This article appeared in the February 2015 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
Low interest rates and gradual improvement in the property sector good news for Australian Real Estate Investment Trusts.
By Stephen Hiscock, SG Hiscock & Company
Australian Real Estate Investment Trusts (AREITs) performed strongly over 2014. The total return for the AREIT sector, including distributions (as measured by the S&P ASX 300 AREIT Accumulation Index) was 25.8 per cent, compared with the broader sharemarket's return around 5 per cent.
Why such a strong performance? First, the AREIT sector started the year at a modest discount to our internal calculation of the sector's fair value - we call it net asset value (NAV) - of around 3 per cent.
Second, bond yields rallied considerably over the year, with the 10-year bond yield declining from over 4 per cent to under 3 per cent, helping with AREIT valuations and lowering their borrowing costs, which boosted earnings. This allowed them to increase distributions without making material changes to their payout ratios.
The earnings performance was robust in 2014 and defensive, despite difficult property operating conditions with rising vacancies in CBD office markets and tough leasing conditions in the retail sector. The fact that AREITs were able to improve their earnings and manage their portfolio vacancies well has improved investors' perception of them as defensive investments.
(Editor's note: Do not read the following ideas as stock recommendations. Do further research or your own or talk to a financial adviser before acting on themes in this article).
AREIT sentiment rising
Improving sentiment further has been corporate activity in 2014, the most notable of which were the Westfield restructure and creation of Scentre Group and Westfield Corporation, Dexus taking over Commonwealth Property Office, and the Australand takeover by the Singapore REIT, Frasers Centrepoint.
Westfield Corporation, which makes up approximately 17 per cent of the AREIT index, also benefited from the strengthening US dollar as it has about 70 of its asset base in the US.
As the chart below shows, AREITs finished the year at a premium to our NAV of around 10 per cent, so they are no longer cheap. We believe they can sustainably trade at a small premium, say 5 per cent, to their NAV.
Source: SG Hiscock & Co
What to expect this year
In 2015 we expect continued supportive conditions for AREITs from low long-term interest rates, offset by the soft property operating conditions in Australia. We also expect the market to look beyond 2015 and build in a gradual improvement in property operating conditions (higher occupancy and rental growth) but for this to be partly offset by expectations that long-term interest rates will rise at some stage.
Pleasingly for investors, we expect AREITs to maintain their prudence and discipline in distribution payout ratios and gearing levels. There is always the temptation to increase payout ratios and borrow more, given lower interest rates and availability of debt capital, but we are optimistic that the majority of AREITs have learned their lessons from the GFC and will continue to manage prudently.
Given the shift down in long-term interest rates and prudent capital structures, and despite the continued tough operating conditions, we see limited downside risk to AREIT distribution guidance for 2015, especially as managers can always marginally adjust payout ratios.
However, we are always on the lookout for factors that could provide difficulties for the sector, and the following are some of the possible risks and issues (albeit these are not our central case):
- A dramatic increase in credit margins and interest rates would have a detrimental effect on refinancing.
- A sharp decline in consumer spending or business conditions/sentiment.
- A sharp decline in property operating conditions, although given properties are well occupied and typical lease terms are five years, this is unlikely to be a short-term risk.
- A material fall in residential construction volumes would harm residential AREITs such as Stockland Corporation and Mirvac Group.
- A higher Australian dollar versus the US dollar would specifically have an impact on Westfield Corporation.
We are also paying close attention to AREITs with relatively full payout ratios (close to, or above, 100 per cent of their gross earnings). We do not favour this practice and prefer trusts to hold back some of their earnings to provide an adequate buffer for items such as maintenance capital expenditure and leasing incentives. The AREIT does not then have to draw on debt to fund ongoing expenditures.
Regarding the office sector, we continue to see merit in having exposure to AREITs that offer a quality portfolio in predominantly CBD locations around the country. These include Dexus Property Group, Investa Office, GPT Group and Mirvac Group. However, we remain fully cognisant of the present income-growth headwinds, given the over-renting in some portfolios and high rental incentives.
We are wary of Perth and Brisbane office assets, given the weakness in the mining and resources sector. In Brisbane, vacancies are at an all-time high and rental incentives are often 30 per cent or more.
We have an investment in GDI Property Group, whose "contrarian" focus is on assets that are more secondary-grade in nature, yet located in CBDs in the major cities (in terms of the assets held on their balance sheet). We expect such office assets to do well, as the yield gap between primary and secondary remains large, providing attractive potential returns should the repositioning be successful. At present there is a negative effect on GDI from its large exposure (on balance sheet) to Perth.
In the retail sector, the drop in oil and petrol prices (despite the fall in the Australian dollar) should start to benefit consumers. This is on top of the rising wealth effect (at the margin) from increasing house prices across the east coast. We currently prefer exposure to the super regional retail centres that dominate their trade area, and large leisure/entertainment precincts serving as a destination for consumers are desirable.
Domestically, Scentre Group provides the best such exposure, with its vertically integrated business model focused on regional shopping centres in Australasia. We also continue to favour convenience-based neighbourhood centres providing everyday non-discretionary needs. Exposure to this sector is via our holdings in Charter Hall Retail and Shopping Centres Australasia.
Investors were rightly disappointed by the extremely poor performance of the property trust asset class during the GFC, and we believe institutional investors collectively have a duty to encourage AREITs to be prudent, defensive and transparent, and to protect their investors.
Performance in the past few years has gone some way to reassuring investors that the sector is in good shape. But it is critical that trusts understand that to maintain investors' confidence they must continue to have sustainable distribution payout ratios, moderate gearing levels, focus on cost control, and not chase growth simply to expand.
About the author
Stephen Hiscock is Managing Director of SG Hiscock & Company, a boutique fund manager specialising in Australian equities and real estate, with approximately $2.3 billion in funds under management. He jointly manages the AREIT portfolios with Grant Berry.
SG Hiscock & Company is a foundation member of is a foundation member of the ASX mFund Settlement Service. The mFund Settlement Service enables you to buy and sell units in selected unlisted managed funds directly with the mFund issuer via a stockbroker or advisory services used to transact shares or other ASX products.
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