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Opportunities in listed property

Photo of Grant Berry, SG Hiscock & Company By Grant Berry, SG Hiscock & Company

min read

Why the A-REIT sector is in excellent shape for continued solid returns.

There is good reason to believe we are at an advanced stage in the property cycle. Capitalisation rates (rental yields) are at levels as low as, or even lower than, previous peaks in property cycles.

The global environment of very low bond yields is supportive of property pricing, but we adopt a more cautious “through the cycle” approach in investment analysis.

The listed Australian Real Estate Investment Trust (A-REIT) sector on the surface is trading at a premium to published net tangible asset value (NTA).

However, when value is included for corporate activities such as funds management, development value-added, and property services, the sector is trading broadly in line with the current valuation of the direct property sector, but at a premium to our longer-term “through the cycle” valuation approach.

There has been a high and increasing level of indexation in the sector over recent years. This suggests an efficient market, but we believe this presents opportunities, as evident last year. The growing influence of passive (index) funds is potentially extending moves which, ironically, give active managers opportunities to exploit.

An example was occurring this time last year. There was nervousness about those A-REITs or property groups with “value added” thematics, such as residential development, and investors sought the refuge of A-REITs, which were perceived as safe.

This was notable in the case of A-REITs with high exposure to retail, traditionally regarded as the most stable and lowest-risk sector. This theme hit its peak post-Brexit into early September.

The valuation disparity between the two types of property groups (residential development and retail) at this point was very stretched and in our view, did not appropriately reflect the risk differential between the two. To us it felt that “safety” was being way overpriced, and was vulnerable to a material readjustment, but as always, the timing of these adjustments is uncertain.

Following Brexit, there was an easing back on monetary policy by central banks, and growing expectation of fiscal stimulus, which saw bond yields rise, and this provided the catalyst for the readjustment. There was a refocus towards growth-oriented investments and the “expensive defensives” sold off with a renewed interest in those groups that provided levers to growth.

The rotation was very quick once it started and painful for those invested in index funds and other funds holding significant weighting in the “expensive defensives”. The fiscal stimulus theme has continued in 2017 and seen many growth-oriented sectors benefit.

It is interesting that the expectation and subsequent announcement of Amazon coming to Australia has further compounded this rotation away from the “expensive defensive” retail REITs, now to such an extent that it is starting to feel like the flip side of last year.

For an active investor such as us, this represents a great opportunity to position for the inevitable rotation before it occurs.

Generally, balance sheets of A-REITs are in good shape, far better than before the 2008 Global Financial Crisis, and their gearing (debt to equity) is moderate.

With interest rates low, there is a temptation for A-REITs to borrow to buy property assets, but we are pleased to see that the A-REITs are not doing that. There is a far greater level of fiscal discipline in this sector now and this is one of the best things to come out of the GFC.

Retail sector and the Amazon effect
The headlines have not been great: multiple failures and administrations, the looming impact of Amazon, the continuing growth in on-line, the changing face of the consumer, price wars – the backdrop for retail is tough.

But many of the major shopping centres are managing the current environment well and are generally 99 per cent full. Retail sales are lacklustre on a comparable basis and re-leasing spreads continue to be tough and challenging. But they are better than they were.

There has been much discussion on the impact of Amazon coming to Australia. We are a bit more sanguine about it. We think it will impact some sectors, such as electronics, books and apparel. Food-based centres are well-placed, so we do not see Amazon’s arrival as having a big impact, especially in the short to medium term.

Concern about Amazon's arrival is more sentiment than reality and while sentiment will run its course, this should create opportunities within the sector.

High-quality super regional assets have, in the past, been referred to as “Fortress Malls” (given their high barriers to entry). The same cannot be said for premium office assets, which can be more readily replicated and hence we are at a very interesting relative pricing point between these two property sectors. The sentiment towards office is greater than retail. We see this as a cyclical, not structural, thing.

Office sector
There have been a couple of years of very strong net absorption (net demand for office space), though the latest figures have come back quite a bit on the take-up of space for Sydney, from around 150,000 square metres per annum to a more modest 50,000. Rents have still grown very strongly in Sydney and are robust in Melbourne.

Positively, maintenance capital expenditure and incentives for the office A-REITs are starting to come down a little, which is a bit of a tailwind. That was most evident recently in GPT's result.

In the most recent half-year reporting season, some of the office landlords were starting to talk about 2021, when the supply cycle will start to come on in the Sydney CBD.

Interestingly, last year people were talking about vacancy rates heading down to 3 per cent in Sydney. Now they are starting to look beyond this and recognising that supply will come about, and we would expect REITs to start implementing strategies to manage their leases ahead of that increase in supply.

A recent article in the Australian Financial Review reported a construction boom is set to begin across the Sydney office markets in the next two years.

We believe it is likely that the excitement about the office sector (especially in Sydney) will start to wane a little as a result.

Residential property
Last year there was a prevailing cautiousness towards those A-REITs with residential operations, with concern about peak cycle development activity and the risk of settlement defaults for offshore buyers.

The focus has been on default rates; Mirvac’s default rate has moved up to 2 per cent and Lendlease’s is less than 1 per cent. These appear to be modest levels and, importantly, they have been able to manage them; and where there have been defaults they have been able to on-sell units at a gain.

In addition, alternative sources of funding have emerged, so while there has been a level of defaults, they have been low and lower than during the GFC. We note that residential margins have been expanding for Stockland and Mirvac.

Affordability continues to be an issue in the Sydney and Melbourne markets. Given this, we are becoming more cautious but still expect continued higher residential property supply.

This is a positive for developers and more importantly, a positive for home buyers, as we believe that ensuring there is adequate supply is the critical issue in determining residential prices in the long term.

Fund managers
Goodman Group and Charter Hall Group have both had good headline numbers with strong growth. They are keeping their balance sheets in good shape. We also focus on the quantum of their performance and transactions fees. By their nature, they are lumpy and lower quality (in that they are less recurring) than other sources of income.

At some point the market will turn. We are close to peak capitalisation rates in office, and beyond prior peak capitalisation rates in industrial, so while there may be good embedded performance fees going forward, on any new deals, given more elevated pricing, the metrics are going to be far harder to achieve.

Westfield Corporation
There are different views on Westfield Corporation. Its earnings trajectory and revisions (to market forecasts) have been a bit underwhelming in the past 18 months because it has been selling lower-quality (higher-yielding) assets and has also been impacted by currency.

In a strong market, selling lower-quality assets is the right thing to do. Westfield is improving its portfolio and building what will be, in our view, the best quality retail real estate portfolio globally.

We believe Westfield is doing all the right things and therefore, in time, people will come to give it more credit. Those who are focused only on short-term earnings trajectory may be underwhelmed in the short term, but investing is for the long term and that is how Westfield is positioning its business.

Conclusion
The A-REIT sector is in excellent shape, which, given that we are at the latter part of the property cycle, is a very good thing. Modest levels of debt, high-quality portfolios and earnings streams, all position them well for when there is the inevitable property downturn.

Pricing, like most asset classes, is elevated. However, we believe pricing is consistent with the direct property market, and positions the A-REIT sector for modest returns over the next five years, but returns that are still likely to be superior to those achieved from investing in cash.
 

About the author

Grant Berry is a director and portfolio manager of SG Hiscock & Company, a leading boutique fund manager specialising in Australian equities and real estate.

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