[Editor’s Note: Do not read the following article as a recommendation to invest directly in A-REITs or funds or ETFs that invest in the sector. Like all sectors, A-REITs have risks. The sector can underperform when interest rates rise, the economy slows and property demand and property valuations ease. Growth in e-commerce and the work-from-home trend are longer-term challenges for the A-REIT sector. This article in the previous ASX Investor Update provides useful educational information on the features, benefits and risks of A-REITs, and is a good place to start for investors who are new to the sector. The following article provides more of a market update on A-REITs and is designed for intermediate investors with some knowledge of the sector].
Australian Real Estate Investment Trusts (A-REITs) sold off collectively over the course of 2022. Direct commercial property has proven more resilient, at least until recently.
The chart below highlights the underperformance of A-REITs (the S&P/ ASX 300 A-REIT Accumulation Index is the blue line in the chart) vs the broader equity market (being the S&P/ ASX 300 Accumulation Index, or orange line).
SG Hiscock has picked the commencing date of December 2021 as the A-REIT underperformance was over the course of calendar year 2022.
Source: Iress/ SG Hiscock and Company Limited
The chart above also shows, for the calendar year to date in 2023, the A-REIT sector has performed generally in line with the broader equity market.
When we think of traditional property investment, we think of the ability to generate income via rent. Over a long period of time, there is a relationship between property capitalisation rates (yield) and inflation-linked bonds.
Inflation-linked bonds historically have provided a positive yield base, with coupons that grow with inflation over time. Property provides a yield based on rent, which grows over a long period of time. The relationship makes sense.
However, real bond yields (inflation-linked bonds) declined to extremely low levels and were, in fact, negative in late 2021. Property yields also declined and it should follow that, as inflation-linked bond yields rise, there should be upward pressure on property capitalisation rates/ yields.
Prime cap rate vs. real bond yields
Source: JLL, Macquarie Research, June 2023
Overlaying this are the fundamentals. Rental growth has been very positive for industrial property. There has also been good outcomes for retail property.
Office has its obvious challenges, however data from Jones Lang LaSalle to the end of June highlights a more positive picture in that CBD net effective rents have grown well for Sydney (up 6%), Brisbane (up 5%), modestly in Perth (up 1%) and for Melbourne only slightly down (by 2%) over the past 12 months. This may surprise people when they read the negative headlines on office properties.
In summary, the decline in A-REIT prices is a multiple valuation adjustment as opposed to a deterioration in fundamentals, in SG Hiscock’s opinion.
The table below from JP Morgan highlights the valuation adjustments over the period from December 2021 (close to peak) to valuations (so far) in June 2023.
As observed, the most notable negative impacts have been in office properties followed by service stations.
Industrial property has had the greatest capitalisation rate (yield) expansion, however, strong rental outcomes have supported valuation growth.
Self-storage has been the best performer with strong rental growth as well as firming capitalisation rates. SG Hiscock’s view is that rental conditions for both industrial and storage should decelerate in a softer economic climate.
Cumulative Valuation Changes December 2021 to June 2023
Source: JP Morgan and SG Hiscock and Company Limited
* Major Malls within the A-REIT Sector have not reported June 23 Valuations.
The chart below highlights the implied underlying yield premium (being the implied capitalisation rate of A-REITs) based on trading price versus underlying book capitalisation rates at that given point of time.
In essence, A-REITs are implying a capitalisation rate expansion in the order of 1.3%.
Market implied cap rate expansion vs. last book values
Source: JP Morgan
The following chart is the implied discounts by the A-REIT prices to underlying property valuations at the most recent period for each interval.
Source: JP Morgan
In summary, valuation declines to date have been modest relative to what is implied across the A-REIT sector.
[Editor’s Note: For example, an A-REIT with a $1 unit price might have net tangible assets (NTA) of 80 cents, thus trades as a 20% discount to its NTA. The market might expect the A-REIT’s future NTA to fall as valuations of its underlying properties are marked down when next revalued. However, revaluations in direct property this year have so far been less then market expects, judging by average NTA discounts. Put another way, the downgrades so far this year, on average, have not been as bad as the market feared].
The table below highlights the total returns of the subsectors within the S&P/ ASX 300 A-REIT Index.
As previously mentioned, the material change to the high inflation environment, the commencement of the Reserve Bank raising rates, and the upward shift in real bond yields all transpired over 2022.
Reviewing the performance over the past 18 months, retail property has been the best performer, benefiting from the reopening of the economy and a strong consumer and rental income that responds more favourably to higher inflation.
Conversely, office has been the most challenged sub-sector, with weaker linkages to inflation as well as the impacts associated with more flexible working.
Industrial A-REITs have performed well over the past 12 months, with very elevated levels of rental growth supporting the sub-sector.
S&P/ASX 300 A-REIT Accumulation to 30 June 23
The biggest implied discounts to direct valuations tend to be in the office subsector, with implied pricing within the A-REIT sector in the order of 30% to recent valuations.
However, this does not necessarily mean that is where the best value resides, in SG Hiscock’s opinion.
Across retail, industrial and service stations we are observing implied valuation declines circa 10-20% and more modest declines of less than 10% for industrial.
Taking a 12-month view is challenging and certainly what transpired in each of the last three years is testimony to SG Hiscock’s approach to invest for the longer-term and take a five-year view.
Australian property is well placed for the longer-term, in SG Hiscock’s opinion. Recent research from CBRE predicts that Australia’s population will grow by about 14% over the years 2021 to 2030. This is more than double the rate of the United States and higher than Europe. High population growth, a transparent investment environment and a generally favourable economic climate is positive for property investment.
In recent months, SG Hiscock has been cautiously adding to office A-REITs in its portfolio as it feels that fundamentals, and most likely prices, have bottomed while cognisant that pricing in the direct market remains elevated.
SG Hiscock has also become more enthusiastic towards the residential exposed entities. While it seems that Australia is in the “eye of the storm” with rising interest rates, declining house prices and collapsing volumes, the medium-term fundamentals are strong, in SG Hiscock’s opinion.
There is a chronic undersupply of housing in Australia as evidenced by low vacancies and strong rental markets. This will be amplified as immigration hits record levels for the next couple of years and likely to remain elevated thereafter.
Interest rates are close to peaking and real bond yields (inflation linked bonds) - which are a key valuation input - are at reasonable levels, in SG Hiscock’s view.
A-REIT security prices have adjusted downwards over the past 12 months or so, whereas direct property has only started the process.
The question is: do A-REITs reflect where direct pricing will go or have A-REIT prices over-adjusted? SG Hiscock’s view is somewhere in the middle; direct property has some softening to go and A-REITs may have short term upside.
There are numerous risks with investing in A-REITs including those relating to quality of assets, subsectors, lease covenants and duration, capital management (balance sheet, interest cover etc) and management.
From a macro perspective, the risks of a deep recession, a credit crisis or a considerably more significant rise in rates would be the key risks to look out for, which can have material impacts. That is the nature of investing and not unique to A-REITs.
Taking a long-term view, SG Hiscock is comfortable with current A-REIT pricing and in particular, relative to direct market pricing for core real estate.
SG Hiscock & Company has prepared this article for general information purposes only. It does not contain investment recommendations nor provide investment advice. Neither SG Hiscock & Company nor its related entities, directors or officers guarantees the performance of, or the repayment of capital or income invested in the Funds. Past performance is not necessarily indicative of future performance. Professional investment advice can help you determine your tolerance to risk as well as your need to attain a particular return on your investment. We strongly encourage you to obtain detailed professional advice and to read the relevant Product Disclosure Statement and Target Market Determination, if appropriate, in full before making an investment decision. SG Hiscock & Company publishes information on this platform that to the best of its knowledge is current at the time and is not liable for any direct or indirect losses attributable to omissions for the website, information being out of date, inaccurate, incomplete or deficient in any other way. Investors and their advisers should make their own enquiries before making investment decisions.