiscock & Company.
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