Seven issues for property investors
A-REITs rally amid expectations of ‘lower for longer’ interest rates.
Investing in Australian real estate investment trusts (A-REITs) is meant to be boring. The aim of the game is stable distributions that turn up like clockwork and low share price volatility to match the predictable returns.
Over the past two years the sector has delivered on that commitment, and a whole lot more. While the ASX All Ordinaries index is below the level of June 2014, the ASX 200 A-REIT index has risen by more than a third.
For investors in the sector and those attracted by the yields it offers, that prompts some key questions.
1. What’s behind the recent price rise?
We believe interest rates are the key. The “lower for longer” argument refers to the expectation that global growth and inflation will be low for an extended period. Indeed, the emerging theme in financial markets is “even lower for even longer”.
That is having a big impact on long-term bond yields, which have hit record lows. Not only is this reducing the borrowing costs of the sector, it is driving interest in A-REITs. With global interest rates heading towards zero and in some cases going negative, investors seem more willing to pay up for yield.
With term deposits and Australian government bonds paying 2 to 3 per cent per annum, the A-REIT sector’s average current annual yield of 4.5 per cent is comparatively attractive. There are few places where you can find a yield of this quality.
2. Can the rally continue?
If interest rates continue to fall, yes. We expect the “lower for longer” theme to play out for some years yet, and this would be good news as lower rates are likely to equal further price rises.
That is because, depending on which valuation tool you use, valuations are not yet stretched. Net tangible assets (NTA), a measure which many analysts prefer, indicates valuations are indeed expensive. But we believe this is a distorted figure because the impact of stocks such as Goodman Group and Westfield Corporation, which include significant amounts of corporation earnings – those delivered by property development activities rather than rents.
These stocks trade at significant premiums to NTA, as much as 70 to 100 per cent, and represent about 26 per cent of the A-REIT sector, distorting the overall market premium to NTA. There are still a number of A-REITs that trade below NTA.
Moreover, A-REITs are liquid assets not liable for stamp duty and legal expenses, which can be as much as 6 per cent of an asset’s value. A “neutral” 10 to 15 per cent premium to NTA is not unreasonable. Exclude Goodman Group and Westfield Corporation and the sector’s premium to NTA is 24 per cent.
Although common, NTA is far from a perfect tool to value stocks. Many A-REITs are structured with securities in a trust and a company stapled together. Both parts should be valued separately. The Net Asset Value (NAV) does that. It indicates the sector is trading around fair value. Further, future growth in rents and asset values should deliver further increases in NTA.
If you believe that interest rates will stay low for an extended period, our valuations imply value in the sector. All up, the recent surge in A-REIT share prices seems to have a foundation and we believe the fundamentals remain attractive.
3. What if interest rates rise?
A-REIT share prices would probably fall, just as they have risen as rates have fallen. Eventually, rates will rise but in our view that is years away. Even when they do, the typical lease agreement (market-based resets at various points) may mitigate against this impact.
Generally, interest rates rise to inhibit an overheating economy. When the economy is strong it normally translates into higher rents. As rents grow, it flows through to earnings, paid out as dividends, or distributions as they are called in the sector. A-REITs can therefore mitigate somewhat against increasing interest rates, especially compared with fixed interest, where the income return is static.
4. Is the A-REIT market reminiscent of the pre-GFC period?
Definitely not. Debt is now lower and better managed, with a greater diversity and longer tenure. The earnings A-REITs produce are driven by rents rather than “corporate” earnings, where previously the sector chased over-priced assets. Overseas earnings are significantly lower and management teams more realistic and sensible
We believe the key risks that were substantially responsible for the magnified impact of the GFC on the A-REIT sector are now far lower than in 2006-7. The sector has returned to its roots and is all the better for it.
5. What’s the outlook for A-REIT distributions?
We expect steady increases in distributions based on lower interest charges (due to lower interest rates), underlying rental growth and potential accretive acquisitions.
Short to medium-term price spikes and dips will occur, but if investors take a view over five to seven years – as we recommend – low volatility, income and growth in total returns is quite achievable. APN’s objectives are to give investors income, low volatility, tax-advantaged income and capital growth. Despite this period of strong A-REIT share price rises, we are confident of delivering this.
6. Which parts of the sector have the best prospects?
There is long-term value in retail property. High barriers to entry typify much of the sector we are invested in. Investments in super regional shopping centres such as Chadstone in Melbourne and Bondi Junction in Sydney are likely to perform strongly. Well-located and managed assets that cater to daily shopping needs may also provide a steady earnings stream. Office portfolios exposed to the strong Sydney and Melbourne markets should also deliver earnings.
You are better off in a diversified, balanced portfolio of A-REITs than trying to pick individual winners. Diversification is just as important in this sector as any other, which is what the APN A-REIT Fund is all about. For those investors seeking geographic diversity away from Australia, the APN Asian REIT Fund, currently featuring a running yield of 6.10 per cent per annum, offers exposure to Tokyo, Singapore and Hong Kong – among the world’s biggest commercial office and retail markets.
(Current running yield is calculated daily by dividing the annualised distribution rate by the latest entry unit price. Distributions may include a capital gains component. Distributions are not guaranteed and past performance is not an indicator of future returns.)
7. What are the key themes to watch next financial year?
“Lower for longer” is likely to dominate. We agree with the Reserve Bank that inflation will trend lower and economic growth will not be above the long-term trend rate. We expect income investments to remain popular as a result.
If asset values continue to rise, debt as a proportion of gross assets should fall for most A-REITs, allowing them to borrow more (at low interest rates) to acquire more assets. Correspondingly, we expect growth in A-REIT portfolios to deliver higher earnings and greater diversity.
Mergers and acquisitions may be a possibility in coming years. GPT Metro Office Fund is currently being pursued by two suitors and we expect to see more of this kind of activity. Following the market rebuff to the Dexus Property Group’s proposal to take over Investa Office Fund we expect these transactions to be earnings positive to the target or run the risk of failure.
About the author
Michael Doble is chief executive office, Real Estate Securities, APN Property Group. For a copy of the PDS and more details about the APN A-REIT Fund click here. For further updates and insights, sign up for Review, APN’s monthly email newsletter. This article is for general information only, without taking individual objectives, financial situation or needs into account. Read the product disclosure statement for the APN A-REIT Fund before making any investment decision. Follow: @apngroup
Michael Doble is chief executive office, Real Estate Securities, APN Property Group. For a copy of the PDS and more details about the APN A-REIT Fund click here. For further updates and insights, sign up for Review, APN’s monthly email newsletter. This article is for general information only, without taking individual objectives, financial situation or needs into account. Read the product disclosure statement for the APN A-REIT Fund before making any investment decision.
APN Property Group 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.